Saturday, May 19, 2012

It's 8:00 AM, do you know where your tax money is going?

 
How does the federal government spend your money?

Before your eyes glaze over and you click to a new page, this is a topic that on some level all Americans need to understand in a way that until recently citizens of the EU PIIGS really never did.

Consider that for every dollar that you, the American taxpayer, sends to Uncle Sam in the form of taxes, it is spent as described in the chart above.

Remember that this money we send to the IRS are not nearly enough to fund federal government operations so as a result the country is running deep in the red, issuing debt and pumping up the federal deficit to a point that would have been unimaginable just a few years ago.

While the columns marked "Medicare and Health" and "Social Security and Labor" are frightening enough, eating up 33.6 cents of every dollar spent, I'd like to focus on the column marked "Interest on Debt"!

These interest payments on the federal debt currently consume 14.5 cents of every dollar taken in.


Is paying that amount of federal tax receipts for interest payments on the federal debt really so bad?

If we use historical interest rates and the amount of interest that's been paid on the federal debt in the past as a gauge, it would seem to any rationale thinker (Washington politicians do not qualify) that it is!

At some point this debt bomb is going to pose a huge operating problem for the country where right now for many it is merely a political talking point.

Because as some EU countries are finding out, there is a very expensive price to pay when the markets thinks that there is risk to a return of their money from investing in your bonds!

While historically US treasury bills have been used as a proxy for the risk-free rate (until recently, historically the US has also had a AAA rating), if at some time there is the smell of blood in the water the bond market vigilantes as well as the basic investor will cause a spike in the coupon the US government needs to offer in order to find buyers.

Currently Washington operates under the assumption that, as mentioned above, we are one of the two games in town for investors who want to protect their money (Germany is the other).

If we simply assume that this will always remain the case no matter how we handle our financial affairs, we are sorely misguided.

This is of course an entirely separate issue from the fact that macro-economic conditions will at some point force interest rates higher.

Interest rate comparison!

In January 2000 the blended interest rate being paid by the federal government was 6.41% and the amount of interest payments to service the outstanding debt was $361.99 billion.

In 2011 the blended interest rate being paid by the federal government was 2.37% with interest rates on new debt and rollovers even lower than that.

Incredibly the yield today on the US treasury 10-year is 1.70%.

With today's Obama-inflated deficits, the unbelievable level of US government debt outstanding and interest rates 1/3 what they were in 2000, the amount of interest expense to service this outstanding treasury debt in 2011 was $454.4 billion compared to the $361 billion in 2000.


Here's where the problem is going to come in!

Because of the artificially low level of interest rates courtesy of the Federal Reserve, quantitative easing and other similar programs like Operation Twist, even with the huge increase in outstanding treasury debt the interest expense for the country in 2011 is up less than $100 billion over 2000 (see chart below).

Now, consider the interest expense on the approximately $15 trillion of marketable and non-marketable treasury debt outstanding when rates ultimately revert to the normal levels or quite possibly higher than the norm if inflation does what some people expect.

Even if they only went back to 2000 levels we are talking about a 400 basis point increase on a whole lot of bonds.

As an example if you pay 1.7% on $1,000 of debt it is $17.00 out of your pocket every year. If you now have to pay 6% it is $60.00 right? Big increase but on only $1,000 it may be somewhat manageable.

Now take that increase and apply it to $15 trillion in debt and even for Washington we will be talking about real money!

Where would the country get that money? Higher taxes of course along with the impact to any economic growth we may have at that time.

And remember, back in the early 1980's interest rates were in the high double digits. Where will we be if that ever happened again?

While the talking heads and government officials talk about interest rates as if they don't really matter and rising debt as if it's simply a necessary evil, nobody really explains to the American people what is going to happen when rates go up as they inevitably will.

Remember that "There is no free lunch" and that eventually the piper is going to need to be paid!

Chart Source
Chart Source







 
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