Interest on the debt: Why all the fuss?

What’s the big deal about paying interest on the debt?  It only takes nine or ten percent of our tax receipts to cover it, but politicians everywhere keep moaning and groaning about it, as if it’s some kind of financial catastrophe.  But it isn’t anywhere near a catastrophe. 

In fact, if that’s all it takes to cover the interest on the debt, we should be happy to use even more “Other People’s Money” than we already are (including OPEC’s) for extra investments in things such as counterterrorism and oil independence incentives. 

Why interest payments aren’t a big deal
In order to eliminate the interest payments, we’d have to pay down the principal.  Obviously we aren’t currently choosing to do that; what we’re choosing to do is the opposite: eliminate the principal payments by continuing to pay the interest. 

I like it that way, and I’ve been trying to think of different ways to explain why for about two years now.  Maybe one of these days I’ll be able to turn a light bulb on in a politician’s head.  Maybe even two or three politicians, who knows?  (I’m an optimist.) 

Present value
This time, I decided to do a “present value” analysis of several different ways the federal government could elect to handle its current level of publicly-held debt—including paying off all of the principal immediately, all the way to never, ever paying off one dime of it.  Then I turned those spreadsheets into a movie, to make it easier to observe the different alternatives without falling asleep.  I hope it’s self-explanatory. 

And here’s the conclusion:

Summary
Should we pay off the principal to avoid future interest payments, or should we keep paying the interest to avoid future principal payments?  To the federal government, it doesn’t matter which policy is chosen for handling the interest and principal payments; the present value is the same in any case. 

To the private sector, however, it makes a big difference.  Paying down the principal requires the federal government to tax extra money away from us, so it can pay that money back to us in order to extract our Treasury bonds, bills, and notes.  Paying down the principal causes private sector net financial wealth to decrease by the amount of the Treasury securities that disappear from existence.  Not only do we feel less wealthy when the government pursues a debt-paydown policy, the economy usually tanks, too. 

That’s why I favor a policy of continuing to pay only the interest, leaving the principal intact.  To the feds, the present value is the same—so what’s the problem? 

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End notes:

• Debt held by the public isn’t exactly $5 trillion, but it’s close enough for government work, and also for purposes of this analysis.  [Update: My original posting of these graphics showed $4T instead of $5T, but they are now corrected.]

• Debt held by the public isn’t staying constant; it’s growing, and will grow even faster if and when the social insurance trust funds go into deficit.  But the main idea is the same: what’s the problem with growing debt principal and growing interest, if growing tax receipts in a growing economy keep the interest payments at a comfortable fraction of tax receipts? 

• The discount rate I chose was 5%—but any other assumption will yield the identical conclusion: no differences in present value of federal outlays for interest and principal among all the alternatives.

Comments

[ilsm]

Do "we" pay down the debt?

I need to think about the NPV analysis.

David Walker US Comptroller briefs defense acquisition personnel on the fiscal future each year.

Nov 06, he projects that if tax cuts expire in 2010, spending projections unchanged, interest as GDP rises to about 6% of GDP in 2040.

If the tax cuts do not expire interest as per cent of GDP could be 15% of GDP, about what he thinks medicare and medicaid would be.

[CoRev]

ilsm, how do you square your comment/hypothetical with Steve's scenario of a balanced budget in 08? One is more correct than the other!

[Patrick]

I was just looking at the FY2008 budget historical tables.

Interest payments as a % of outlays starting in 1989:

14.8 14.7 14.7 14.4 14.1 13.9 15.3 15.4 15.2 14.6 13.5 12.5 11.1 8.5 7.1 7.0 7.4 8.5

hmmm

q: can anyone tell me what "on-budget" and "off-budget" means?

thnx

[steve]

the key point to remember about paying interest on the debt or even paying it off, is that you are effecting an income transfer from taxpayer to bondholder. a net neutral in the sense that they are often one and the same. before people run off and complain about the money going to foreign owners, what do you think they are going to do with the cash that they wouldn't do already? right, same thing. paying off the debt is always a dumb idea. trying to maintain a budget balanced net of interest payments is not.

[Steve]

The toughest concept to communicate, in my experience, is the dynamics of growth. That's why I used a static number ($5T) in this illustration, in the interest of sticking with one concept at a time.

If the static model becomes clear, then it's easier to convey (subsequently) the dynamics of growth: when assets grow at least as fast as liabilities, we get better off, not worse off -- therefore, why aren't we debating how to enhance growth of assets (real and financial), instead of how to reduce financial liabilities?

I envision a vibrant future economy: $90 trillion debt, $140 trillion GDP. (Or change "trillion" to "quadrillion.")

[john]

Steve,

To keep the ratio intrest payment/receipts in balans is a sound senario. But to keep that balans maybe you have to pay down in good times and borrow extra in not so good times. ( We always are cutting cost in not so good times and spent when we feel good that even makes the up and down swings even stronger). But as you don't i am worried about intrest money going to much to foreign owners. It will be very difficult to keep the balans between intrest and receipts if the intrest is going outside our pockets. So we better can start saving again and keep this sound balans. The reason we do not see a doom senario already in japan with a 160% debt/GDP ratio is because of sound domestic savings and ownership.

[Steve]

john,

Think about what foreigners who collect T-bond interest can do with those dollars. (Three possibilities: keep them out of the US; purchase US-made goods or services; purchase US assets, real or financial, including more T-bonds.) Now try to think of how any one of those helps us vs. hurts us.

[ilsm]

CoRev,

The estimates are from the Comptroller General of the US, David Walker, as of Nov 2006.

The projections are long term.

He was on 60 Minutes Sunday worrying on Medical Costs in 2040, and not about the same level of obligations in his estimate to pay interest in 2040.

He may be a hack, but he is Comptroller General. Like going to war, we go bankrupt with the hacks we have.

I like Steve's optimism, but balanced unified budget includes increasing the debt held by OASDI and other intragovernment accounts, which grow even as the government does not have to increase borrowing from the private sector.

Being less optimistic I don't know if I will see a "balanced" unified budget in the same time.

I believe cash will used from surplus OASDI receipts to "balance" the unified budget in FY08..

[ilsm]

q: can anyone tell me what "on-budget" and "off-budget" means?

By law lots. OASDI and other accounts are off budget.

Discretionary programs and other pork are on budget.

The official reports separate these.

The reporting is on "unified budget" which includes all the cash surpluses and only reflects the mooney raised from T Bill sales.

That is why Steve posts both private debt and total debt.

The deficit we hear about is not the legally required report it includes all kinds of off budget stuff to make it look better.

[Bob]

Steve,

How many politicians let alone voters do you think can grasp discounted cash flow?

Anyway, perhaps moving away from the discussion of debt and moving to more discussion on growth could make things more interesting. Questions to be answered:

Why are we so afraid of growth?

What government initiatives need to be curtailed and what new ones need to be implemented to achieve growth? In other words, what laws (tax code or others) are restricting growth?

Why is ~2.5% real GDP growth constantly referenced as a manageable growth rate?

Many other questions, I'm sure.

[ilsm]

Teah, shoot I can do that on .xls in a second.

Why am I afraid of growth?

I am afraid of growth of the gumint.

I am concerned we need the gumint to borrow to get growth.

I am concerned that the gumint spends money on things that do not support growth now or ever.

So, can the US economy grow without gumint deficits?

If no why not?

If no what does the gumint do to promote net worth?

[Bob]

ilsm:

No inference made that the government has to borrow for the economy to grow. Nevertheless, as the economy grows (and the tax receipts with it) one thing you can make book on is the government will grow NO MATTER WHICH PARTY IS IN POWER.

So, conceding that fact we need to discuss just where the government is going to grow so that it adds value instead of destroying it.

And yes, Excel makes it easy to plug in cash flows and a discount rate to compute PV. But, my question remains the same: How many people understand what the numbers mean and when to use them?
And if too few people understand it then should not the topic of growth (new businesses and jobs and increased income) be stressed?

I've been in corporate America and have (more than once) seen how a hunker down, rob peter to pay paul philosophy creates a destructive malaise. Playing catch up sucks big time.

In a previous post Steve quoted Red from Sawshank - "Get busy livin' or get busy dyin". I'll take the former thank you very much.

[Steve]

Bob,

"How many politicians let alone voters do you think can grasp discounted cash flow?"

Close to zero politicians, for sure, and less than 1% of voters (my guesses). So why does our Comptroller General tour the nation advertising $60 trillion "PV of future liabilities"? To scare people into signing up for his agenda. Why do I show a PV analysis? To balance the fear-peddling by officials like that who should know better, but apparently don't.

You're right, though: more discussion of growth is needed, and that means more debate about how the government could better "invest" for the future. By the way, I consider national security and homeland security an important form of investment, because effective spending along those lines is "destruction prevention."

[Bob]

Steve,

I'm with you on defense and security. It can start RIGHT NOW with our southern border as far as I am concerned.

Lets assume though that there won't be skimping on defense going forward (far left loons aren't that powerful). So the debate comes back to investing in the future and the future, IMO, is all about innovation and discipline in these areas:

Education
Energy
Health Care

Maybe some other folks can name some other priorities (the absurd tax code comes to mind) but I'm all for focussed agendas. We don't need an extensive laundry list of programs.

[john]

Just some thinking(I'm far from an economist):

So what we want to do here is keep the ratio intrest payments/receipts at a constant level. So GDP growth ratio, the intrest ratio on debt, debt growth ratio, receipts/GDP ratio all influence this balans!?
Receipts/GDP ratio we have to keep constant also i think.
So if GDP growth slows or the intrest on debt gets higher we have to slowdown the debt growth.
So if GDP growth gets higher or the intrest on debt gets lower we can add even more debt.

[Jon Thompson]

Bob,

I'm very sorry I have to say this, but you meant to say that there was no implication, not inference, made. Clearly, ilsm did infer something.

Regardless, I don't believe that the government has to borrow for the economy to grow, and I think that in good times we should press hard for a balanced budget, and let the deficit grow to increase demand during recessions (I'm not a neo-Ricardian).

However, I basically think that is what is happening. I don't care about the total debt (I don't say that my pants owe money when I shift a dollar from the right pocket to the left pocket), and I don't care about the total deficit. On the other hand, the real deficit is now 2% or so and dropping nicely (we have a structural surplus again, which Japan and Germany don't).

So, while there are many things I'd like, I don't see any reason not to be relatively optimistic about the near future. And in the long run, the effects of the baby boomers retiring will dwarf everything done in the next decade anyway.