Washington: The mother of all

This relatively short-term debt maturity is no accident. During its first term, the Obama administration has added close to $5 trillion to the US debt. In order to make budget deficits appear lower than they really are, the administration chose to finance all of this debt at a rate of 0.3 per cent in two-year bonds, rather than at 2 per cent in 10-year bonds. As a result, net federal interest payments are lower than they were in 2007 and lower than they were in nominal dollar terms even in 1997, when public debt was a mere $3.8 trillion. This disguises the magnitude of the debt threat and only postpones the problems to a later date, “kicking the can down the road”, as it were. As of January 2012, the US government is paying an average interest rate of 2.24 per cent. As recently as 2007 the government was paying 5 per cent on its debt, which is the average of the last two decades. During the 1990s, the average was well above 6 per cent.
If the US government had to pay the 5 per cent rate that it was offering before the financial crisis on today’s debt, the annual interest payments would be $535 billion, a 100 per cent increase. And in the event that rate goes up to 6 per cent, the annual interest payments of $642 billion would surpass total federal spending on Medicare, currently at $484 billion. Federal Reserve Chairman Ben Bernanke has reiterated time and again that interest rates will be kept at the current low level for at least another two years but a rate hike cannot be ruled out altogether. Should the US economy recover robustly, the Fed may have to raise rates to forestall inflation.
One remedy the US Treasury could look at is to borrow for a longer term at today’s low rates. This would make a lot of sense but given the magnitude of the current debt load, investors have lost the appetite for 30-year bonds at such a low rate. The risks of rate increases or inflation are too great. Last year the Fed purchased a stunning 61 per cent of the total net Treasury issuance. This not only creates the false appearance of limitless demand for US debt, but also the Fed is in effect subsidising US government spending and borrowing. In recent years foreign investors and the US private sector have grown less willing to fund the US government debt. In 2011 foreign purchases of US Treasury debt plunged to 1.9 per cent of GDP from nearly 6 per cent in 2009. Similarly, the US private sector, namely banks, mutual funds, companies and individuals have reduced their purchases of US Treasury bills to a scant 0.9 per cent of GDP from a peak of more than 6 per cent in 2009.
Sooner rather than later the Fed has to manage the withdrawal from its historically accommodative monetary policy. Lessons from the recent European sovereign debt crisis and past emerging market financial crises illustrate how it is often the adjustment between budget borrowing requirements and the market’s appetite to fund deficits that triggers a crisis. Budget deficits often take years to reduce, while financial markets do not have the same patience. The longer the delay, the bigger the problems will be. The failure to curtail ballooning deficits puts the US and global markets at risk of a sharp correction. If not handled properly, this debt time-bomb will make the European debt crisis look like child’s play.

Teera Phutrakul CFPTM
Teera Phutrakul, a certified financial planner, is the founder of JT Financial Planners, an independent financial planning firm (www.jtplanner.com)