The Fiscal Hawks Were Right About Debt and Interest Rates

While some nations tremble at the thought of high indebtedness, we Americans bask in the warm, comforting glow of $34 trillion in government IOUs. Why worry about a debt crisis when everyone wants to buy U.S. debt?

Those of us who advocate fiscal prudence have been asked that question repeatedly in the past 15 years. We would point to the host of unfunded liabilities looming in our future. They would respond by pointing to the trend of declining interest rates over time. Low rates, they said, meant we should be able to handle interest payments on outstanding debt while growing the economy with smart investments. Indeed, thanks to low interest rates, payments on federal government debt as a share of GDP dropped from more than 3 percent in the early 1990s to 1.5 percent in 2021. Debt seemed cheap and manageable, so why worry?

As the 10-year Treasury rate hit 5 percent this year, with interest payments on the debt rapidly increasing and bondholders' interest in buying U.S. debt declining, it's tempting for us fiscal hawks to simply say, "We told you so." But it's more productive to understand how we ended up in this quagmire, in hopes of avoiding similar mistakes in the future.

Politicians constantly face incentives to spend and print money, thanks to interest groups' never-ending demands. But a deeper rot in conventional economic thinking allowed those who thought interest rates would stay forever low to think they had a theoretical justification for recklessly spending and borrowing.

Olivier Blanchard, a senior fellow at the Peterson Institute for International Economics and former director of the research department at the International Monetary Fund, was the first economist to present a plausible theory of fiscal sustainability despite rampant debt. In his presidential address at the 2019 American Economic Association Annual Meeting and a follow-up paper called "Public Debt and Low Interest Rates," he made the case that if real interest rates were low and the real interest rate on the debt stayed below the economy's growth rate, then public debt is nothing to worry about. "If the future is like the past," he argued in the paper, "this implies that debt rollovers—that is, the issuance of debt without a subsequent increase in taxes—may well be feasible. Put bluntly, public debt may have no fiscal cost."

This theory seems to make sense, but only under certain scenarios. Say, for example, that the government needs more money than it is willing to raise in taxes, and that bond investors are willing to lend that money to the U.S. at extremely low interest rates. Uncle Sam borrows $10 trillion to respond to an emergency, raising the debt-to-GDP ratio from 100 percent to 150 percent. After the emergency, the government imposes austerity and spends only revenue raised through taxes, fees, and interest on government assets. It borrows new money only to pay interest on its outstanding debt, and for no other reason. At an interest rate of 1 percent, the debt then grows by 1 percent per year. If GDP grows at 2 percent, then the ratio of debt to GDP slowly falls by 1 percent per year. Put this austerity formula on repeat for decades, and sooner or later you are back at the debt-to-GDP level where you started.

That was, in fact, the most important mechanism by which the U.S. government reduced its debt ratio from 106 percent in 1946, right after World War II, to 23 percent in 1974. The other factors were inflation, fiscal repression (i.e., policies that direct lending to the government at lower rates than would exist in a deregulated market), and economic growth.

Other economists agreed with Blanchard that debt would not be a problem, but for different reasons. Harvard University economists Lawrence Summers and Jason Furman published a paper in 2020 on fiscal policy in an era of low interest rates. They argued that "at current and prospective interest rate levels, nominal and real Federal debt service is likely to be low not high by historical standards over the next decade." According to their theory, many investment opportunities exist where government spending would get large returns and boost the economy at no cost—just so long as interest rates remain low.

After a decade of low interest rates, and no signs of price inflation despite big increases in deficits and debt, this "Debt? Why worry?" position became dominant just in time for politicians to justify the greatest spending spree this country had ever seen: the fiscal response to the COVID-19 pandemic.

The latest Congressional Budget Office (CBO) numbers show public debt has reached close to $26 trillion, or 97 percent of GDP. Ten years ago, it was roughly $12 trillion, or 71.9 percent of GDP. About 70 percent of this debt has been taken on since 2019. While jacking up spending in times of emergency is understandable, COVID didn't require spending more than $5 trillion in just two years. Even by Keynesian standards, the amount of cash injected into the economy since 2019 was larger than any plausible output gap. What's more, in the last year the deficit has doubled even though the pandemic is effectively over.

Even the most optimistic of the "forever low interest rates" academic constructs came with caveats, but these were fast forgotten to make space for that pandemic spending. For instance, Blanchard's thought experiment required that the one-time increase in debt be followed by decades in which spending on public goods and services excluding interest payments are equal to revenue. In other words, interest rates must stay low for decades to come, the economy must grow faster than the rate of interest, and big deficits must end for the "debt doesn't matter" crowd to be correct.

Such a happy confluence of events was never going to happen in the United States. For one thing, revenue hasn't equaled or exceeded noninterest spending in two decades, and it isn't likely to happen again anytime soon either. According to the CBO, in the next 30 years primary deficits will be larger than 3 percent of GDP—and that's assuming no more emergencies and no new programs. Under these unrealistic assumptions, the debt-to-GDP ratio will also grow from 97 percent to 180 percent in 30 years. That means the Treasury is going to have to borrow four times more in the next three decades than it has in the entire history of our nation.

Even if interest rates had remained relatively low, such rates applied to a debt so humongous would have eventually become very expensive. In 2020 the CBO projected that by 2050, 8 percent of GDP—roughly 40 percent of government revenue—would be going to pay interest on the debt.

Another reason to rein in debt growth even in a low-rate environment is that debt itself begets higher interest rates. The most conservative empirical literature on this issue finds that for each percentage point increase in the debt-to-GDP ratio, long-term interest rates rise by 2 to 3 basis points. In other words, an 84-percentage-point increase in the debt-to-GDP ratio projected by CBO over 30 years would add 2.4 percent to the interest rate at the time.

Even if we never faced a full-on debt crisis like the one that played out several years ago in Greece—i.e., assuming that the CBO is correct that we can glide smoothly to a 180 debt-to-GDP ratio—we would still face the unfortunate possibility of becoming Japan. At least 40 academic studies show that growing debt slows growth. Japan may have never had a real debt crisis, but it did go through what many call a "Lost Decade," and it has barely been growing since. It also has had flat real wages for decades. High debt contributed to these problems.

The U.S. may well come down with the same disease. As debt grew, real GDP growth went from being higher than 4 percent in the 1960s to around 3 percent in the 1970s to less than 2 percent in the past decade. This trend of slowing real GDP growth is projected to continue and even worsen. That should worry us. Healthy economies are not only invaluable for lifting all boats; they promote openness, tolerance, democracy, and peace. Slower growth, on the other hand, is associated with tribalism, intolerance, and violence. That remains true even in countries that are still rich but slowing down, like ours.

Our debt problem is clearly becoming more acute. Yields on 10-year notes shot above 5 percent in October, though they are back down to 4.5 percent. Two-year Treasuries are paying a 5.2 percent yield, and three-month Treasury bills are paying 5.5 percent. As a result, many of the "forever low interest rates" crowd has woken up and started to say that deficits may matter after all. From economist Paul Krugman to Federal Reserve Chair Jerome Powell, everyone agrees that even if debt didn't matter before, it matters now.

The federal government wasn't as smart as most Americans, who learned about the danger of variable rates during the last recession and have since locked in low rates. By contrast, most of the government's debt is short-term. According to the latest Treasury Department data, 52 percent of all U.S. Treasury debt has a maturity of 3 years or fewer, with a third of our debt needing to be rolled over within a year. That's more than $8 trillion. Rising interest rates mean that each time the government pays back short-term investors, it must issue new debt at higher rates. This explains part of the upward trajectory in debt-servicing costs for fiscal year 2023, from $476 billion last year to $660 billion now.

The CBO's interactive budget tool calculates that if the interest rate on the 10-year Treasury note is 1 percentage point higher in the coming decade than is currently projected in the baseline, the cumulative budget deficit during the same period will be $2.8 trillion larger than the baseline projection. One percentage point is the current gap between what CBO projected and what prevails today. If the gap is larger, the deficit and debt will explode further.

Congress hasn't a clue about how it will pay for these unplanned expenses. Even those who understand the need for fiscal prudence are not emphasizing strongly enough how big of a mess we are in. This is what the Committee for a Responsible Federal Budget, for instance, noted in October to illustrate the impact of higher interest rates on our long-term debt: "Stable primary deficits of 2.5 percent of GDP would drive debt above 400 percent of the economy by the 2080s, assuming interest rates are 100 basis points above the growth rate. If high debt further pushes up interest rates and stifles growth, as economists expect, debt could spin out of control in the 2050s, breaching 500 percent of GDP."

I don't believe the U.S. can almost double its debt, let alone get to 500 percent of GDP, with inflation staying stable. The most plausible, though undesirable, path is one where, sooner than later, Washington's refusal to stabilize the debt will lead to higher inflation.

Here's why. If people do not think the government will repay all its debts by eventually running fiscal surpluses (that is, taxing more than spending), they will worry that the Fed will resort to printing money to help repay that extra debt. As they try to get rid of the debt to buy things instead, that drives prices up and lowers the real value of debt to what people believe the government will repay. In that sense, government budget policies can directly influence inflation and the general price level.

Recently, Federal Reserve officials have attributed rising yields to expectations of strong future growth thanks to the Fed's efforts to reduce inflation. I have a different interpretation. Perhaps financial markets are starting to realize that inflation isn't going away and may even go back up, so short-term bondholders are demanding higher interest rates because they fear they will be paid back in deflated money.

I don't blame them for being skeptical that inflation has been conquered. First, the fiscal implications of higher rates (due to the Federal Reserve's fight against inflation and possibly due to bondholders' inflation expectations) pose a threat to inflation reduction. Higher yields raise the growth rate of interest payments on Treasury debt, as explained above. If spending gets cut to finance these higher interest payments, that will help the Fed reduce inflation by lowering aggregate demand. But if—as seems more likely, given past and current congressional fiscal irresponsibility—the interest is just paid by increased borrowing, we could be headed for a prolonged bout of inflation, as that move would signal there is no plan to pay for all that red ink. In that scenario, further Fed actions won't help.

The recent weak Treasury auctions seem to confirm this intuition. On November 9, for instance, the Treasury couldn't sell all the 30-year bonds it was trying to auction off—there was insufficient demand for the bonds at the prices and yields being offered. If investors are unwilling to buy the bonds at the current interest rates, they may expect higher yields for one reason or another, such as inflation concerns or an anticipation that the Fed will raise interest rates to fight inflation. These investors also know the Treasury is about to put trillions of dollars in bonds on the market in the next few years and that the government may not have any other choice but to raise rates to sell it all. So why buy today at lower rates than you can tomorrow?

Note that foreign buyers of U.S. debt, such as China and Japan, have become less reliable lately. Foreigners have reduced their share of government debt from 47 percent 10 years ago to 30 percent now. The Fed had picked up a lot of the difference, but it is now unloading its portfolio at the rate of $60 billion a month. Interest rates will have to rise to convince people to hold that debt.

That brings us back to where we started. For decades, Washington has spent money it didn't have on entitlement programs that benefit the relatively old and rich. They have picked up the pace of spending in recent years, encouraged by economists and pundits who claimed that interest rates would always stay low and that the insatiable appetite for U.S. government debt would not end anytime soon.

You don't have to be ideologically committed to a smaller government to understand that this was a risky bet. Rates are up, and people aren't as eager to buy U.S. debt at the current price, especially since there is much more to come. So we're probably in for more rate hikes and higher interest payments, and we may get more inflation. I don't know where that will end, but I do know that all this was utterly predictable—and that the blame rests not just on lawmakers' failure to tend to the country's fiscal health, but on those who made up dubious economic theories to facilitate their fiscal delinquency.