As another debt ceiling showdown approaches in the midst of a government shutdown, people can cool their heels, knowing there will be no default. 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 similar past crises, often politicizing and dramatizing each one as though it were distinct and separate. 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 creditors’ loss of confidence that President Obama and his party are serious about getting the national debt under control. Clearly medium and long-term liabilities of Social Security, Medicare and Medicaid need to be reduced. However, it’s also vital to understand interest rate and market risks that could undermine solvency in the near-term.
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%, or $246 billion annually. This historically low borrowing cost is the result of Federal Reserve’s Quantitative Easing (QE) policies. But that policy is reaching the end of its usefulness.
Moreover, 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 a warning of what is in store for the U.S. government debt market.
When the Fed communicated a mere consideration of tapering its Quantitative Easing program in late May, bond markets immediately reacted. In just 60 days, 10-year U.S. Treasury rates rose 69% from 1.60% to 2.70%.
Over the past 50 years, the average yields on 2-year, 5-year and 10-year Treasuries, have been 5.98%, 6.25% and 6.58% respectively. A simple reversion to average interest rates would more than triple U.S. debt service costs from $250 billion to over $750 billion annually.
How will Washington handle an additional half trillion dollars in interest payments on our debt? With Congress divided and unable to raise taxes or cut spending in any significant way, it might be assumed that the additional interest expenditures could be financed by additional borrowing.
But not so fast. When markets digest that the U.S. borrows to offset not only the deficits of government operations, but also the cost of its outstanding debt, there could be a rude awakening. A breach in confidence in the creditworthiness of the U.S., however remote or based on rumor, would precipitate a dramatic adjustment in the capital markets, a bit like a run on a bank or what happened in Greece.
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.
So, as messy as the current impasse over government spending and the debt ceiling is, it is necessary and constructive for Congress to do its job. The Constitution grants Congress exclusively the power to appropriate funds. This power of the purse is one of Congress’ primary checks on the executive branch and the debt that will cause financial ruin.
Scott Powell is senior fellow at the Discovery Institute.