A Controlled Explosion
Policy + Politics

A Controlled Explosion

The U.S. is borrowing record amounts. The challenge now is in managing the debt

Even as President Obama tries to make good on his pledge to reduce deficits in the years ahead, Treasury officials are mapping strategies to deal with the government’s existing mountain of debt and the need to borrow additional trillions in the years ahead.

Thanks to plunging interest rates and the size and clout of the United States in global financial markets, the federal government was easily able to borrow a record $1.7 trillion last year --  about $200 billion more than it collected in tax revenue--and yet pay less in total interest than it had the year before.

But those favorable conditions may not last much longer. Administration officials expect the total volume of publicly-held government debt, now almost $8 trillion, to keep climbing sharply for at least another two years. They also expect interest rates to edge higher as the economy recovers, which will drive up the government’s cost of borrowing. And they are keenly aware of the need to reassure global investors that the United States can get its long-run finances under control.

"We understand that we can’t take things for granted," said Matthew Rutherford, deputy assistant secretary of the Treasury who oversees the issuance of new debt. "People want to know, what’s your plan? What’s your flight plan to reduce the deficit? What’s your plan for revenues?"

In his budget proposal for 2011, Obama called for a three-year freeze on most "discretionary" spending – programs that Congress has to vote on each year.

But with official estimates predicting that the government may have to borrow at least another $1.3 trillion in 2010 and $1 trillion in 2011, Treasury officials are grappling with two immediate practical challenges: locking in today’s low interest rates, and keeping the machinery for selling Treasury debt running smoothly at top speed.

The U.S. government issued trillions of dollars in short-term bills at the height of the financial crisis, paying average rates of less than 0.3 percent. Treasury officials now have to refinance nearly $2 trillion — nearly one quarter of its marketable debt — within the next year.

To reduce what analysts call "rollover risk," Treasury officials are gradually replacing much of that short-term debt with longer-term notes and bonds. The strategy should save money as rates climb higher in the future, but it costs money up front, because long-term interest rates are currently much higher than short-term ones.

Adding to the urgency, the Federal Reserve, which slashed its benchmark overnight interest rate to almost zero in December 2008, has begun winding down programs that helped keep interest rates low. The Fed has eliminated many of its emergency credit programs, and it plans to end its $1.2 trillion program of buying mortgage-backed securities by the end of March. Some analysts estimate that the Fed’s purchase programs artificially reduced long-term interest rates by about half a percentage point.

Administration officials and most private economists contend that record deficits were a necessary response to the worst recession in decades. With private economic activity in a free fall in late 2008, aggressive government spending and tax cuts were the only source of growth. Even now, economists warn, the economy is so fragile that a premature rush to tighten spending or raise taxes could still derail the recovery.

At the same time, chronic high deficits could spook investors and lead them to demand sharply higher interest rates. That would be dangerous for both the federal budget and the economy as a whole.

In an early shot across the bow, Fitch Rating Service warned in mid-January that the  U.S. government’s AAA credit rating could be at risk if it failed to make headway on the deficit within the next three to five years.

"In the absence of measures to reduce the budget deficit," wrote Fitch analyst Brian Coulton, "government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the U.S.’s AAA status."

Fitch said the United States remains "exceptionally creditworthy" for the time being, in part because the central role of Treasuries in world markets gives the federal government "unprecedented financing flexibility" in borrowing the money it needs – even compared to other AAA-rated countries. The federal government’s debt load, equal to about 55 percent of gross domestic product, is lower than those of Japan, Germany and other wealthy countries.

But Mr. Coulton said a more accurate, apples-to-apples comparison would include debt held by state and local governments. By that measure, he said, debt load is on track to be higher than that of any other AAA-rated country by the end of 2010.

Thus far, the Treasury’s debt issuance machine has kept humming without any glitches.

Treasury debt managers now routinely sell more than $20 billion at a time. In one fairly typical week in January, investors snapped up $84 billion in long-term securities through four Treasury auctions. In a sign of strong demand, investors bid for about three times as much debt as was on offer.

Drastically lower interest rates during the crisis allowed the government to borrow at an average rate of less than 1 percent in 2009. As a result, interest payments actually declined by 26 percent in 2009 to $187 billion, even though its total debt ballooned.

But those savings will evaporate if interest rates return to more normal levels. The government’s average interest rate in December 2009 was only 3.29 percent, far lower than the rate of 4.78 percent it paid in January 2008, before the crisis erupted in full fury. If the government’s average cost of borrowing climbs back just to that level, interest payments this year would be about $120 billion higher than if rates remain unchanged.

To put that in perspective, the extra spending on interest would be more than the combined budgets for the departments of Homeland Security, Housing and Urban Development, Interior and Labor.

Both the White House and the Congressional Budget Office estimate that the annual cost of interest payments could more than triple by 2020 to about $700 billion. That would be slightly higher than the total projected spending for all non-defense discretionary programs.

“With such a large increase in debt, plus an expected increase in interest rates as the economic recovery strengthens, interest payments on the debt are poised to skyrocket,” the  Congressional Budget Office warned last month. But even those projections could prove optimistic. They assume that interest rates will climb only modestly, with the rate on 10-year Treasury bonds rising to 5 percent from less than 4 percent today.

The CBO estimate is also based on current law, which calls for all of the Bush tax cuts to expire at the end of 2010, although Democrats plan to extend most of them. White House projections assume savings from its proposed freeze on many spending programs and from proposals to raise taxes on foreign profits of corporations – which are likely to encounter opposition in Congress.

There are other uncertainties. Lou Crandall, chief economist at Wrightson ICAP, said Treasury officials and bond investors alike assume that the appetite for Treasury debt will remain much as it was prior to the crisis, before the volume of debt soared to previously unimaginable levels.

"The market is currently not pricing in much long-term impact from rising federal debt levels or structural changes in the financial system," Mr. Crandall said. There is a risk there. It’s all a question of what the new normal is, to borrow a phrase."