Managing the National Debt

You can't go a minute without hearing it. America is in debt up the kazoo. We've mortgaged the future. Sold the potential. Become beholden to others. You know all the taglines. A look at public debt growth over the past 15 years tells the story:

Source: Treasury Direct.

The annual increase in today's debt is nearly equal to 1994's total debt accumulated over the previous 200-plus years. GDP growth makes some of that increase reasonable, but not nearly enough. Any way you spin it, we're more in hock today than at just about an ytime post-World War II. Here's a good illustration.

This observation alone, though, ignores an important point. What's crucial isn't the amount of outstanding debt, but the cost of that debt. Borrowers can handle astronomical debt loads if the cost stays low enough for long enough. That's why fast-food workers could live in McMansions in years past. Keep costs low, and big debt loads look controllable.

With that in mind, have a look at the national debt's annual cost over the past 15 years. 

Source: Treasury Direct.
*The government fiscal year runs Oct. 1 – Sept. 30.

That's pretty remarkable. Even though public debt has more than doubled since 1997, the interest expense is roughly the same. This, obviously, is the result of lower interest rates. In 1997, a 10-year Treasury note yielded about 7%. Today, it's about 3.5%.

But there's little comfort here. No sober person thinks interest rates will stay as low as they are now indefinitely. Two primary forces make this so: The Federal Reserve will someday be forced to ratchet up short-term rates to sensible levels, and foreign buyers will lose both confidence and the need to keep plowing dollars into Treasuries. Once those forces really take hold, borrowing costs on public debt could be pushed to dizzying heights.

Investors know this. Politicians know this. The Treasury knows this, too. So going forward, the Treasury plans to skew debt sales more toward late durations, such as 10- to 30-year notes, rather than short-term bills. According to Bloomberg, the Treasury may sell 40% more long-term bonds next year than it did this year. The idea is to lock in long-term borrowing costs now, then reap the benefits when they inevitably surge.

Nothing wrong there. If someone is willing to lend Uncle Sam money for 30 years at a spit above nothing, we debt-hungry citizens should take as much advantage of them as possible.

But doing so doesn't come without major implications -- some good, some bad.

Longer maturity dates on debt will drive long-term yields higher. Bond prices are inversely correlated to yields, so when supply increases, prices fall, and yields rise.

Two important shifts come from this, both affecting banks. First, higher long-term interest rates steepen the yield curve, or the difference between short-term and long-term interest rates. This is generally a positive for banks' bottom lines. When a bank can borrow at 0%, and lend at 7% (an example of a very steep yield curve), good things happen.

Indeed, the current yield curve, already quite steep, has been a godsend for banks like Wells Fargo (NYSE:WFC) and US Bancorp (NYSE:USB). Nowhere has it been more beneficial than at the bond trading departments at Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM), which are absolutely minting money thanks to huge spreads on fixed-income products.

But here comes that jerk, Mr. No Such Thing as a Free Lunch. Much of why the banking industry hasn't turned into confetti is because of monumental efforts to keep consumer borrowing costs as low as possible. Low borrowing costs make things like housing more affordable, and hence put upward pressure on prices.

Remove that pillar, letting long-term interest rates rise, and the housing recovery could be set aflame. Fragile recoveries would be mowed down. Refinancing would wane, ushering in more foreclosures. Demand would fall. Home prices would sink anew.

And then begin the ripple effect: Bulldoze housing's rebound, and you also bulldoze the likes of Home Depot (NYSE:HD) and Caterpillar (NYSE:CAT), so on and so forth. You know the drill. You lived through the past two years.

Then comes a weaker economy. Then come cries and pleas for more deficit spending. More deficit spending increases long-term interest rates, squashing housing prices. Then comes a weaker economy. And around we go. Rinse and repeat.

And hence the irony of managing the national debt: Lock in a low cost of capital on public debt, avoiding long-term public problems, but do so at the expense of private-market issues that can brew into long-term public problems.

We'll say it again, Fools: There ain't no such thing as a free lunch.

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