By James C Capretta
James C. Capretta is a RealClearPolicy Contributor and holds the Milton Friedman chair at the American Enterprise Institute.
As the economy heats up, the federal government’s borrowing costs are set to soar. The most recent budget projections from the Congressional Budget Office (CBO) show the government’s annual interest payments on federal debt more than doubling over the next decade — from 1.5 percent of GDP in 2018 to 3.1 percent of GDP in 2027. Moreover, interest rates could easily rise more rapidly than CBO projects (the agency will be updating its projections later this year). Higher borrowing costs threaten to make the government’s already daunting fiscal challenges even more intractable.
History dictates, and pinches
The federal government ran very large budget deficits due to the financial crash and the deep recession of 2007 to 2009. After 2009, the economy grew at a sluggish pace and federal deficits remained higher than they would have been in a stronger recovery. From 2009 to 2016, the government ran a cumulative deficit of $7.3 trillion. At the end of 2016, federal debt reached 77 percent of annual GDP—up from 39 percent at the end of 2008.
The recent deficits would have been even larger if not for the extraordinarily low interest rates paid by the government on the national debt. The Federal Reserve, along with other central banks around the world, drove interest rates to historically low levels in order to provide a sustained monetary stimulus to the global economy. Among other things, the Federal Reserve purchased large amounts of federal debt as part of its quantitative easing program.
In 2008, the federal government made $253 billion in net interest payments on debt that was $5 trillion at the end of the fiscal year 2007, for a 5 percent average interest rate on the debt. The government made only $240 billion in interest payments in 2016, although the debt had more than doubled to $13.1 trillion at the end of the fiscal year 2015, for a 1.8 percent average interest rate.
Monetary versus fiscal policy
The era of ultra-easy monetary policy appears to be ending, as it has become clear that the economy is now growing more rapidly than at any time since 2010. The Federal Reserve is widely expected to raise short-term borrowing costs at least three times in 2018. As monetary stimulus ends, and interest rates move toward more normal levels, the federal government will be required to pay higher rates on the funds it borrows.
CBO projects a rise in the average real interest rate paid by the federal government, but to a level that would still be below what it was historically. In CBO’s projection, the average nominal rate paid on the debt would rise from 2.2 percent in 2018 to 3.5 percent in 2027. With inflation (as measured by the CPI) projected to rise to 2.4 percent in 2027 from 2.2 percent in 2018, CBO is envisioning an average real interest rate paid on the federal debt of around 1 percent over the coming decade. By contrast, the average real interest rate on 10-year Treasury notes was just over 3 percent from 1990 to 2007.
If the average real interest rate instead gradually rose to around 2.2 percent over the next decade, then federal interest payments could reach $1.2 trillion in 2027—or more than $0.3 trillion above CBO’s current forecast. The annual budget deficit would widen from $0.7 trillion in 2018 to $1.8 trillion in 2027.
Projected growth rates
CBO has cited several reasons why real interest rates may remain below their historical levels throughout the next decade. These include slower productivity growth and more risk aversion in the aftermath of the financial crash. CBO may be right that real interest rates will not return fully to where they were before 2008. But even a partial normalisation of interest rates would dramatically increase federal costs, making it even more difficult for policymakers to get the nation’s fiscal house in order.
The prospect of stronger economic growth over the coming years is welcome news, especially for workers who are likely to see their wages rise more rapidly than they have since 2008. Stronger growth will also boost federal revenues above what is reflected in current projections. But the return to stronger growth also will bring back more normal interest rates on federal borrowing. Moreover, the added interest expense on the debt is likely to far exceed the added revenue from stronger economic growth.
The federal government was able to borrow liberally over the past decade on the cheap, thereby masking the severity of the nation’s fiscal problems. As interest rates rise, the full scale of the budgetary challenge will be more visible. An optimistic view of these developments is that greater visibility of the problem will prompt action to address it. The administration and Congress might see the economic risk that growing federal debt now poses, and take some initial steps to get projected deficits more under control.
The requisite modifications
The keys to limiting future deficits and debt are gradual changes in spending on the major entitlement programs, to lower their costs over the medium and long-term. While it is not necessary to achieve balance in the near term, it is necessary to slow the rate of future spending growth to prevent federal debt from spiralling out of control. Social Security and Medicare should be modified for future entrants to encourage longer working lives, more reliance on private savings in retirement, and greater efficiency in how health services are delivered to patients. These changes can be put in place even as more protection is provided for those with modest lifetime incomes. Current beneficiaries can be fully protected from any changes in their benefits.
Although it is possible that rising federal interest payments will prompt this kind of action in Congress, it does not seem likely. It is more probable that both parties will advocate steps this year that will make the problem worse, not better.
It would be far better for the country if political leaders took steps now to head off a potential fiscal crisis that could come with rising debt. Fixing the problem after a crisis has started will be more painful. At the moment, though, neither party seems ready to face budgetary reality.
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