I read through some of “The Budget and Economic Outlook: Fiscal Years 2010 – 2020″, published by the Congressional Budget Office (CBO) in January 2010, by Doug Elemndorf, Director of the CBO. Fascinating stuff… really… if you’re into horror stories.
Given all of the recent talk about sovereign debt, potential downgrades of various countries’ credit ratings, etc., I thought I’d take a cursory view of the United States Budget projections with respect to our ability to service our own debt. I have my own theories as to what our current situation is and what our prognosis is going forward (not good), but for this post, I’m going to simply look at one aspect of our current fiscal policy – debt service.
Loosely speaking, your “debt service coverage ratio” measures your ability to make payments on your debt by comparing your payments against your income. In the classic case, the payments consist of the amortization of both interest and principal. For example, when someone applies for a mortgage, the bank will typically look at the cost of the principal + interest + taxes and divide that by your income. They’ll want to see a ratio of less than a certain amount, say 32% or whatever. That ratio will help determine if you are making enough money to afford the particular loan you are trying to qualify for. Most people who have bought a house should follow that example pretty well, having gone through it.
Thinking that this is a reasonable way to look at finances, I wondered how the federal government’s interest payments compares to its income. This first graph shows the percentage of the government’s projected income that will go to pay interest from 2010 – 2020 (all data directly from the CBO report). Note that this is interest only and does not include repayment of principal.
It looks like the amount of income that will go to pay interest on our federal debt ranges between 17% and 24%. Now that doesn’t sound anything like Greece, so maybe we’re not in that bad of shape. But let’s take a look at some of the CBO’s assumptions in this projection: inflation will never rise above 2.0%, GDP will increase to 5.6%, unemployment will drop to 5.0%, the Ten Year Treasury will only increase from 3.6% to 5.5%, the Bush tax cuts are allowed to expire (taxes are raised), and the Alternative Minimum Tax “fix” is no longer fixed (i.e. AMT taxes hit more people in the middle class than ever.) In other words, the perfect economy plus some increased taxes.
This is in spite of flooding the market with trillions of dollars in fiat currency during a time of decreasing production (the classic definition of inflation is more money chasing less goods), monetizing a large chunk of the debt, and continuing to spend more money than the government takes in by an average of $600 billion every year over the next decade (again, according to the CBO).
Call me a chicken-little, doom and gloom actuary, but I don’t think that this makes a lot of sense. While I hope things go well, let’s do a little sensitivity testing. What if, due to some of the above mentioned facts, inflation actually goes above 2%? Not an unreasonable question. Or what if, in continuing to sell more Treasuries to pay for our ongoing deficit spending, we have to increase rates more than anticipated to continue to attract buyers? Or what if the Fed needs to raise interest rates more than the modest amount assumed in these projections in order to try to keep inflation down?
All of these sorts of very plausible “what-if’s” would cause rates to increase more than the CBO’s projection. Let’s say that interest rates go up 2% or 4% more than the rosy CBO scenario suggests. What will happen to our “debt service ratio?” Remember the power of compound interest folks and look at the next graph. The red line shows rates up by 2%. The blue line shows rates up by 4%.
Not a pretty picture. If rates go up 4% more than expected, then the debt service jumps from averaging 20% of revenue to 40% of revenue. Carefully consider what that means. In order to get that ratio from 40% back down to 20%, the tax revenue would have to be DOUBLED. Tax revenues, to my knowledge, have never been doubled. The other alternative would be that the government would have to cut enough other expenses out of the budget to make room to pay for the additional cost of the interest payments. I have never known the government to implement a 20% across the board cut. In fact, they’re rioting in Greece, literally burning bodies in the street, due to that country’s austerity plan, whose cuts are not even close to 20%.
If this isn’t enough to make your head explode, consider that raising interest rates causes the cost of capital to go up, plus the aforementioned tax increases cause economic growth to be stunted, and total tax revenues don’t meet the rosy projections in the CBO’s baseline scenario. For example, due to the recession, federal revenues dropped by 1% from 2007 to 2008. They dropped by 17% from 2008 to 2009. During the previous recession, revenues dropped by 2% in 2001, 7% more in 2002 and an additional 4% in 2003.
What happens if tax revenues fall 10% short of the CBO’s projections in 2010 because a 2% or 4% unanticipated rise in interest rates holds the economy down. This is not unreasonable. After 2010 I assume that revenues will continue to grow going forward at the CBO’s assumed growth rate. This is just a one year hiccup. Here’s the result:
Or what happens if the one year hiccup is a 20% shortfall in tax revenues from the CBO’s projections because a 2% or 4% unanticipated rise in interest rates holds the economy down. Debt service of over 50%, that’s what:
So, according to the CBO’s rosy baseline scenario, we are adding an average of $600bil per year to our debt by spending $600bil per year more than we collect in tax revenue. The graphs above are simple “what-if’s” given some very plausible scenarios. The results would be catastrophic.
Still don’t think that whole Greece thing could happen here?
