The mounting stand-off over raising the federal government’s debt ceiling has put a renewed focus on the rising cost of financing the nation’s debt.
The costs of a debt ceiling crisis will be borne by households and middle market firms.
While these interest payments are rising quickly as the Federal Reserve raises rates to tame inflation, it’s important to have some perspective.
As a percentage of the economy’s total output, interest payments have increased to 3.5% of potential gross domestic product, sharply above the 2.5% average of the pre-pandemic era.
But they are well below the 4.5% to 5% range of the 1980s and 1990s. More important, the possibility of default on the nation’s debt—what this debate is all about—carries far more risk to the economy.
Underlying the debate is a significant structural problem—the inadequate flow of federal revenue since 2000. If this imbalance is not addressed, interest payments on the federal government’s debt are bound to increase as rates rise off their historic lows of recent years.
Some in the political authority, though, see this stand-off as an opportunity to create a crisis that would not happen otherwise.
Such an artificially induced crisis is in no one’s interest. It only places more burdens on consumers—for instance, the average rate paid by American households on their credit cards is already 19%—and raises the cost of issuing of debt by the federal government and businesses.
In the end, the costs of a debt ceiling crisis will be borne by households and middle market firms.
To better understand what is happening, let’s break down the moving parts. To begin with, interest payments are determined by two factors: debt outstanding and interest rates.
The amount of debt necessary to operate the government is the difference between revenue and expenditure. Policy decisions and business-cycle factors affect both revenue and expenditures.
Revenue is first and foremost a function of the tax rate, with economic growth playing a supporting role. Higher growth would be expected to lead to higher income streams and higher tax revenues. Conversely, lower growth would reduce tax revenue through reduced contributions from fewer workers and reduced business profits.
The level of expenditures would increase over time as the population and the economy grew. In the short term, economic downturns would temporarily lead to greater spending on the social safety net.
Policy decisions to expand or contract the role of government—according to changes in societal needs and national security—will affect the level of expenditures as well.
To standardize the level of debt over time, we look at the amount of debt relative to the size of the economy. We can measure economic output as either actual gross domestic product or by what the economy is capable of producing at each point in time, known as potential GDP.
Finally, we now measure public debt as the value of outstanding interest-bearing marketable securities (Treasury bills, notes and bonds).
We consider the level of marketable debt compared to the economy’s potential as most relevant to our discussion of the debt ceiling crisis.
Marketable Treasury securities form the backbone of the global financial system and trade, while potential GDP scrubs out the ups and downs of the business cycle.
We stress the importance of the Treasury market to the global financial system and the domestic economy. It is essential that the U.S. government guarantees the payment of its securities.
The growth of U.S. debt
Contrary to common belief, debt as a percent of GDP has not always been on an upward trajectory.
Instead, the growth of the economy in the postwar era and then the reduction of tax rates in the modern era of supply-side economics have played two distinct roles.
The rapid growth and industrialization of the economy from 1950 to 1970—coupled with high tax rates—resulted in a declining ratio of marketable debt to potential GDP.
Since 1980, however, public debt compared to the size of the economy has surged. The first increases came with the mix of Reagan-era tax cuts and military spending, which arguably led to the end of the Cold War.
The economy of the 1980s and early-1990s, however, suffered from the lingering effects of the inflation shocks from the oil embargoes as an outdated economy waited for the transition from traditional industries to the technology boom.
The next wave of debt—after a brief period of surplus in the Clinton years—resulted from Bush-era tax cuts and unfunded spending on the wars in Afghanistan and Iraq. That was followed by emergency spending surrounding the 2008-09 financial crisis and then the economic drag of austerity measures and recurring crises of the debt ceiling and fiscal cliff.
Most recently, public debt has shot up again as the result of tax cuts and sluggish growth in the pre-pandemic years, followed by pandemic assistance programs for businesses and households.
The level of interest rates
The ratio of debt to potential GDP reached what is likely to be a peak in 2020, absent any further shocks that might derail the economic expansion.
As part of that expansion—and then the response to the energy crisis and inflation—interest rates began to rise again. Federal government interest payments have increased as well.
This increase has created an ill-timed rise in federal government expenditures as the Treasury works to extend the date of the debt-ceiling default.
The government would not be able to override the bond market if Congress were to allow a default. The increased risk of holding a Treasury bond would pressure interest rates higher, causing additional Federal interest rate payments.
Absent creating another set of securities or exercising the 14th Amendment’s guarantee of debt payments, there is no rational alternative to abandoning the debt ceiling.
We should note that from 1990 until 2021, 10-year interest rates were trending downward, lowering the level of interest rate payments compared to the size of the economy even as debt levels were increasing.
But the combined effects of low energy prices, access to cheap goods produced by inexpensive labor and the disinflation of the previous decade are unlikely to occur again, even if the debt ceiling debate were to turn into another financial shock and recession.
Still, zero interest rates (and low rates of return on business investments) are unsustainable for a growing economy, and the return of 10-year yields to the 3% to 5% range should be a welcome sign of normal investment conditions.
What has also proved unsustainable is the idea that tax cuts will pay for themselves through economic growth and higher revenues.
According to the nonpartisan Congressional Budget Office, noninterest expenditures in the federal budget have exceeded total revenues in 40 of the past 60 years. The difference between noninterest expenditures and revenues (the so-called primary budget balance) has been widening during the era of tax cuts in later decades.
With interest rate payments expected to increase, that will only add to the amount of debt necessary to fund the government.
As the CBO data shows, while individual income taxes and payroll taxes have increased compared to gross domestic product, the share of corporate, excise and estate taxes has decreased. The burden of funding the government is increasingly dependent on households.
Most arguments about reducing the increase in federal spending center on Social Security and health care programs mandated by Congress. Military spending is categorized as discretionary.
The increases in programmatic spending during the economic shocks of 2008-09 and 2020 were arguably necessary responses to dire situations. There will be other economic crises and health emergencies and unavoidable events like the war in Ukraine.
No responsible lawmaker or policymaker suggests that we cannot fulfill our responsibilities to households and businesses or to the holders of our debt. But Congress needs to reassess the cost and benefits of tax cuts and increases in spending.
What has become a regressive set of tax programs—reduced corporate taxes and increased payroll and income taxes—has not led to increased economic growth. Instead, the economy has settled into a long-term average growth of less than 2% per year.
Finally, the idea that defaulting on existing debt is a benign way to resolve the increase in debt is misinformed at best.
A fiscal problem requires a rational fiscal solution. The debt ceiling debate is an artificial crisis with real economy effects.