As we approach another debt ceiling showdown in the midst of a government shutdown, people need to keep their cool and remember that this is just one more sideshow in a “theater of the absurd” procession of impasses that include the S&P rating downgrade of U.S. debt, the fiscal cliff and the sequester rankling episodes.
The media have played up every unfolding crisis, often politicizing and presenting each one as though it were a distinct and separate drama. But they consistently miss connecting the dots and explaining that each crisis is part of a continuum of the same problem that keeps moving the nation ever closer to the endgame, when global capital markets lose confidence in the U.S. dollar and dollar-denominated government debt.
The real threat is not a government default because of the failure to raise the debt ceiling, but rather the increasing risk of insolvency from creditors’ loss of confidence that U.S. debt is a good bet. Many fiscal hawks are rightfully concerned about the medium and long-term insolvency of Social Security, Medicare and Medicaid. However, it’s also vital to understand near-term risks that could turn the elusive smoke in the theater into an unstoppable blaze that would melt down America’s finances.
As the U.S. government debt clock strikes $17 trillion total, the current financing cost of the $12.6 trillion portion of interest bearing debt is about 1.98 percent, or $246 billion annually. True, the market has been manipulated by the Federal Reserve’s Quantitative Easing (QE) policies, which have artificially driven interest rates and the cost of financing government down.
But if financial markets teach us anything, it is that there is almost always a correction—a reversion to the mean or average. A few months ago, we got a taste of that and what may come in the U.S. government debt market.
When the Fed communicated a mere consideration of tapering QE in late May, bond markets immediately reacted. In just 60 days, 10-year U.S. Treasury rates rose 69 percent from 1.60 percent to 2.70 percent. So no one should doubt how quickly markets adjust to rumor in seeking new price and yield equilibrium.
The long-term average yield on 2-year and 5-year U.S. Treasuries is about 5.98 percent and 6.25 percent respectively. So a simple reversion to those average rates would triple U.S. debt service costs to about $750 billion annually. How will Washington handle an additional half trillion dollar debt service cost from interest rate normalization? Since Congress is so divided and unable to cut spending in any significant way, it might be assumed that the additional interest expenditures would likely be financed by additional borrowing.
But not so fast. When markets digest that the U.S. borrows to offset not only current deficits but also to cover most of the cost of its outstanding debt service, there could be a rude awakening. A breach in confidence in the creditworthiness of the U.S., however much a mere rumor, would precipitate a dramatic adjustment in the capital markets, a bit like a run on a bank.
Thus, perception of possible insolvency could quickly become reality. Such a crisis would likely cause federal debt service costs to skyrocket well above historic averages or norms — triggering a downward-spiraling liquidity crisis ending with the U.S. government unable to finance its obligations.
As messy as the current impasse over government spending and the debt ceiling is, it is necessary and constructive if it educates people about the virtues of the Constitution with its checks and balances and the specific vesting of Congress with the power of the purse to provide restraint against spending and debt that cause financial ruin.
Scott Powell is senior fellow at Discovery Institute.