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Time is running out on deficit control

Borrowing from a recent editorial by Caroline Baum of Bloomberg, four figures will be used to explain why U.S. debt matters. They are:

  • 2.2 percent;
  • 62.8 months;
  • $454 billion;
  • $5.9 trillion.

First, the 2.2 percent represents the average interest rate earned on a U.S. Treasury bond. This is actually a very low rate and represents how much interest the government must pay to attract investors to buy bonds. While that sounds great, this can actually be bad because it encourages government to finance higher deficits.

This process of financing debt takes place through the U.S. Treasury Department, which offers a wide assortment of bonds (also known as debt securities) that range in maturity. It includes Treasury bills that are short-term debt obligations that can range from a few days up to six months. Then there are Treasury bonds and notes that have more than a year in maturity and can be as long as 30 years. While investors are paid interest and principal once for U.S. Treasury bills, interest is paid every six months on U.S. Treasury bonds and notes.

The U.S. government must issue these debt securities because they currently spend more than they take in from tax revenues. This is similar to an individual, who uses a credit card when their current income is not sufficient to meet their needs. While most individuals face a much higher interest rate than that, the U.S. government can attract a much lower interest rate due to being the strongest economy in the world and also never being late once on an interest payment.

That leads us to 62.8 months, which is the average maturity of a U.S. debt security. This is a little more than five years. Given that a U.S. Treasury bond lasts for 30 years, that should give you an indication that the U.S. is relying on short-term financing. Even though the U.S. currently pays a very low interest rate, we should be concerned whether we can refinance our debt at these low interest rates in the future.

To further illustrate that point, let us look at the last two figures of $454 billion and $5.9 trillion. The $454 billion represents the interest owed annually by the government, while the $5.9 trillion is the amount of U.S. Treasury debt securities that will mature within five years, which would represent almost 40 percent of overall debt outstanding.

Given the current trend and historically low interest rates, we should not be surprised if those maturing bonds are renewed at higher interest rates. That is important because most consumer and business credit are indirectly tied to the yields earned on U.S. Treasury bonds. If those yields rise, then it becomes more expensive for consumers to take out loans and businesses to invest in job-creating opportunities.

Another factor is that higher yields on bonds will mean more interest paid by the government. That will lead to less funding available to spend on various government services, such as Social Security, Medicare, national defense, and transportation.

Actually, the U.S. should be facing more of the consequences for consistently running high budget deficits, but actions from the Federal Reserve have been effective in keeping interest rates artificially low. Usually, bond investors become wary of governments that resort to excessive borrowing to finance government spending because there is greater concern of credit default. However, the Federal Reserve has covered this shortfall by purchasing approximately 61 percent of all U.S. government bonds issued, according to Center for Financial Stability President Lawrence Goodman. That is a massive amount.

While these measures likely prevented a more painful economic downturn, it is not a sustainable strategy and carries substantial risk in the form of inflation and global instability. A trip to the local grocery story and the gas pump indicates we are facing higher prices. While signs of turmoil in China and other developing nations that are facing a glut of U.S. dollars due to the Fed’s actions are dealing with possible asset bubbles that can result in devastating economic corrections similar to what the U.S. experienced in 2008.

In order to reverse this negative trend, we need bipartisan cooperation that achieves significant, but responsible deficit reduction that balances fairness without sacrificing economic growth. We must resist partisan policies that either contribute to growing income inequality or severely curtail economic growth. It is essential that we find common ground in making tough decisions.

However, time is running out. Hopefully, our politicians will swallow their egos and act in the best interest of our country rather themselves.

Aaron Johnson is the assistant professor of economics at Darton College in Albany. In addition to his teaching duties at Darton College, he is also a board member for the Albany Dougherty Economic Development Commission and the Albany Dougherty Planning Commission. He also publishes a blog on economic and financial literacy at http://www.econprofaj.wordpress.com.