Prof. Cam Harvey's Take on the Current Debt Service Burden

The sharp rise in long rates poses seven major risks, including the debt service burden. Interest on the Federal debt will become the 2nd largest category of government spending over the next year.

#1 Increasing Interest Service

The average interest rate on Federal debt is 2.8% and obviously will rise. Total debt service is $620b. Let me explain the math. Total debt is $32.3t. It is important to strip out agency debt (e.g., agencies holding Treasury debt). So, the debt held by the “public” is $25.5t. The Fed is considered the “public” so we also need to remove Fed holdings (the Fed rebates interest to the Treasury). Net debt is about $22t (69.4% of GDP). Interest is 22% of tax receipts. It is reasonable to expect over the next year that interest service will become the second largest expenditure category (exceeding health, national defense, etc.). Historically, it is a very bad idea to borrow to pay the interest on your debt. Further, the $32.3t of debt does not include the many unfunded government obligations.

#2 Financial Sector Instability

Increasing long rates hits bank balance sheets. Most banks are locked into longer-term loans and treasuries. Both collapse in value when long rates rise. Think of banks’ holdings of mortgages. From July 2020, 30-year mortgages averaged less than 3% for over a year. The current rate, 7.3%, is more than double that. This type of duration risk is exactly what took Silicon Valley Bank down (in SVB’s case, it was holdings of longer duration Treasury bonds).

#3 Credit Squeeze

The combination of an inverted yield curve (which hits bank profitability) and higher long rates (which hits banks’ balance sheets) has led to the strange situation where banks can only afford to pay a few basis points on their savings deposits. This leads to capital flight to money market funds. The MMMFs invest in treasuries and other safe securities. The capital flight slowly squeezes credit out of the system. This leads to slower growth.

#4 Lack of Investment

Higher rates increase the cost of capital. Investment spending is already negative. Increased cost of capital makes fewer investment projects viable. Investment is a major driver of GDP.

#5 Stress On The Consumer

The post COVID savings glut will be exhausted by year end. These savings have been the main driver of GDP growth in 2023. Some consumers are already depleted and credit card debt is increasing. We cannot count on the consumer to bail out the economy in 2024.

#6 Commercial Real Estate

The vacancy rate in San Fran is 32%. Chicago is at an all-time high nearing 20%. Banks hold a substantial amount of real estate debt. While banks would like to roll over into much higher rate loans, they may be unable to do this.

#7 Resumption of Student Loan Payments

40 million have student loans. The COVID-era pause on payments ended this week. It is increasingly difficult to get replacement credit due to a credit squeeze at banks and higher rates make loans less affordable.