America has no backup plan if interest rates rise.
We shouldn't bet the country's future on interest rates remaining low forever.
S enator Joe Manchin has (for now) killed the president’s Build Back Better proposal that — once the fake expiration dates are inevitably removed — would have added $3 trillion in new debt over the decade. Yet even without this legislation, Congress and the White House have been engaging in the largest borrowing-and-spending spree since World War II. Following $3 trillion of (largely justified) pandemic spending in 2020, President Biden has already signed legislation adding $2.5 trillion in new ten-year debt, and Congress is trying to raise the discretionary spending baseline by an additional $1 trillion over the decade. Combined with baseline deficits, the national debt held by the public — less than $17 trillion before the pandemic — would surpass $40 trillion a decade from now.
And yet there has been no widespread debt backlash from politicians, voters, economists, or financial markets. This newfound comfort with debt is based on the contention that low interest rates have rendered almost any government debt level to be affordable. The average interest rate paid by Washington on its debt has fallen from 8.4 percent to 1.5 percent over the past three decades. However, economic variables tend to fluctuate, and only a fool would assume that a current economic trend will last forever. In the past, economic forecasts and markets told us that high inflation and high unemployment cannot happen simultaneously, that the late-1990s tech-stock bubble wouldn’t burst, and that national housing prices can never fall. Just last year, the Federal Open Market Committee consistently underestimated current-year inflation by three full percentage points. Interest-rate forecasts have proven spectacularly wrong for 50 years.
But now, economic commentators assure us that soaring federal debt is affordable because interest rates will remain low forever.
By contrast, the Congressional Budget Office projects that rates will nudge up to 4.6 percent over three decades. That is easily possible. After all, a broad range of studies show that the projected 100 percent of GDP increase in federal debt over the next three decades should, by itself, add three percentage points to interest rates. Added federal debt over the past 15 years also put upward pressure on interest rates, but this was offset by low productivity, baby-boomer savings, and Federal Reserve policies that pushed rates downward. For interest rates to remain low, those offsetting factors would have to accelerate much further to counteract the three-percentage point effect of future debt.
Other economic factors could raise interest rates even further. For example, the end of the recession should push rates upward. As 74 million baby boomers retire, they will shift from saving money to drawing down those savings. The recent productivity slowdown could reverse as the technological revolution finds new applications. The global savings glut is already slowing, and savings could chase higher-return investments in the U.S. and emerging economies.
This means that CBO’s projection of rates gradually rising to 4.6 percent over three decades is prudent, and may even represent an underestimate.
And that leads to the real danger of higher interest rates colliding with a historic surge of government debt.
CBO estimates that escalating Social Security and Medicare shortfalls will bring $112 trillion in 30-year baseline deficits. Unlike interest rates, these long-term federal deficits can be reliably projected because they are based on Social Security and Medicare spending commitments that are already set in law.
Under this baseline scenario, the national debt will double from 100 percent to 202 percent of GDP over the next three decades. Annual budget deficits would gradually rise to 13.3 percent of GDP (compared to 3 or 4 percent of GDP in the recent pre-pandemic years). Interest payments would become the largest federal expenditure, consuming half of all tax revenues. And beyond that point, the debt would continue rising by 80 percent of GDP per decade.
This is just the CBO baseline scenario, which assumes peace, prosperity, the expiration of most of the 2017 tax cuts, and no additional spending expansions.
But what if interest rates exceed the CBO baseline by even one percentage point? That would add $30 trillion in interest costs over three decades — equal to the entire defense budget over that span. The debt would instead leap to 243 percent of GDP (and rising steeply), the annual budget deficit would jump to 17.6 percent of GDP, and interest payments would consume 70 percent of all tax revenues.
Even low interest rates would not save us from the consequences of Social Security and Medicare’s enormous shortfalls. A scenario in which interest rates never again exceed 3 percent would still leave annual deficits of 10 percent of GDP within three decades and the debt’s share of GDP growing steadily forever. There is no plausible interest rate that stabilizes the long-term debt under baseline tax and spending projections. Rising rates would only accelerate the day of reckoning.
And no, foreign borrowing cannot bail us out. China and Japan have financed just one percent of the $11.7 trillion in federal deficits over the past decade, and their combined $2.3 trillion in U.S. debt holdings suggest they have neither the capacity nor the desire to take on much of the coming $112 trillion deluge. The Federal Reserve has increased its Treasury holdings to $5 trillion, yet trying to monetize much of the $112 trillion would certainly risk hyperinflation. That leaves American savers and investors to finance perhaps $100 trillion in new federal debt over three decades. That may be a heavy lift that requires higher interest rates.
The fact that America “owes the money to ourselves” due to domestic lending does not mean the debt is free. The people and businesses lending the federal government tens of trillions must be repaid, and those future repayments (and the interest costs) will have to paid out of significantly higher taxes, reduced federal benefits, higher inflation, or more borrowing until the markets stop lending.
No, Japan’s 200 percent of GDP debt does not prove that debt does not matter. Its past three decades of deficit spending have been accompanied by sluggish economic growth. Japan’s debt has not been inflationary because much of it has been funded by substantial domestic savings — such as corporate retained earnings equaling 89 percent of GDP. America’s entitlement-driven annual deficits are projected to far exceed — and prove more politically difficult to reverse than — Japan’s smaller annual deficits that financed flexible priorities such as stimulus and infrastructure.
America cannot afford to keep spending and take a “wait and see” approach on debt. Social Security and Medicare costs cannot easily be pared back once the baby boomers are in their 70s and 80s. Surging interest costs are mostly irreversible, too. The principal will only get larger as more debt accumulates (and will continue to accumulate if Social Security and Medicare cannot be reformed), and the rising interest rates in this situation cannot simply be reversed either (unless the Federal Reserve unwisely commits to monetizing much of the debt). If interest rates are driven upwards by financial markets losing faith in the federal government’s long-term ability to manage its debt, the resulting risk premium may remain baked in for several years or even decades.
Debt crises typically build slowly over many years, with little response from the financial markets or the broader economy. Then, any economic event — a severe recession, an unexpected emergency expenditure, a breakdown of congressional budget negotiations — can trigger a financial market panic out of fear that Washington is on an unsustainable course. And at that point the only options are damaging tax hikes, painful benefit cuts, or steep inflation.
Debt doves confidently assert that we should pile on even more spending and debt on the simple assumption that the interest rate on this debt will never again exceed 3 percent or 4 percent — even though higher rates prevailed as recently as 2008. The reality is that no one knows what interest rates will be in five, ten, 20, or 50 years, and any claim otherwise is hubristic and naïve. That’s why Washington should practice basic risk management, rather than continue excessive spending and gamble our economic future on the hope that interest rates stay low forever. After all, America has no backup plan if interest rates rise.
For a more in-depth look at this topic, see Brian Riedl’s new Manhattan Institute report, “How Higher Interest Rates Could Push Washington Towards a Federal Debt Crisis.”