Like a great many landmines left by the failures of our political establishment over recent years, there is a disaster lurking down the path, soon to be under our feet. The name of this landmine is the national debt. While it’s true that historically the national debt has hardly ever been a serious issue for the United States, and doesn’t necessarily need to be, unless we set risky new precedents or weaken the fairness and functioning of our economy, we might find ourselves standing a live mine, and not a dud.
When the Federal Government funds its doings, it acts similar to a bank insofar as it debits and credits accounts as it sees fit, and worries about evening the balance sheet afterwards. Eventually the government borrows by issuing Treasury Bonds at varied rates of interest and terms of maturity.
Really until the Second World War, if the government borrowed money, the only way it could deal with the interest cost was by either paying down the debt or inflating away and outgrowing the debt. At some point, the Federal Reserve (which was created in 1913) began occasionally purchasing Treasuries. During the war the big bank purchased and held Treasuries equaling a little more than a tenth of the national income, falling and then leveling off at one-twentieth of the national income by 1960.
When the Great Financial Crisis hit in 2008, the Federal Reserve broke precedent and increased its holdings of Treasuries to a then-peak of 14 percent of GDP. This of course was surpassed in this year’s COVID-19 pandemic, when the Federal Reserve banks increased their holding of Treasuries to an all-time high of 23.6 percent of GDP, projected by the CBO to reach nearly 30 percent over the next few years. This is congruent with the Federal Reserve Board’s sentiment that Congress must be bolder with its fiscal policy and forget the deficit for the time being.
The issue however is that without changing any laws, the debt will explode if interest rates climb again. The above chart depicts this using a conventional budget model based mostly on the CBO’s long-term budget model and its interest rate projections. The CBO projects the average rate of interest on Treasuries to climb to 4.2 percent by 2050, and while I think that’s not very likely with our current economic policy regime, I’d take it seriously, especially as they’ve got a much more nuanced analysis than I have.
Either way, debt piling is difficult because it automatically increases deficits in a ponzi fashion as the government borrows more to finance its interest commitments. If this this effect becomes inflationary (and that’s a serious possibility), there is no law that states the Federal Reserve is required to purchase Treasuries and remit interest to the Federal Government. To make matters worse, the interest burden acts as an automatic destabilizer and as interest outlays typically fall sharply during a slump and rise during a boom. This should have the effect of exacerbating both the slump of a recession and the inflation of a boom.
If it waits too long to take action, Congress will be stuck between a rock and a hard place. One option will be to strongarm the central bank (which was made to be independent) and make it gobble up zillions in U.S. debt securities to essentially nullify the nation’s debt commitments or make them less obtrusive. The other option will be to raise taxes, which would likely be done in a regressive fashion, and with no accompanying public welfare benefit.
When in the past the nation had a interest problem, it just waited it out. In the 1960’s and 70’s when interest rates began to rocket upwards, the country had relatively little debt, only around a fifth of GDP. After the War on Inflation and Reagan Tax Cuts, federal debt held by the public had climbed to 47 percent of GDP in 1993, but as interest rates fell and the economy picked up pace, it fell fairly rapidly to 31 percent in 2001.
These interest rate declines brought net federal interest outlays less Federal Reserve remittances (which peaked in 1991 at 2.8 percent of GDP) to a 74 year low of just 0.7 percent of GDP in 2016. The effective Federal Reserve funds rate fell by more than 99.6 percent from its peak in 1981 to its then-all time low in 2011. As a consequence of the historic 2020 pandemic, the funds rate reached a new all time low of 0.05 percent. In addition, the CBO projects the average rate of interest on Treasuries to fall to an 107 year low around 2025 before rising again.
However okay things seem to go, I still don’t believe the fate of our economy and price stability should rest on the whims of the Federal Reserve, and I further don’t believe Congress should force itself and the Fed into such an awkward situation as a consequence of the political establishment not being able to tolerate higher rates of tax on rents, profits, and ultra-high incomes. In a society of such inequality, social and health disease, unemployment, and needless misery, all of our fiscal resources should not be squandered on debt interest for the marginal benefit of the most privileged, wealthy class of people into history of humanity.