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February 19, 2011

Interest Rate Sensitivity

Over the past 10 years global debt has grown to $180 trillion while global GDP has grown to $62 trillion.  With debt at three times global GDP, interest rates matter....they matter immensely.  Global debt has grown at a rate of 11% annually, while global GDP has only grown at a rate of 5% annually.  This 6% shortfall means we have fewer than 5 years before we reach the universally acknowledged debt tipping point of 4.2X GDP, and shorter if interest rates start increasing the way most experts think they will.

Let's put this in the perspective of the average American who makes $50,000 a year.  Applying the current debt to GDP ratio to this scenario, this average American would owe $150,000.  If the interest rate on this average American's debt is 5%, he has to pay $7,500 in interest annually, or 15% of this person's income.  Should the interest rate increase to 10%, the amount doubles to $15,000 or 30% of this person's income.

Should this person have $210,000 of debt instead, at 5% he would pay $10,500 or 21%.  At 10% it would be $21,000, or 42%.

Those who say we are "growing our way out" of our problems are fools.  You can only grow your way out of debt if the percentage increase in GDP generated is greater than the percentage increase in the debt itself.  Those who spend $11 to make $5 soon go bankrupt.  

We are complacent because we are spoiled by low interest rates.  The entire sub-prime house of cards collapsed on the back of a less than 2% increase in mortgage interest rates in 2008.  

The average American who makes $50,000 a year lives on a very tight budget indeed.  Many of them have found they can't afford to pay the debts they have now.  What happens when the interest on their debt goes from 15% to 30% of total income?

I believe that the global debt is subject to the same sensitivity and that the global dominoes will begin to topple far sooner than anyone imagines.  More likely as not, when Bernanke stops buying $100 billion a month in Treasuries and the Germans get sick of subsidizing the entire Eurozone.