There are still a few years left in this bull market for stocks and economic expansion. When this bull market is over, there will be a normal bear market and a recession. But that bear market and recession may be exacerbated by the U.S. government’s debt.
The U.S. government’s debt
The federal debt stands at just below $20 trillion right now. Let’s assume that in a few years, the government spends as much as it does today and the debt doesn’t increase. (The government will likely spend more and the debt will increase in a few years. That only makes matters worse).
The government spends approximately $4 trillion, of which 6% goes towards paying interest on the Federal debt. This amounts to just under $250 billion a year.
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Why the debt isn’t a problem right now
The doomsayers aren’t right. The federal debt has not “crushed” the U.S. government yet.
But they aren’t entirely wrong either. The only reason why the government pays so little on its debt is because interest rates are at all time lows.
- The 30 year Treasury yield is at 2.7%.
- The 10 year Treasury yield is at 2.4%.
Of course, not all of the government’s bonds have been sold at such low interest rates, but much of it has been sold at mid-low single digit yields. This is a historic abnomally.
Why the debt will be a problem in a few years
With the U.S. economy approaching full employment (NAIRU), inflation is coming in late-2018 to 2020. And when it does, interest rates go up. In addition, the Federal Reserve plans to sell trillions of dollars worth of bonds in the next few years. These 2 factors will push Treasury yields up.
As a result, the U.S. government will be forced to borrow money at higher and higher interest rates. If 30 year yields go from a mere 3% to 6%, which historically is a normal target during inflationary periods, the burden of the U.S. debt will double!
This means that the government will have 1 of 3 choices:
- Cut spending in other areas.
- Increase the debt more and more.
- Print money.
Cutting spending during a recession is disastrous. That’s part of what led to the Great Depression.
Raising more debt is difficult during recessions because very few people have money left to buy bonds!
Printing money will merely exacerbate the problem. It pushes inflation and yields even higher, making the government’s debt problem more painful.
The ridiculous solution
An economist raised a solution to this problem. We find his solution to be ridiculous.
The government doesn’t need to finance its debt via long term bonds. It can simply finance its debt via short term bonds. The Federal Reserve – not the market – controls short term interest rates.
This is nonsensical. The government cannot finance its entire debt on short term bonds. Let’s assume that long term rates go up to 8%, and the Federal Reserve artificially keeps short term rates at 2%.
- No one is going to buy the government’s short term bonds. No one is going to buy a 2% bond when a similar yield determined by market forces is 8%.
- Keeping rates so low while inflation is high will merely drive inflation higher.