Will higher interest payments cost the U.S. its empire?

Newsweek's current cover story puts forth a provocative thesis for those who own gold. It suggests the U.S. might have to raise interest rates dramatically to attract investors to its government bonds, which would make gold less attractive. And given the huge rise in U.S. indebtedness that began in 2001, such a boost in interest rates would squeeze so much cash from the U.S. Treasury that we wouldn't have enough money to pay for our military -- thus marking the end of our global empire.

The author of this piece, Niall Ferguson, is a Harvard professor -- but not all Harvard professors are right, to say the least. Witness former Harvard president Larry Summers, who The Boston Globe blames for a $1.8 billion plunge in Harvard's endowment.

Even so, Ferguson provides some interesting historical precedents to boost his argument. He notes that pre-revolutionary France spent 62% of royal revenue on debt service by 1788. The Ottoman Empire's interest payments and amortization rose from 15% of the budget in 1860 to 50% in 1875. And Britain's interest payments consumed 44% of its budget in the 1930s, making it tough to rearm in the face of a new German threat. What does any of this have to do with the U.S.?

Well, our national debt has more than doubled from $5 trillion in 2000 to $12 trillion today, and our Federal budget deficit is at a record $1.4 trillion. Fortunately, the world has been willing to keep lending us money at negative interest rates for the past few years. Peter Orszag, Obama's budget advisor, completed a study which concluded that a 20 percentage point increase in the U.S. government-debt-to-GDP ratio should lead to a 0.2% to 1.2% increase in real interest rates.

Meanwhile, those who have enjoyed gold's rise to record nominal prices are expecting that this cheap financing will end some day. At that point, they envision the end of the world -- a world where the U.S. is spending so much of its budget on interest that it can no longer afford to keep the world's most powerful army in clover. Under its current plan, Ferguson sees the Pentagon spending in decline from 4% of GDP in 2009 to 3.2% in 2015 and 2.6% in 2028.

It all sounds pretty scary, but the future is difficult to predict. If anyone can explain why the world has been willing to lend us money at negative interest rates for so long, that would help me figure out whether this cheap financing is sustainable.

If it's not, we are going to have to pay down that debt in big chunks -- and fast.

Meet Peter Cohan at The World Money Show Orlando, February 3-6, 2010 at The Gaylord Palms Resort.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter. He has no financial interest in the securities mentioned.

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