The Exploding Cost of Servicing Our Debt

Building on my post from last week about the cost of our debt, I have made this chart showing the changes that will occur when the Congressional Budget Office’s interest-rate assumptions are modified to reflect historical interest rates and private-sector forecasts.

Using data from the CBO’s “January 2011 Budget and Economic Outlook” and “Analysis of the Effects of Three Interest Rate Scenarios on the Federal Budget Deficit,” the above chart compares CBO baseline interest costs between 2011 and 2021 with interest costs under each of three interest-rate scenarios: 1) a scenario similar to that experienced in the 1980s; 2) a scenario similar to that experienced in the 1990s; and 3) a scenario consistent with the ten highest projections found in Blue Chip Economic Indicators. Under each of these scenarios, the cost of servicing our debt exceeds the costs projected in the CBO baseline.

This suggests that CBO baseline projections, which already show an explosion in the cost of servicing our debt, may in fact be an underestimate.

For instance, if interest rates were modified to reflect the average rates in the 1980s — a time in U.S. history when interest rates were driven up by inflation and economic uncertainty — in 2021 our interest payments would nearly triple from CBO’s projection of $749 billion to $2.0 trillion. Accumulated interest payments over this period would double from their current projected level of $5.7 trillion to $11.0 trillion. Needless to say, the impact of these increased interest costs on the deficit would be huge.

But why would interest rates increase beyond what the CBO has projected? It’s simple. A growing debt sends signals to our investors that the risk we represent is growing, too. It has consequences. What happens when you max out all your credit cards and you don’t have enough money coming in to pay your bills? One thing you do is you get another credit card and you roll over the balance. But how long before you represent such a liability that no one will give you another credit card? How long before your interest rate goes from 12 percent to 30 percent in order to get that card?

That is precisely the game the U.S. is playing right now. We are constantly rolling over short-term debt. When our lenders wise up, they are likely to increase interest rates to reflect the risk that we’ve become.

This fuels another concern: inflation. To get deficits under control, the federal government could cut spending or increase taxes (or both). Neither of these policies are popular, hence the temptation to resort to printing money (or “monetizing the debt”) to pay its bills.

However, there is no free lunch. The resulting inflation reduces the value of each one of your dollars and also introduces high levels of uncertainty. Obviously, the Federal Reserve is unwilling to take such a dramatic step today. However, investors know that other central banks have done this in the past and it could happen again, so, in exchange for extending more loans to the federal government (which has become a riskier client), lenders could soon be asking for a higher interest rate — an inflation premium.

The only way to address the increasing costs of our debt is to address the driving forces behind it — legislated explosions in Social Security, Medicare, and Medicaid spending.

Veronique de Rugy — Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. Her primary research interests include the U.S. economy, the federal budget, homeland security, taxation, ...

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