Millions are no doubt wondering how we know that the government has to reduce deficits by $4 trillion over the next decade. This appears to be the magic number that underlies the budget discussions between President Obama and the Republicans in Congress, and it is widely accepted by Serious People everywhere, but where did this magic number come from?

One place where it gained prominence was in the report authored by Morgan Stanley director Erskine Bowles and former senator Alan Simpson, the co-chairs of President Obama's deficit commission. However, many other people have touted this $4 trillion number as the appropriate limit on the country's debt burden.

The attachment to a particular debt number seems more than a bit peculiar for a number of reasons. The first and most obvious is that the financial markets don't seem the least bit bothered by the current levels of debt and prospective future levels of debt. They presumably understand what most people in the Washington policy debate do not, the high deficits of the last 5 years are the result of an economic collapse, not profligate spending or huge tax cuts. This is why the interest rate on long-term Treasury bonds is at post-war lows.

The markets recognize that if the economy recovered, then deficits would again be at manageable levels. In the mean time, low interest rates reflect the fact there is little demand for capital.

However beyond the economic facts, the Washington debt mongers also seem confused on what the debt means. The proximate burden of the debt on the government is the amount of interest that we pay. Instead of being very high, this is in fact near a post-war low. 


                     Source: Congressional Budget Office.

This raises another point that our Wall Street friends know well, the market value of the debt will fluctuate inversely with interest rates. This means that if we issue long-term debt at today's low rates, but interest rates increase as the economy recovers, then the market value of this debt will fall. The figure below shows the market value of a 30-year bond issued today at a 2.75 percent interest rate under various assumptions about interest rates in 2015.



                                   Source: Smart Money Bond Calculator.

As can be seen, if the interest rate rises from the unusually low current levels to a more normal 6 percent by 2015, then a 30-year bond will be selling for less than 60 percent of its face value. If the interest rate rises to 8.5 percent, a level that we saw in much of the 80s, then the market value would be just 40 cents on the dollar. And if we started to look like Greece and the interest rate rose to 12 percent, then debt would be selling for less than 30 cents on the dollar.

This suggests a very simple way to reduce the country's debt. When interest rates rise, we can just buy up huge amounts of debt at discounted rates. For example, if the interest rate rose to 6 percent by 2015 we could buy up $2 trillion in 30 year bonds for just $1.2 trillion. In that way we could eliminate $800 billion in debt without raising a dollar in taxes or cutting a dollar in spending.

From an economic standpoint this would be a silly exercise. The interest burden on our debt will not have changed one iota. But if the problem is the size of the debt as the Serious People claim to believe, then we will have accomplished a huge feat and made the Washington Serious People crowd very happy.