Debt's Impact Could Be Worse If Interest Rates Rise

Jul 22, 2011

For all the attention lately on the ballooning size of the national debt, short-term interest rates are so low that the government, at least at the moment, can borrow that money almost for free.

"Right now, with money as cheap as it is, the deficit is not a drag at all," said Albert "Pete" Kyle, a finance professor at the University of Maryland. "But if you look at what's coming in the future, the potential drag that you see in the future is a really big problem."

This has everything to do with interest rates. With rates so low, it's as if the government is floating trillions of dollars in debt on one of those zero percent credit-card offers in the mail. Those are great while they are at zero percent, but if you don't pay the card off before the rate resets and shoots up, you can be in big trouble quickly.

"That's exactly the problem the federal government's facing," Kyle said. "So the big danger to the U.S. economy going forward is that interest rates go up."

'The Cost Is Real'

Especially if they go up faster than the rate of inflation. Now, it's not as if there's some date set in stone where the government will suddenly have to pay higher interest rates. But most analysts say rates won't stay this low forever. You don't have to go back too far in history to see interest rates that were much, much higher: In 1980, banks' prime lending rate stood at 17.75 percent.

But rates don't have to spike that high to cause big problems. That's because with the size of the national debt right now, nearly $15 trillion, any increase will start siphoning mind-boggling amounts of money out of the treasury.

"When you have $15 trillion in debt, 1 percent on that is $150 billion," said Scott Simon, a top bond investor at Pimco. "So the cost is real."

Kyle says most analysts expect short-term rates will start rising. He says they predict "interest rates will, starting about a year from now, rise a percentage point a year, and they'll do that for several years."

So five years from now, Kyle says just the interest on the current level of national debt could cost $750 billion a year.

"That's a lot of bridges not getting built or Medicare not getting paid," he said.

'Insane' Politics

But for now, the economy has to make it past the Aug. 2 deadline for raising the debt ceiling. Whatever their thoughts on the deficit, just about nobody in the business world wants to see lawmakers force the U.S. Treasury to default.

"The Treasury note is the single most important security. It cannot default. It would be a horror story globally," says David Kotok, chief economist at Cumberland Advisors. "The politics of this are insane."

Kotok says a default would set off a terrible chain of events: Interest rates could spike right away, banks could go insolvent and the housing market might collapse.

"You run the risk in a default by the United States of a catastrophic meltdown like we saw when Lehman Brothers failed or AIG failed — only much larger," he said.

So far the stock market seems to be betting that lawmakers in the end won't take that risk and will work out a deal to avoid a default.

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