Are Low Interest Rates Masking Future Deficits?

By :: July 9th, 2013

Thanks to artificially low interest rates, the United States has been able to finance deficits exceeding $1 trillion every year from 2009 through 2012 at very low cost. Throughout the period, the ratio of interest to the GDP has remained almost stable and is not expected to start rising until 2015. Some argue that this has encouraged the Congress to be fiscally irresponsible, although others believe that deficits have not been large enough given the severity of the recession.

But low interest rates will not last. In June, Federal Reserve Chairman Ben Bernanke gave the impression – apparently unintentionally -- that the Fed would soon reduce its purchases of Treasury debt and mortgage-related securities. That helped propel a major increase in bond yields. The 10-year Treasury rate rose from under 2.0 percent to over 2.8 percent in a matter of days.

The Congressional Budget Office (CBO) baseline assumes rates will gradually rise over the next few years until the 10-year rate stabilizes at a more normal 5.2 percent in 2018 and thereafter. The implications for federal interest payments are alarming. The bill is assumed to rise almost four-fold between 2013 and 2023 or at a rate of 14 percent per year. Interest would become the fastest growing expenditure item in the budget by far, leaving health costs in the dust.

CBO’s baseline must assume that current law does not change. For example, numerous tax reductions, such as the research and experimentation tax credit, are temporary under current law and the CBO must assume that they expire, even though Congress has routinely extended them over the years.

CBO provides an alternative fiscal scenario that incorporates more realistic policy assumptions. Before the fiscal cliff deal that made most of the “temporary” Bush tax cuts permanent, the alternative fiscal scenario and the baseline were very different. They have come together recently, but the alternative is still more pessimistic than the baseline, implying a debt-GDP ratio of 83 percent at the end of 2023 compared to the baseline’s 74 percent. That would make interest costs grow even faster than 14 percent per year, though the difference is small relative to the usual error in forecasting interest rates.

Countries are often pushed into a sovereign debt crisis because of growing interest payments.  It becomes politically impossible for them to increase taxes or reduce noninterest spending fast enough to keep up with rising interest costs. The debt-GDP ratio begins to explode. A debt crisis is sure to follow.

Today, it is hard to see that happening in the U.S. over the next 10 years. But throw in another recession and/or an increase in interest rates above normal levels and the risks grow.  Recent good news on the fiscal front has caused CBO to project a fall in the baseline debt-GDP ratio from 75 percent in 2013 to 71 percent in 2017. However, it begins to rise after that at an increasing rate. Given these downside risks, a growing interest bill would severely limit government flexibility. And  no one should be happy with that.

Rudolph G. Penner is an Institute Fellow at the Urban Institute.

 

 

3Comments

  1. Michael Bindner  ::  2:47 am on July 11th, 2013:

    The fact is that the debt is entirely financed based on the ability to tax incomes (since you can never be sure the world will continue to buy the debt). As many people pay no income taxes (the 47%) and the vast majority who do pay a modest amount, those who are really on the hook for repaying the debt are the very rich. They can pay now or have their kids pay later. Until those taxpayers are convinced that they are robbing from their own kids, the possibility of a financial implosion will continue. The best way to prevent it is to convince them of this reality – that essentially in a normal economy any individual’s share of the national debt is a factor equivalent to the ratio between the total debt and the amount of revenue of income taxes collected – which is about 9 – although it is currently about twice that. In other words, if you pay $100,000 in taxes in a year, you owe about $1.5 million of the national debt – or your children do.

  2. Charles Slavik  ::  10:01 am on July 11th, 2013:

    Increasing taxes is not the only option. As the author suggests in a prior article, we can 1) reform entitlements 2) cut other spending or 3) raise taxes. Likely we end up with some retarded mix of all of the above that makes no sense logically but all good sense politically (folks have to get re-elected). But that may be the cynic in me speaking.

    http://www.taxpolicycenter.org/publications/url.cfm?ID=411912
    “Analysts make such long-run projections to show that they cannot happen. Obviously, foreign and domestic public and private investors will stop buying our debt long before deficits explode. Therefore, something has to give?hopefully before there is a crisis in international capital markets. The three rapidly growing programs must be reformed; all other activities of government must be cut to the bone; or tax burdens must rise.”

  3. hassan  ::  9:43 am on March 5th, 2015:

    This is a wonderful article. I would like to suggest you that please keep sharing such type of info. I really found this article very informative. It is what i was searching for. 
Thanks
    dini evlendirme sitesi