Government is, by anyone’s account, inefficient. Likewise, all spending involves at least some waste, and public debate often centers around whether the amount of waste inherent to a policy is outweighed by the policy itself, but even wasteful programs do accomplish something, just perhaps not effectively.
One type of government spending contributes nothing whatsoever: interest payments on the US debt. In 2015, by the projections of the Congressional Budget Office, the US will be paying close to $400 billion per year just to service US bonds, and in contrast with other wasteful spending, the government has little control over the cost of interest payments.
Certainly, the government can control how much debt it issues, but once it has sold a bond, the interest rate (often called the yield) of the bond is determined by market forces, just as it is for a corporate loan or an adjustable rate mortgage. Now, the rates that the Federal Reserve sets can affect the performance of government bonds, but ultimately, the market decides what must be paid to justify the loan and offset the risk.
Because investors want to hedge risks, a riskier loan commands a higher interest rate. To make loaning one’s money to a riskier entity worthwhile, the bond issuer must sweeten the deal with higher rates of return, and US bonds are no different. Investors usually judge the risk of a bond based on the credit rating of the issuer (as determined by the three big rating agencies, Fitch’s, S&P, and Moody’s), and they price the yield accordingly.
As the US approaches its inevitable credit downgrade in 2015, one must ask what that sort of downgrade in creditworthiness will cost. In evaluating downgrades from Aaa to Aa1 (the second highest rating) over the past 30 years, one can approximate the degree to which investors will demand more of a return on US debt to counteract the added risk.
By looking at the credit rating changes of Canada, Australia, and Norway and the yields on the bonds that make up their sovereign debts, one sees a clear relationship. Because global interest rates change over time, the best way to isolate the particular changes of an individual country is by examining the differences between the yield on its bonds compared to the global median for Aaa countries. In this way, one can see how much riskier or safer a certain country’s debt became relative to the rest of the world, and one can evaluate how much more that risk cost.
When Canada lost its Aaa rating in 1993, its cost to borrow relative to the global median increased by 60%, and as its rating stabilized and the country righted its fiscal wrongs, the market regained confidence, the cost to borrow decreased, and the rating went back up.
When it became clear that Norway would lose its Aaa credit rating, in 1986-1987, its interest payments spiked by 290% relative to the global median, or almost by a factor of four, and then they returned to median levels as the country regained its credit rating.
Finally, when Australia went from Aaa to Aa1 in 1986, its cost to borrow relative to the global median increased by 96%, so it essentially doubled, and when Moody’s demoted them yet further to Aa2 on 1989, the cost to borrow spiked again by 86%. As the country restored fiscal solvency, its costs to borrow decreased and it regained its prime rating.
The takeaway from this is quite simple: the United States can expect a massive increase in the yields of its bonds in 2015 when Moody’s demotes US debt from Aaa to Aa1. Specifically, the US can expect bond yields to rise by approximately one percentage point, meaning a 33% minimum increase in its costs to borrow, and as Norway shows, it could cost far more.
Taxpayers should brace themselves, for there will be an additional spike in 2015 to the tune of $133 billion. To put that in perspective, the budget allocates $130 billion per year for operations in Afghanistan and Iraq. Moreover, the spike could far exceed this conservative estimate, as the Norwegian example shows. In short, now is the time to end overspending so that when that downgrade and cost spike hit, the US is ready to pay them, not mortgage the future of generations yet to come.