Higher rates end up imposing a kind of discipline on the drunken party in government and even in the private sector. It would be a good thing.

By Wolf Richter for WOLF STREET.

There has been a lot of hand-wringing recently among the crunch deniers. They’re now saying in their latest barrage that the Fed can never raise its key rates above x%, like 2% or whatever, because the government can never pay those higher interest rates on its huge debt and will go bankrupt. And look, they say, interest payments have already jumped, and there’s no way the government could pay much more than that.

In the first quarter, federal interest payments on its debt jumped 11.7% year-over-year to $140 billion. OK, they’re still a long way off the Q2 2019 peak of $147 billion, but you kind of get an idea what they’re saying:

So let’s take a look.

Only newly issued debt bears the new interest rates. Existing bonds pay the same interest they have always paid, until they mature. There are a few exceptions, such as Series I Savings Bonds (I-bonds that people can buy directly from the government), TIPS, Floating Rate Notes, etc. But for the most part, Treasury securities pay the interest at which they were issued until they mature. At that point, they are replaced by new debt, and this new debt comes with current interest.

It is not the $30.5 trillion in total public debt that will suddenly cost more as interest rates rise, but only the newly issued debt. Thus, this higher interest charge will only gradually affect the debt.

Interest expense rose sharply due to soaring debt. Since March 2020, the gross national debt has increased by $7 trillion, or 30%, from $23.5 trillion in March 2020, to $30.5 trillion currently.

The spiraling federal government debt since March 2020 is nothing short of staggering. But it slowed in 2022 and is now back to its pre-pandemic growth rate. Obviously a spike like this can’t be sustained without some major redevelopment, say, like a big bout of inflation, I mean, oops…

But the burden of interest charges is near historic lows. Government tax revenue increases with GDP and inflation, as growth in economic activity and profits and wage inflation create higher tax revenue, and the creature of asset price inflation from the Fed has created higher tax revenues on capital gains, even though they will plummet as assets. are reviewed under QT and higher rates, and capital gains turn into capital losses.

Interest charges have therefore increased, but tax revenues have grown even faster with GDP, and the burden of these interest charges on the United States has fallen to 2.21% of GDP in the third quarter of 2021, the lowest since 1959.

In the first quarter of 2022, interest charges as a percentage of GDP reached 2.35%, still very close to these historic lows. The increase in the percentage is partly explained by the drop in GDP in the first quarter.

In 1985, during the Reagan years, interest payments first exceeded 5% of GDP, and remained within that 5% range until 1991, when the ratio began to fall, to as low interest rates gradually trickle down to debt. and as the economy grew.

For the data geeks: the graph is calculated from real quarterly interest expenditure in dollars (not seasonally adjusted annual rate) divided by quarterly nominal GDP in current dollars (unadjusted and not adjusted for inflation), expressed as a percentage.

Yield solves all debt demand problems. Who would want to own Treasury securities, given this debt and inflation? But here’s the problem: if people don’t want to buy 10-year Treasury bills at a yield of 3% when inflation is 8%, then the yield will have to rise until the sellers find a buyer, and at higher yields, buyers emerge. . At some point, a 10-year treasury paying x% yield will be a bargain, and demand always emerges after a price discovery.

Yield solves these kinds of demand problems. And the government will have no trouble selling new bonds, but they will have a higher yield – and therefore a higher outlay for the government, and a higher income for investors.

Higher interest rates reinforce discipline. Ultimately, higher interest rates combined with inflated debt levels will push interest charges to such an extent that they will increasingly hog the growing budget, and Congress will have debates about this. subject, and after some demagoguery, praise and the consideration of maximum lobbying money, there might even be a compromise on spending and taxes because the only discipline in a capitalist system is the cost of capital.

And if the cost of capital is zero, or is below zero in real terms, and for long enough, then there is no discipline, and the drunken party continues, and the debt continues to pile up, including in the private sector, until the problem is solved in another way: Massive inflation, but at a lasting and brutal cost to the economy.

Higher interest rates will impose a kind of discipline on the drunken party, including in the private sector, sober participants and prevent the kind of lasting destruction that massive inflation inflicts on the economy, and that would be a good thing thing.

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