Wednesday, February 06, 2013

Debt interest burden

By Frank Moraes

A couple of days ago, Dean Baker published one of his weekly "Robert Samuelson is an idiot" articles, It's Monday and Robert Samuelson Is Confused. It's a good article. I always look forward to Mondays because Samuelson is a Very Serious Idiot and Baker really does have something to say about him every week. So click over and read it, if you like. However, I bring it up, because Baker touched on something that I would like to expand on.

Baker often pushes an important idea that very few people talk about: government debt versus debt interest burden. Let me explain this with an example. Assume a country named Freedonia. Currently, long-term (30 year) bonds on Freedonia debt pay 1%. Freedonia needs to borrow $100, so they issue a bond for it. This means that their debt is $100 and their debt interest burden is $1 (1%) per year. Now let's suppose that the Freedonia economy starts to improve so that next year, the bond rate jumps way up to 3%. The government still has all its $100 debt locked into a 1% bond, so nothing changes—at least not for another 29 years when the $100 principle will be worth almost nothing anyway.

The person who holds the $100 bond will lose out in this situation. He is now making $1 per year. But if he made the same investment now (in long-term bonds), he would get $3 per year. So his bond is effectively only worth $33 now. Indeed, if he wanted to sell it, he would only get $33 for it (See Afterword below). So the government of Freedonia could borrow $33 (by issuing a new bond) and buy back last year's $100 bond. Thus, the government would have decreased its debt by two-thirds! Woo! Now Freedonia only owns $33!


But what is Freedonia's debt interest burden? They would have to purchase a $33 bond at 3%. So they would again owe $1 per year. In other words nothing at all has changed. What this shows is that the raw amount of money that the government owes is meaningless. What matters is how much the interest burden is. And here's the thing: ordinary people understand this. This is what people do all the time with consolidation loans. They aren't lowering the total amount that they owe; they are lowering their debt interest burden so that they can pay off what they owe.

The Very Serious People who are forever (and ever and ever) harping on our debt conveniently forget all about our interest burden. Actually, it is worse. Many times, people argue that bond interest rates will suddenly go up and greatly increase our borrowing costs. This obviously isn't the case with 10 and 30 year bonds.

I think this example clarifies the situation very well. What is our total debt? About 70% of GDP. What is our total debt interest burden? About 1.5% of GDP. With such a manageable "problem," you have to wonder why these Very Serious People want to inflict so much suffering on the nation. Just kidding: we know very well why they do this.

Afterword

Bonds don't work exactly the way I've claimed here, but the principles are valid. The truth is that the $100 bond would not sell for $33 the second year; it would sell for something more like $50. That means in reality, the government could reduce its debt only by raising its interest burden substantially. So the real life case is even more ridiculous than the Freedonia case.

(Cross-posted at Frankly Curious.)

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