How a Decade of Low Interest Rates Fueled Reckless Government Spending

Y ears of low interest rates have given policy-makers the green light to spend trillions of dollars in borrowed money, but with this year’s rate hikes, economic theories that have long depended on low rates are being turned upside down.

From the global financial crisis of 2007–2008 up until last year, the prevailing theory among many economists was that governments could borrow almost endlessly so long as interest rates remained low.

Almost two years ago, I warned about this theory, which I labeled “the fallacy of low-trending interest rates infinitum.” It was always unsound for economists to assume that because interest rates had been in a downtrend since the early 1980s, they would keep falling and remain well below historical averages into the foreseeable future. Yet in recent years, this became the prevailing view among economists and many policy-makers.

Take French economist Oliver Blanchard, who in 2019 argued that governments could continue to borrow and run up large levels of public debt so long as the interest rate on debt financing remained below the growth rate of the economy:

If the future is like the past, 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.

In 2020, former Obama-administration economists Larry Summers and Jason Furman published a paper in which they argued that perpetually low interest rates meant Federal debt service would likely remain low for the next ten years.

This change in thinking about debt has been apparent over the years in policy-makers’ shifting rhetoric. In the late 1990s, Janet Yellen, then chairwoman of the Council of Economic Advisors, stressed the importance of paying down the debt. Yellen noted:

When the government pays down the debt, it’s also borrowing less in capital markets. That adds to the economy’s savings and helps the economy and households by driving down interest rates, raising investment and making sure that our children will enter workplaces that are better equipped so they can be more productive.

As recently as 2017, in testimony before Congress, Yellen reiterated that the debt trajectory should keep people awake at night. Yet in the years since, Yellen seems to have done a complete 180. Last year, she described plans to grow the national debt to 117 percent of GDP as “fiscally responsible.” Then, after the passage of the $2 trillion American Rescue Plan, Yellen endorsed plans for an additional $4 trillion in spending, adding: “If we ended up with a slightly higher interest-rate environment it would actually be a plus for [sic] society’s point of view.”

The problem is that the bills for the easy-money policies of successive governments, which rested on the idea that interest rates would stay low forever, are now coming due, and those bills are becoming increasingly expensive as the Treasury has to roll over its debt into higher-interest-rate bonds.

Since the start of the year, the interest rate on Treasury debt has spiked significantly. The five-year Treasury rate has shot up from about 1.3 percent to almost 4.3 percent, while the real (inflation-adjusted) rate has leapt up from about -1.6 percent to about 1.8 percent.

These upward movements in Treasury yields have serious implications for the Federal budget. They mean that larger shares of the budget will be consumed by interest payments, which in turn will crowd out funding for other spending priorities. And the pain will be made worse by the short-term average maturity of U.S. debt: About half of all Treasury debt has a maturity of three years or less, while about 30 percent of it has a maturity of one year or less.

The increasing costs of servicing public debt are already being reflected in ballooning monthly payments. In August, monthly debt-service payments reached $63 billion — equal to total government defense expenditures for the same month. By comparison, the government spent $42 billion servicing its debt in August 2021.

In September, the average interest rate on interest-bearing public debt rose above 2 percent (2.07 percent). This equates to 1.98 percent of GDP (annualized) spent on debt-service payments. By the end of the year, that annualized figure is projected to rise to 2 percent of GDP. With the upward trend in interest rates, we will likely be paying 3 percent of GDP annually, if not even more, to service our debt by the end of next year. The explosion in interest payments will leave less federal money for other budget priorities, while the crowding out of capital will diminish our already-anemic growth rates.

The lesson here is simple: It’s time for economists to stop basing future economic policy on past trends and flawed theories.