The election of Joe Biden to the presidency has prompted liberal calls to set aside pesky budget deficit concerns and go deeper into debt to finance large new spending initiatives – well beyond short-term stimulus. Influential left-of-center experts such as the Harvard economists Lawrence Summers and Jason Furman, journalist Matt Yglesias, and Biden adviser Jared Bernstein assert that today’s low interest rates make government borrowing too good of a bargain to pass up.
The Congressional Budget Office projects that Washington will borrow $104 trillion over the next three decades in a scenario that assumes no new bailouts or spending expansions, and that also assumes the tax cuts passed in 2017 expire on schedule over the next several years. This will push annual budget deficits to 12.6 percent of GDP. Andrew Harnik/Associated Press
The arguments these commentators make differ in their details: Yglesias proposes a lavish “ice cream party” with something for everyone: tax cuts for Republicans and enough spending to make Biden’s presidency “FDR-sized.” Summers and Furman more modestly propose abandoning the ideal of a balanced budget during good economic times while keeping debt-servicing payments at levels they believe are manageable. But they still propose $5 trillion in additional deficit-financed investments (only half of which would be related to the current crisis) over the next decade. All these writers share the view that the persistence of low interest rates – currently about 1 percent for a 10-year Treasury bill – means the rules of the fiscal game have fundamentally changed.
They are right that the current recession is the wrong time to worry about budget deficits. Falling revenue and “automatic” social spending (such as unemployment benefits) naturally raise deficits during recessions – as do additional support measures such as the spring’s CARES Act. Such spending not only keeps families and businesses afloat, but that stability also benefits the economy. More legislation is likely needed to get the United States through the rest of the pandemic. But once the economy has fully recovered, deficit advocates must face two fundamental realities: First, the debt is already set to soar in the absence of any new spending. And second, these bloated debt levels will mean that any future rise in interest rates could bring a full-scale debt crisis.
That second point is especially important: Deficit doves are essentially gambling the future of the U.S. economy on the expectation that interest rates never again exceed 4 percent or 5 percent. While they are correct that, contrary to expectations, interest rates have in recent years declined even as public debt has grown, they are wrong to assume that state of affairs will continue.
Let’s examine the rising debt trajectory. The Congressional Budget Office projects that Washington will borrow $104 trillion over the next three decades if left on autopilot – that is, in a scenario that assumes no new bailouts or spending expansions, and that also assumes the tax cuts passed in 2017 expire on schedule over the next several years. This new debt is almost entirely driven by annual Social Security and Medicare shortfalls, caused by obligations to 74 million aging baby boomers, that will rise to nearly 7 percent of the gross domestic product by 2050.
This much debt will make interest rates vitally important. While the average interest rate Washington pays on its debt has gradually fallen from 8.4 percent to 2 percent over the past three decades, the CBO assumes that rates will gradually rise to 4.4 percent over the next 30 years.
Altogether, the CBO projects that the national debt – which has already more than doubled, to 100 percent of GDP, since the Great Recession – will approach 200 percent of GDP within three decades and continue to rise steeply thereafter. By 2050, interest payments will consume nearly half of all tax revenue and push annual budget deficits to 12.6 percent of GDP – the equivalent of $2.5 trillion today. The CBO assumes this large debt will eventually slow the economy and reduce family incomes.
And that is the rosy scenario of peace, prosperity, no new government initiatives and modest (if steadily increasing) interest rates. But what happens if interest rates exceed the projections by even 1 percentage point?
Should that occur, over 30 years $30 trillion in interest costs would be added to the debt, pushing it to 264 percent of the economy’s value, a ratio that is unprecedented in modern economies. And the rate of debt accumulation would be accelerating. By the time today’s babies are in the workforce, two-thirds of their federal taxes would simply pay the interest on the national debt.
And again, this scenario involves a mere 1-percentage-point increase in interest rates. Exceeding the projections by 2 or 3 points would mean annual interest costs consuming all projected tax revenue, leaving no taxes to finance normal federal programs.
These debt spirals become nearly impossible to escape, as rising interest costs necessitate more borrowing, which in turn brings higher interest costs, as nervous lenders demand higher interest rates. The government would face grim choices: Drastically raise taxes to make these interest payments, gut federal programs or risk hyperinflation by financing the debt with new money (via the Federal Reserve).
Yet many critics shrug off such concerns, overconfidently projecting current interest rates and spending levels well into the future. To their credit, Summers and Furman concede that “current projections do raise concerns over the fiscal situation beyond 2030,” but they stress the “uncertainty” of long-term projections. They also mention, almost in passing, that remedying long-term debt problems hinges on reforming Social Security and Medicare (and they offer budget projections that assume an unspecified Social Security fix), although their general downplaying of debt is likely to make lawmakers less motivated to address the problems with these programs.
One way to make borrowing less risky would be for Washington to lock in today’s low rates by issuing more 30-year bonds. Instead, Washington is behaving like a subprime homeowner and making long-term debt commitments based on short-term interest rates. The average maturity of the U.S. debt is five years and sharply declining, which means most of the national debt would quickly roll over into any future interest rate increase.
There is simply no guarantee that interest rates won’t rise. The reasons that interest rates have not gone up as debt has risen remain much debated. But they include declining productivity and lower inflation growth, a global demand for safe assets (inspiring investment in bonds over stocks) and – relatedly – baby boomers saving more as retirement nears. In a recent post, Ernie Tedeschi, a Treasury adviser during the Obama administration, confirms that – all else equal – the coming 100 percent of GDP rise in the debt would ordinarily raise interest rates by approximately 4 percentage points. But he argues that (so far) pressure on interest rates has been offset by higher saving and the like.
But for interest rates to remain low, those offsetting factors would have to not only continue, but also accelerate enough to offset all the upward rate pressure from this new debt. This seems unlikely, as productivity is unlikely to fall further, retired boomers will draw down those savings, and investors may eventually seek out higher returns than government bonds. In that context, assuming the average interest rate gradually nudges upward from 2 percent to 4.4 percent is far from outlandish.
All in all, it seems reckless for debt advocates to dismiss the possibility of interest rates returning to 4 percent, 5 percent or 6 percent in the medium to long term. The past half-century has not been kind either to economic forecasters or to the pronouncements of overconfident technocratic economic managers. Just 15 years ago Wall Street’s mathematical models failed to anticipate how mortgage-backed securities and the housing market could crash. Advocates for long-term deficit spending say the low rates on 30-year bonds show that markets aren’t worried about the debt, but markets rarely predict future economic and budget crises.
Reality check: No one knows for sure what interest rates will be in five, 10 or 20 years. Yet an economic recovery and $104 trillion in new debt are likely to push rates above today’s low levels. Deficit doves would gamble America’s economic future on the hope that interest rates will never again top 4 percent or 5 percent. Are you feeling lucky?
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