I have frequently seen concerns about rising interest rates brushed aside with a casual argument that we “can always buy back debt at a discount” if that happens. Each time I have asked the speaker what that means I have either received a dumb look or been told that if they have to explain it to me that I will not understand the explanation.
Well, Dean Baker explained it three years ago. I suspected that it was going to be frustrating and entertaining when I saw the words “Financial Engineering” in the title, because those words never bode well. It exceeded my expectations.
“An overlooked possibility for reducing a high debt burden,” he says, “is simply buying back bonds at a discount when interest rates rise, as is widely predicted.”
“Long-term bonds that are issued at low interest rates,” he continues, “will sell at substantial discounts to their face value if market interest rates rise. Looking at publicly held marketable debt issued as of the end of February 2013, the face value of the debt is $3,857 billion. The projected market value of this debt is $3,399 billion for an implied debt reduction of $458 billion, or just under 2.3 percent of the GDP projected for 2017.”
He concludes, “The interest burden on the Treasury will not change through these transactions. The only effect will be to lower the official value of outstanding debt. However if people in policy positions continue to attach importance to this number then this sort of debt exchange should rank high on the list of policy options. There is no less costly way to eliminate close to half a trillion dollars in debt.”
The term “buying back debt at a discount” sounded to me like a self-licking ice cream cone (as in, “With what funds are you going to buy that debt?”), but it turns out to be a self-licking ice cream cone with no cone and very little ice cream.
A quick lesson on what a bond is. It is a “note” of money borrowed and has a nominal face value. It has a market value which may be higher or lower than the face value, depending on how badly someone wants to buy or sell it. It pays interest, usually quarterly, at a fixed interest rate which was determined at the time it was created.
So, let’s start with the basic principle of “buying back bonds at a discount when interest rates rise.” Since the government does not have a lot of cash laying around, the money to buy those bonds is going to come from… Wait for it… From selling more bonds. So how does selling high-interest bonds in order to buy and retire low-interest bonds improve your financial position?
Well, it might, if you bought the low-interest bonds cheaply enough to offset the higher interest that you will pay on the new, higher-interest bonds that you sold in order to buy them. You would have to buy them really, really cheaply, and the 12% discount that Baker cites later on is nowhere nearly enough to do that.
And if you tried to buy them cheaply enough to offset the difference in interest you would not have much luck, because that would be a bad deal for the holder of the bonds and he would just keep them until you offered him a better price. People who buy and hold bonds are not as stupid as economists are.
The net result though, in any case, is that you might have a lower debt burden, but you will be paying a higher interest rate on it. You probably, almost certainly, will not come out ahead of the game any more than the inventor of a perpetual motion machine will succeed.
He says that the “as of the end of February 2013, the face value of the debt is $3,857 billion,” but he’s more than a little off, there. According to the government, as of 9/30/2012, the debt was $16,066 billion, so he’s off by $12,209 billion, plus whatever growth the debt experienced in Oct 2012 through Feb 2013. Okay, I’m nitpicking, but this is not a minor inaccuracy.
“The projected market value of this debt,” he says, ”is $3,399 billion for an implied debt reduction of $458 billion…” And my projected blood pressure for 2017 is about 350/220 if I keep reading what people pull out of their asses and label as “projections.”
“…or," he continues, “just under 2.3 percent of the GDP projected for 2017,” as if that percentage would mean anything even if it was a real number and not just one that he pulled out of his ass.
He then says that, “The interest burden on the Treasury will not change through these transactions,” proving that he is not even living on this planet. The whole reason for this exercise in “financial engineering” is that interest rates have risen, and we just sold $3.4 trillion in new bonds at a higher quarterly interest payment in order to do it. How can that possibly make “no change on the interest burden?”
He finishes with a smug statement that, “There is no less costly way to eliminate close to half a trillion dollars in debt,” as if reducing the debt by 2.5% was some kind of major achievement.