The US Federal Government’s Debt Burden

The US federal government’s financial accounts end each year on September 30th. Last week the Treasury Department reported the government’s financial position for the fiscal year ended 2016, and it does not look good.

I will ignore for the moment the government’s negative net worth, which itself means that the federal government owes more than it can possibly ever repay. The next negative net worth statement will be reported in a few months when Treasury releases the government’s consolidated financial accounts. Instead I will focus only on cash flow, specifically the cash that comes into the government from taxes and borrowing, the total of which is the amount of cash the government spends each year.

The first point to note on the September 30th accounts is the deficit. The government last year spent more than it received in taxes and thereby incurred an annual deficit, which is not surprising because this mismatch between income and spending has been a perennial event. This difference between what the government received from taxes and what it spent was funded by the cash the government received from new borrowing, which of course increased the national debt. In the past year, the national debt grew by $1.4 trillion, which requires some explanation.

You will recall that the federal government was at an impasse on September 30, 2015. For months the Democrats and Republicans had locked horns over whether or not to approve a new budget. In the absence of that approval, Treasury was unable to issue new debt.

In order to get the cash it needed to keep operating, Treasury Secretary Jack Lew sold assets in pension funds and used other means including accounting gimmickry to sidestep the budget impasse and raise cash to keep the lights on in D.C. As a consequence, the deficit for fiscal year 2015 and the national debt at the end of that fiscal year was significantly understated.

When the budget was finally approved in the current fiscal year, the government unwound the accounting gimmickry and also borrowed what it needed to replenish the pension funds it had tapped to get cash. Borrowing in 2016 the cash that was actually spent in 2015 and not properly accounted in that year distorted the 2015 year-end accounts.

To adjust for this distortion, it is necessary to calculate average growth in debt over the last two years, which provides a reasonable estimate of the annual deficit for each of the last two fiscal years. That number is a staggering $875 billion in each year.

I say staggering deliberately because in each of the last two years, 21% of the cash the federal government spent came from new borrowing. To put this percentage into perspective, imagine the consequences if 21% of the cash you spent in a year came from cash that you borrowed. But as bad as this number is, it is only half the story.

The federal government has been given a windfall by the Federal Reserve. Its near-zero interest rate policy understates the true burden of the national debt on the federal government’s financial position. This distortion arises because the government is not paying a fair rate of interest on the national debt.

A large part of the federal government’s total expense is the cash it pays as interest to the holders of its debt. Therefore, the government’s cash outlay for this interest expense is obviously much lower when interest rates are near zero, than when it is paying a significantly higher fair rate of interest.

So to determine the size of this distortion, I decided to calculate the size of the windfall the federal government is receiving. It is $8.5 trillion, which is even larger than I expected. Here’s how I completed this calculation.

1) I first needed to determine what is a fair rate of interest. I therefore calculated the average interest rate paid by the federal government from 2000 through to 2007, which is 5.3%. I chose 2007 because it marks both the beginning of the financial crisis that led to the Lehman collapse and the Federal Reserve’s interventions to force interest rates lower.

2) I then applied this interest rate to the national debt from 2007 through to 2016 to determine what the annual interest expense paid by the federal government would have been if this 5.3% fair interest rate were applied to the national debt instead of the much lower rate actually paid because of the Federal Reserve’s policy that is keeping rates near zero.

3) I left unchanged the cash the government received from taxes and the cash it spent, except the interest expense. I increased it each year by the difference between the actual amount spent and the added interest expense the federal government would have paid using the 5.3% fair rate.

4) The net result of these calculations is that the additional interest expense increases the federal government’s annual deficit, which in turn increases the national debt as well. So if the federal government were paying a fair rate of interest on its debt since 2007, the national debt today would be $28.1 trillion instead of $19.6 trillion, a difference of $8.5 trillion

By any measure $8.5 trillion is a huge number, so it is understandable that its impact has been profound. First, let’s call this $8.5 trillion what is really is. It is a tax. More bluntly, it is the confiscation of wealth by the government, engineered by the Federal Reserve’s interventionist interest rate policy.

Everyone who held a T-bill, T-note and T-bond that was issued while the Federal Reserve was forcing interest rates to near zero received less interest income than would be the case if interest rates were not being artificially suppressed. In other words, they did not receive the interest income they should have received, which is an important point.

They were denied $8.5 trillion of spending power, which has had a direct negative impact on the US economy.  This $8.5 trillion is equal to about one-half of annual GDP. So removing this spending power from the hands of those who hold the national debt has no doubt impeded economic activity and partly explains the country’s insipid GDP growth.

Taxes are always a hindrance because they put a brake on economic activity. And the tax – or more accurately, the confiscation of income – resulting from the low interest rates imposed by the Federal Reserve is one of the biggest taxes of all.

The Federal Reserve’s stranglehold on interest rates has enabled it to make the federal government’s financial position – horrid that it is – look better than otherwise would be the case. The Federal Reserve has done this by significantly lessening the government’s interest expense burden, which in turn has also restrained the growth of the national debt. But it has come with a cost.

The resulting $8.5 trillion tax imposed on the holders of the national debt has seriously hurt economic activity. Further, that the Federal Reserve can impede economic activity to the extent that it has truly shows that the country is operating with a broken monetary system, which is a key point.

The Federal Reserve’s financial repression and D.C. politicians’ inability to control spending to achieve a balanced budget when taken together point to one loser, and that will be the US dollar.  It is only a matter of timing, which of course cannot be predicted, but there are some valuable clues.

The US core inflation rate last month was just recently reported to be 2.2% year-over-year.  That means the core inflation rate has now been above the Federal Reserve’s 2% inflation target for eleven consecutive months. So given the growing inflationary pressures that are steadily building, perhaps we don’t have long to wait before the dollar falls from its contrived perch.