The state of California will issue IOUs to its business vendors, students awaiting financial aid payments, and taxpayers expecting refund checks. When I first read this story, I had to check the calendar – was it April 1? No, this April Fool’s joke is exactly three months late. I am reminded of my childhood, playing the Game of Life with friends, occasionally resorting to using those last-resort Promissory Notes, which even we kids knew could end up worthless.  The need to issue promissory notes spells out just how dire California’s financial situation now is.  It seems the “Golden State” may have entered its “Golden Years,” at least in terms of its financial vigor.

And yet another large entity is apparently strapped for cash. For the first time ever, the International Monetary Fund announced it would issue $500 million in bonds to help it finance its underfunded programs abroad. China, the largest buyer of our debt, has already committed to purchase $50 billion of these IMF bonds. Russia, Brazil and several other IMF member countries are also expected to participate. But….

In order to purchase the IMF bonds, China, et al. would presumably have to sell a large chunk of their U.S. Treasury Bond holdings. Even if one makes the argument that they will only use new money to buy the bonds, that would nevertheless leave less money for them to continue buying our notes and bonds en masse.

If the IMF bonds do well, there is no reason to believe the IMF will necessarily stop at $500 billion, which puts them in direct competition with the U.S. Government’s bond issuance. If and when China and others scale back their purchase of our bonds, the smaller remaining investors may demand much higher yields than current rates, which are unusually low by historical standards. Higher rates will dramatically increase the size of U.S. interest payments to bondholders. Right now, the overall interest expense of the budget appears lower than it otherwise would because short rates are so low, as a result of the deep recession.  But rates will presumably not stay at these historically low levels, and when they eventually rise to more typical levels, the total interest expense will go up precipitously as it will be calculated on a much larger overall base of total debt outstanding.

The annual budget deficit is expected by some to reach (and presumably surpass) the level of total gdp in 5 to 6 years. When this happens, if the growth of gdp does not keep up with the average interest rate paid on outstanding treasury bonds, the U.S. will begin a game of perpetual catch-up, wherein the tax revenues (which are a direct percentage of gdp) will not cover the interest expense on the national debt.  We will either be forced to keep increasing gdp, just to stay even with the interest expense payments on the debt, or dig ourselves into a deeper and deeper hole, which would begin a truly vicious cycle.

As a colleague of mine wrote me recently: “It’s not the end of the world, just the end of the world as we know it.”

Kathleen Rogers has been a journalist for CNBC and Time Warner, a securities trader and market maker with Bankers Trust in both equities and government securities, and a newsletter editor/publisher. With her B.S. and M.S. degrees in engineering from Stanford, Rogers knows when a structure is well-built, and when, as with many popular financial schemes, it’s only built on wishes and fancy math.

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  • Violet Snow July 3, 2009 at 8:36 am

    Being in debt is a national pastime, from individuals to the federal government. I am not surprised that it’s going out of control. The American way of life states that we all deserve to have what we want. Only catastrophe is going to change that. Kathleen is so articulate and clear, and the Judy Garland shot is priceless–just how I feel!