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!

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