Can A Nation $18 Trillion In Debt Afford Higher Interest Rates & Will This Change Our Retirements?

By Daniel Amerman – Re-Blogged From http://danielamerman.com/

For some years now, very low interest rates have been reducing the earnings of retirement investors as well as the lifestyles of many of those already retired. To understand why this has been happening – and why it may continue for a very long time – one must recognize that there is a direct relationship between the interest rates that are paid to savers, and the interest payments made by a heavily indebted federal government.

For a retirement investor who is currently earning a 1% interest rate, a 5% increase in rates to a 6% return would increase their total investment earnings by 1,263% over 30 years, allowing for a radical improvement to their eventual retirement standard of living.

And for a current retiree who is drawing down their investment portfolio over 20 years, a 5% increase in annual interest rates from 1% to 6% would allow them to raise their standard of living by a full 57% in each and every one of those years.

For the United States government, on the other hand, a 5% increase in interest rates on the national debt would raise the annual deficit by about $900 billion per year.  Because the government borrows the money to make interest payments, this could set off a chain reaction of paying interest on money borrowed to pay interest, leading to a national debt increase of $67 trillion in 20 years (absent major tax increases).

To put such a fantastic number in more personal terms, if we divide it by the number of American households with incomes above the poverty line, that means that for each able to pay family, their personal share of the national debt would rise by almost $700,000.

So the very same major increase in interest rates that so many millions of savers badly need for their financial security – could simultaneously send the national debt spiraling upwards and out of control.

Let me suggest that this relationship creates an extraordinary financial conflict of interest between savers and the government.

Many people believe that the enormous national debt is a somewhat theoretical problem for the future. That is, they suspect that it will at some point be a great financial burden for our collective children and grandchildren to deal with, but they don’t see a direct impact on people’s lives today in any major or practical way.  At the same time, they are quite frustrated by the very low interest earnings that could force them to delay retirement, or if they are currently retired, that are already reducing their standard of living.

What they fail to see is that record setting national debts and record low interest earnings for savers are not separate issues but rather they’re two sides of the same coin.

When we understand this essential point, we can see that massive national debts dramatically and directly impacting the lives of many millions of people is not something to anticipate in the distant future, but rather it is happening right now just as it did last year, and just as it will likely happen again next year.

And in seeking viable solutions for investing in this challenging environment, there is no substitute for understanding why it is that we currently have such low interest rates, and why they may continue into the indefinite future.

A Mysterious Reduction In Interest Payments

The graph below shows the amount of federal debt outstanding over the last 40 years. As can easily be seen, the federal debt exploded upwards with the financial crisis of 2008, and began its meteoric ascent to about $18 trillion dollars outstanding.

(source:  Federal Reserve Bank of St. Louis)

Given its sheer size, if the interest rate on that debt were to rise by even 1%, the annual federal deficit rises by $180 billion. A 2% increase in interest rate levels would up the federal deficit by $360 billion, and if rates were 5% higher, the annual federal deficit rises by $900 billion.

Now ordinarily if we think about having our debts balloon out of control, we would expect to be making much higher interest payments.

That is, all else being equal, if our debt doubles or triples then our interest payments should double or triple.

As can be seen in the following graph, however, this hasn’t been the case for the US government.

(source:  Federal Reserve Bank of St. Louis)

(Interest payments are on a fiscal year basis, which shifted from June to Sept.)

To the contrary, interest payments by the federal government have either been falling or level ever since the financial crisis began.

How can this be?

 (source:  Federal Reserve Bank of St. Louis)

As plainly shown in the graph, the answer is that interest rates have in recent years plunged to their lowest levels in the last 40 years.

At the very same time, savers and investors have also been experiencing these very low interest rates.

Government Interest Rate Interventions

Now if someone viewed the federal government’s being in debt as being similar to an individual being in debt, they might wonder if this just comes down to extraordinarily good luck. To have interest rates plunging even as the amount of debt outstanding was soaring upwards!

And generally speaking, this is where a lot of confusion can occur when trying to understand the debt and the deficit, because indebted national governments that can borrow in their own currencies are nothing whatsoever like individuals or corporations being in debt.

In the case of the United states, interest rates have been controlled for some years now through the actions of the Federal Reserve.

That is, as illustrated in the graph below, at the very same time that the federal deficit has been soaring, the Federal Reserve has been quite literally creating trillions of dollars out of the nothingness and using this brand new money to purchase United States debt – not directly from the US government, but through the markets.

 (source:  Federal Reserve Bank of St. Louis)

In doing so, the Fed has taken control of interest rates in the short, medium and long term in the United States.

Thus there is nothing fortuitous or “lucky” about the current very low interest rates – but rather they are a direct result of governmental policies.

The Impact On Savers & Investors

How do interest rates impact someone who is pursuing a long term investment program, perhaps to fund a desired retirement lifestyle?

As shown in the above graph, a saver who invests at a 7% rate for 30 years can expect to turn a $10,000 initial investment into a $76,123 investment, meaning their total earnings were $66,123.  This is the math that drives conventional long-term investment models – each dollar invested creates another six dollars and more, thus savers who practice long-term discipline are highly rewarded over time.

And if the saver were able to get a 10% rate of return, then their earnings would soar to $164,494, with that 3% increase in interest rates leading to a near tripling of investment returns.

On the other hand, if we drop that interest rate to 1% – then the profits earned over thirty years plummet from $66,123 to $3,478, which is a reduction of 95%.

If interest rates turn out to be 2% on average, a saver would fare better with earnings of $8,114, but that is still a reduction of 88%.

The Federal Government’s Interest Rate Problem

While little remarked upon or understood, the United States government has an interest rate-related problem of its own when it comes to the debt and the deficit.

That is, tax revenues are not sufficient for the federal government to make either principal or interest payments on the federal debt.

 

CONTINUE READING –>

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s