Batten Down the Hatches

The following essay was published in the Winter 2011 edition of Virginia Capital Connections. It serves as a useful reminder of the fact that the looming insolvency of the federal government, and of state governments dependent upon federal largesse, is not some fable foisted upon the American public by shadowy, union-busting billionaires as some commentators fantasize.

Please note: The numbers employed here do not come from “right wing” or “libertarian” think tanks. They come from that hotbed of reactionary conservatism known as The Office of Management and Budget, whose director reports to President Obama. Here in Virginia, we can live in la-la land making up stories of conservative boogie men whose demented goal is to expedite the transfer of wealth from the middle class to the Koch brothers… or we can recognize reality in order to better adapt.

O

ne unalterable fact will shape the debate over the size and scope of federal, state and municipal government over the next decade: Interest payments on the national debt will become overwhelmingly, mind numbingly large. It is impossible to hold meaningful discussions about taxes and spending priorities without fathoming this harsh reality.

According to projections made by the Office of Management and Budget (OMB) in its fiscal 2011 mid-year review, net interest paid on the federal national debt will metastasize from about $220 billion this year to more than $900 billion by 2020.
That’s an increase of nearly $680 billion, and it compares to the $754 billion in increased spending planned for national security… plus discretionary domestic programs… plus Medicare… plus Medicaid. In other words, the national debt is getting so big, and growing so fast, that servicing the national debt will, at a minimum, start crowding out all other types of federal spending, including aid to states and municipalities, by the end of the decade. And that’s the optimistic view.

The Obama administration has every interest in putting the best possible gloss on the budget forecast. Last summer’s estimate (there should be an update in February) was based on two critical assumptions: that economic growth would rebound strongly and that interest rates would remain tame throughout the decade. And, oh, by the way, the projections did not include the parting gifts from the last Congress, which extended the Bush tax cuts, temporarily reduced the payroll tax for Social Security and goosed unemployment benefits, all of which should add more than $800 billion to the national debt over the next two years.

While the Obama administration projected the economy to come rip-roaring out of the Global Financial Crisis in an expansion rivaling the Clinton-era Internet boom, at least in the early stages, it seems increasingly apparent that the rebound will be tepid. The economy is
improving, but it is not beating expectations. Tax revenues are likely to come in below forecast.

As for interest rates, the U.S. Treasury has been the beneficiary of the lowest borrowing costs in decades, resulting in interest payments that are considerably below forecast. But the rock-bottom interest rates will not last long. As the economy picks up speed, private borrowing will push interest rates higher. If Europe resolves its sovereign debt crisis, hot money will flow from the safe haven of U.S. Treasuries back to Europe, pushing interest rates higher. If Europe does not solve its debt crisis, it will be because Greece, Ireland, Portugal, Hungary and perhaps even Spain have defaulted on their bonds, which will mean terrified investors will demand a risk premium for sovereign debt everywhere, including the U.S. … which will push rates higher.

Finally, as older Boomers retire this decade, moving from the wealth accumulation phase of their lives to the wealth-drawdown phase of their lives, they will exert downward pressure on the U.S. saving rate, which will… push interest rates higher.

What few Americans appreciate is how extraordinarily sensitive the U.S. budget is to interest rates when the national debt is $14 trillion While the Obama team assumes interest rates on 10-year Treasuries will never exceed 5.3% in the 2010s, some analysts say that rates could reach 10%. Nobody knows for sure what interest rates will do that far ahead. But it is indisputable that, if 10% interest rates transpire, they would be disastrous for the federal fisc.

When writing my book “Boomergeddon,” I asked Chmura Economics & Analytics, a Richmond-based economic consulting firm, to run some alternate budget scenarios for me. We assumed that interest rates would stay low for three years, as the U.S. benefited from European debt woes, then started an upward march to 10% by 2020 for the reasons described above. Under that scenario, the “miracle of compound interest”—a miracle for savers—would become the “horror of compound interest” for the world’s largest borrower, the United States. Propelled by swelling interest payments, deficits and the debt would mount higher with alarming speed. According to Chmura’s projections, deficits by the end of the decade under that scenario would be running between $2.5 trillion to $2.8 trillion a year, and the national debt could reach as high as $36 trillion!

Of course, we will never actually experience numbers like those. Financial markets would panic long before the national debt passed $30 trillion. The combination of escalating retirement benefits for the wave of aging Boomers and runaway interest payments would plunge
the U.S. into default—an event I call Boomergeddon. Investors would stop lending money, and federal spending then would be limited to what the government brought in from taxes, perhaps 60% of what it had been spending. The other 40%, equivalent to about one tenth of the entire economy, would go poof! The economic downturn would be two or three times as intense as the recent recession, as painful as that was.

Averting this scenario should be the No. 1 preoccupation of President Obama and the Congress. And preparing the Old Dominion to survive this trauma should be the No. 1 preoccupation of Virginia lawmakers. Our economy is more dependent than almost any other state economy upon federal spending. When Uncle Sam goes into default, the impact will be felt here first. Our AAA bond rating will not long survive a collapse in federal spending.

Even though Boomergeddon may be 10 or 15 years off, we need to start preparing now. We cannot conduct business as usual on the assumption that the dysfunctional political system in Washington, D.C., will fix the problem. We must avoid taking on new long-term debt, fully fund our public employee obligations — trust me, it will not get any easier to do it 10 years from now—enact productivity and quality reforms in our health care system, and otherwise batten down the hatches. Boomergeddon will be quite a storm.

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