Debt lever tilts both ways

David MoonBlog

While commentators and analysts focus attention on the ballooning U.S. national debt, it is tempting to overlook the importance – and threat – posed by total debt, including consumer; corporate; and local, state and federal governments. Debt is a lever that creates huge potential benefits in periods of low and declining interest rates. And it is a massive threat when rates are high or increasing.

The official federal debt is currently $31.9 trillion, or 120% of annual Gross Domestic Product. (GDP is a measure of the total size of a country’s economy.) But that figure only paints part of the picture. This official figure excludes $200 trillion (present value) of unfunded Social Security and Medicare obligations. The true debt status is a function of all debt owed by Americans, either indirectly (government debt) or directly (household debt.)

At some point in the next few weeks, Americans’ credit card debt will exceed $1 trillion, a new record, after increasing 17% from a year ago. Combined with debt for student loans ($1.6 trillion), automobiles ($1.6 trillion), mortgages ($12.3 trillion), and other consumer debt ($500 billion), this direct household debt is 76% of GDP. On behalf of their residents, state and local governments owe another $3.2 trillion.

That total debt equals $397,000 for each of the 131 million American households. And whether you realize it or not, you pay the cost to service that debt, even the money owed on your behalf by governments. You pay for it with taxes and inflation. And when interest rates increase, you additionally pay for it via reductions in government services and/or economic growth.

In finance, debt is described as leverage. That is, by using borrowed funds, an individual (or company) can leverage its assets to control more assets or spend more money. Leverage is more powerful than people realize, until it works to their disadvantage.

When short-term interest rates increased from essentially zero to 5%, heavily indebted borrowers suddenly found themselves on the dangerous end of the see-saw, victims of the leverage that had previously served them well.

When you have a lot of debt on which you pay artificially low interest expense, who cares? But rate increases cause massive swings in cost. The U.S. General Accountability Office projects that federal spending on interest expense will grow from 8% of the budget to 27% by 2050.

More than 2,300 years ago, Greek mathematician Archimedes realized that with enough leverage he could move the earth. And for 40 years of almost constantly declining interest rates, the financial lever in our country has gotten longer and more powerful. We are only beginning to see what happens when the fulcrum on which that very long lever shifts.

David Moon is president of Moon Capital Management. A version of this piece originally appeared in the USA TODAY NETWORK.