Why Eurozone Growth Could Trigger A U.S. Budget Crisis

By David Sterman of Street Authority

At this point in President Obama's first term, the world looked very different.

The still-anemic economy made it hard to fathom how we would ever get out from under a crushing government debt load. Government spending far surpassed revenue and concerns grew that our key financial backers (such as Chinese bondholders) would pull the rug out from under us.

Fast forward to 2015, and the notion that our national debt is any sort of real problem has simply vanished. Sure, the Republican party has been recently threatening government agency shutdowns, but this time the issue is immigration and not our nation's unstable finances. The percentage of Americans that believe that deficit reduction should be Washington's top priority has slid to a recent 64%, from 72% in 2013, according to a recent survey conducted by Pew Research.

However, events across the Atlantic Ocean could bring this issue right back onto the front pages.

Make no mistake, decent economic growth, coupled with somewhat higher tax rates on people making more than $250,000 a year, has helped narrow the annual shortfall. What was a $1.4 trillion annual budget gap in fiscal (September) 2009 is now much smaller.

Perhaps even more impressive is the impact of falling interest rates, which enables the U.S. government to handle a still-rising debt load with flattish interest expenses. Back in 2000, the government paid a 6.6% interest rate, though that figure slid to 2.43% in fiscal 2013 and currently stands at just 2.02%.

Falling interest rates coupled with an expanding U.S. economy means that debt service costs are taking an ever smaller bite (on a percentage basis) out of our government's expenditures. And if the economy keeps expanding at a steady pace and if interest rates remain low, then you'd suspect that we can count on more good news ahead.

-- Annual spending for Social Security is projected to grow by almost 80%.
-- Annual net outlays for the government's major health care programs (Medicare, Medicaid, the Children's Health Insurance Program and subsidies for health insurance purchased through exchanges) are projected to rise by more than 85%.
-- The other major portion of government spending -- The Department of Defense -- is also rising ever higher.

Make no mistake, if Uncle Sam could continue to borrow money to service the debt at low rates, then this inexorable rise in spending will be manageable.

Yet it's fair to wonder how realistic that expectation is.

Current low interest rates are almost completely due to the anemic state of the global economy, especially in Europe, which is now receiving massive central bank stimulus. That stimulus, or at least the psychological effect of it, appears to be starting to have an impact.

On March 4, the Eurostat statistics agency said that eurozone retail sales rose more than 1% in January, the best showing in nearly two years. "This reinforces our belief that eurozone growth will pick up markedly to 1.6 percent in 2015 as it benefits appreciably from very low oil prices, a much more competitive euro and substantial ECB stimulus," said IHS Global Insight's Howard Archer to the Associated Press.

His colleague, Nariman Behravesh, told the AP in a separate interview that "the U.S. is doing well, you're getting a lot of good news in Europe," and that "the global economy is gaining traction."

Signs of life in Europe may already be starting to have an impact on our own interest rates. Of course our rates are also driven by expectations around the timing of Fed rate hikes, but a stronger Europe would tilt the balance toward Fed action starting this summer. Investors will want to track the 10-Year Treasury rate very closely, as it is provides a clear signal of U.S. and European economic sentiment.

Make no mistake, if current stimulus efforts in Europe and Japan start to translate into sustained economic growth, then there is no way that global interest rates will remain at current lows. For the sake of context, if the U.S. government had to pay a 3% interest rate to service its debt (instead of 2%), then its annual interest expense would climb to around $630 billion per year, from around $425 billion a year currently.

What does $630 billion a year mean to the U.S. government?

Well, it's the current annual outlay for the Departments of Education ($72 billion), Housing and Urban Development ($46), State ($59), Energy ($35), Justice ($36), Agriculture ($154), Transportation ($98), and Treasury ($110) -- combined. And every percentage point increase in the effective interest rate translates into another $205 billion in further interest expense. And that math assumes our national debt would be frozen in place. But that's not the case, it's rising. (Federal debt equals 74% of GDP, the highest level since the World War II era.)

As noted earlier, a rapidly-growing economy would blunt some of the impact of higher interest rates on our national debt service as the government will generate more revenue. Yet if the economy fails to grow at a solid pace in coming years, then government revenue growth would sharply slow. It's kind of a lose-lose scenario.

Risks To Consider: You have time to assess this issue, as it will likely play out over many months. As an upside risk, we might somehow manage to attain the dual benefits of solid economic growth and rock-bottom interest rates, though such a scenario would be without historical precedent.

Action To Take -- The six-year bull market has been running on auto-pilot, fueled by a simulative Federal Reserve and a shrinking budget gap. But our long-term structural problems haven't gone away, they've just dropped from the headlines. As interest rates start to rise in coming quarters, either through Fed policy or through a slow thawing in the global economy, then the government's debt burden is bound to come back to the headlines. As a result, you need to track economic activity and interest rates more closely than ever. You don't want to be the last person to make portfolio adjusts to a rising rate backdrop of government debt-led economic concerns.

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4 thoughts on “Why Eurozone Growth Could Trigger A U.S. Budget Crisis

  1. Wow John don't hold back. I am in Australia and we are a microcosm of the USA but we have exactly the same arguments as between you and Gerald'
    I hope for both our Countries that the answeri is somewhere in the middle and somewhat on your side of the problem so that we may perhaps negotiate the astonishing predicament the world finds itself in.

  2. debt is still growing much faster than GDP . long term that is a huge disaster in the making.
    and that is our nations largest long term problem. too much spending and currency debasement is what causes the downfall of most empires throughout history.

    1. Currency debasement? Where? That "spending" is the only reason capitalism is even sustaining. Without it, it would collapse and so goes down liberal democracy. Demi-Gods would arise and develop empires out of the old bourgeois state. Mass production would collapse and the people would follow the strongest and most environmentally equipped leaders.

      You do realize that debt is set in those rates and even if it goes up, means little to the debt already accumed? Please don't write this misleading crap if you don't know the processes behind it.

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