- - Thursday, May 3, 2012

Washington’s sole fiscal break, historically low interest rates, will soon end. When they do, higher debt-service costs will act like oxygen to the current conflagration of conflated debt. If you thought the budget blaze is hot now, wait and feel what is coming.

In federal budget terminology, there are two types of spending: discretionary and mandatory. Discretionary spending is determined each year by new laws; mandatory is pre-ordained by past laws and barring action, it goes on indefinitely. Of the many types of mandatory spending, none is more compulsory than the federal government’s interest payments.

Interest payments conform to a higher law than simple federal statute. They are codified in the laws of economics. Debt can only be diminished when it is outpaced by economic growth, and it can only be increased if one has the ability to borrow more. The only way creditors continue to lend is if existing debt is serviced. So interest must be paid, and at whatever rate the market demands.

The federal government has been doing anything but controlling its debt. Since 2008, federal debt held by the public has doubled, growing from $5.8 trillion to an estimated $11.6 trillion in 2012, according to the president’s budget.

However, an unusual thing has happened with this exploding debt: The cost of servicing it has fallen. In 2008, the federal government paid $253 billion in net interest costs. According to the Congressional Budget Office’s estimates, it will pay $224 billion in 2012.

The reason for this anomaly is that current interest rates - the product of unusually easy money and the downturn’s weak demand - have been historically low.

When 2007 ended, the long-term composite Treasury rate was 4.49 percent - almost 100 basis points below its June 2007 peak of 5.41 percent. Yet that year-end rate was almost twice the 2.3 percent rate the CBO projects for 10-year Treasuries in 2012.

Converse to gravity, when it comes to interest rates, what goes down must come up. Demand will increase, and the Federal Reserve, with an eye on inflation, will eventually tighten its monetary policy. The CBO projects it will not take that long. Assuming current law, the CBO projects interest rates doubling in five years - to 4.6 percent in 2017.

As rates go up, they will fan the flames of America’s fiscal inferno. Over the next five years, the CBO estimates cumulative interest costs will be $383 billion higher than five years’ worth at 2012’s $224 billion. They will keep escalating - not simply from continued deficit spending - but from compounding (what Einstein called the universe’s most powerful force) as interest rates increase.

Over 10 years, the federal government will incur an additional $2 trillion in interest costs above the 2012 level. To put that amount in perspective, recall that $2 trillion is roughly the agreed-to deficit reduction accompanying last summer’s debt-limit increase. You would need a similar agreement just to offset the next decade’s increased interest costs, which will largely result from higher rates being applied to old spending debts.

That much of this will be the result of simply paying higher interest rates is clear when you compare debt levels. By 2018, federal debt will have increased by $2.6 trillion - less than half its increase over the last four years. However, overall interest costs will double - from $224 billion in 2012 to $459 billion.

All this new federal spending will occur without the addition or expansion of a single federal policy.

This scenario raises an ominous question: What if the CBO is too optimistic? What if interest costs rise even more rapidly? What if the financial markets don’t calmly accept the piling up of deficit spending on more deficit spending? As we saw in Greece - and still worry about elsewhere in Europe - at some point, confidence breaks down, and rates rapidly rise.

The CBO estimates if Washington simply keeps its current policies in place - in contrast to its more conservative baseline that assumes some programs will expire - at the end of 10 years, debt held by the public will be 50 percent above its official estimate - $23 trillion instead of $15.3 trillion. Should that actually happen, interest costs will rise even higher and more rapidly.

Washington appears mesmerized by its fiscal flames. If anything is going to rouse policymakers, this is it. Rapidly rising interest rates, fueling and compounding enormous pre-existing spending debt, will act like an oxygen infusion to a flame. Firefighters know this as a backdraft - when a sudden rush of air causes a fire to explode even more ferociously. Federal policymakers are about to discover the same thing. Call it a backdraft of overdrafts.

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