“I place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.” - Thomas Jefferson

The process by which an initial investment begins to grow exponentially due to compounded returns is often referred to as the miracle of compounding. This means that interest payments will eventually create a substantial increase in wealth if these returns are continually reinvested and allowed to compound.

However, there is really nothing magical or miraculous about interest. In other words, money does not compound in value of its own accord; it first needs to be lent to someone through investment. The person who lends this money is known as the creditor, and the person who borrows it is known as the debtor. Therefore, an interest payment is actually a fee paid by the debtor to the creditor in exchange for the privilege of credit.

Since a debtor must actually earn the money for these interest payments, a debt whose interest is allowed to compound will soon outgrow the ability to repay it.

The national debt has been compounding at an average annual rate of 9.10% over the past 25 years, but the interest expense for this debt has been carefully disguised. For example, a portion of the Social Security surplus is used to pay the interest on the Social Security trust fund, and the remainder is used to support the budget deficit.

Each year, the government is actually creating new debt in order to pay the interest expense on the existing debt. The national debt has been allowed to compound at an alarming rate, but the true interest expense has been hidden from the public. After all, as long as Social Security continues to run a sufficient surplus, the creation of some of this new debt is merely an accounting entry.

Unfortunately, looming demographic factors will not only eliminate the surplus, they will also necessitate substantial disbursements from the Social Security trust fund.

In order to obtain an accurate assessment of the situation, social insurance and retirement receipts must be excluded from federal tax receipts. Therefore, while the national debt has been compounding at an average annual rate of 9.10% over the past 25 years, the net tax receipts of the federal government have only been compounding at an average annual rate of 4.95%. Regardless of other factors, the interest expense for the national debt will consume an ever-increasing portion of our available tax revenue if such trends continue.

For fiscal year 2004, the effective interest rate on the national debt was 4.4%, and this average rate has been kept relatively low due to a massive amount of new debt that was issued in a low interest rate environment. Also, the fact that Social Security has been generating substantial surpluses since 1983 has provided the government with a cheap source of financing for its budget deficits.

However, not only will the government need to find new financing for the special issue bonds in the Social Security trust fund, but many other bonds that have been issued in this low interest rate environment will pose a substantial rollover risk. In other words, the government will soon need to borrow a very significant amount of money at prevailing interest rates, and these rates could conceivably be much higher than they are right now.

For fiscal year 1980, the effective interest rate on the national debt was 8.2%, and the interest expense on this debt amounted to 20.8% of net federal tax receipts. In fiscal year 2004, the effective interest rate on the national debt was only 4.4%, but the interest expense on this debt now amounted to 28.1% of net federal tax receipts.

If the interest rate on the national debt had been 8.2% for fiscal year 2004 as it was in 1980, this interest expense would have devoured 52.6% of available tax revenue.

Even if the effective interest rate on the national debt remains constant, the interest expense for this compounding debt will continue to grow. If the debt continues to compound at an average rate of 9.10% while net tax receipts continue to compound at an average rate of 4.95%, in another 10 years, the interest expense on the national debt will amount to 41.6% of available tax revenue.

In reality, we have not even been paying the interest on the national debt, because this debt has been compounding in excess of its interest rate. However, we must realize that the government will not always be able to borrow ever-increasing sums of money. In the past, surpluses from Social Security have enabled these budget deficits, but such surpluses will soon disappear. We must take control of this situation before we lose control of it, because we are rapidly exhausting the available sources of borrowing. We must not only reduce federal budget deficits, we must eliminate them.

For while compounding interest blesses creditors, it curses debtors.

Sources:

United States Government - FY 2006 Budget Report - Historical Tables (PDF)

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