In these early days of the Biden administration, some monetary policy decision-makers seem excited about pushing our national debt to record levels and beyond. Only four years ago, then Chair of the Federal Reserve Janet Yellen said that our debt trajectory should “keep people awake at night.” But now, under an illusion of cognitive myopia that I have termed the fallacy of low-trending interests rates infinitum, Treasury Secretary Yellen argues that in a world of low interest rates, we can embark on an open-ended spending spree. However, this “debt doesn’t matter as long as interest rates are low” narrative is not only wrong but dangerous.
Proponents of this fallacy will often show you a chart of Treasury note yields—the interest rates the government pays to borrow money—with a falling trend starting in the early 1980s. But using past trends in interest rates to project that such trends will continue into the foreseeable future is bad economics (that will have serious adverse long-term effects) and ignores the simple fact that trends can, in fact, be broken. Economists in Greece used to be under the same illusion (see Greek treasury yields for 1997–2005 in the figure below) that treasury yields could continue to fall forever, until rates rose from 3–4% to almost 30% in what became the European sovereign debt crisis.
Empirical Evidence of the Fallacy
While demographics and foreign demand for U.S. debt have put downward pressure on interest rates over the years, growing debt and deficits have also put upward pressure on interest rates. Several academic studies have found that each percentage point increase in the debt-to-GDP ratio raises real interest rates by 2 to 5 basis points, while each percentage point increase in the deficit-to-GDP ratio raises real interest rates by 18 to 28 basis points.
Observing 9 industrialized countries over a 20-year period (1977 to 1997), one 1999 study finds that each 1 percentage point increase in public consumption as a share of GDP raises real interest rates by 23 basis points for all countries in the sample and 28 basis points for the United States. Similarly, one IMF study finds that a 1 percentage point increase in the government-consumption-to-GDP ratio raises real long-term interest rates by 20 to 25 basis points, while each percentage point increase in the debt-to-GDP ratio raises rates by about 2 basis points. A CBO study from 2019 finds that the average long-run effect of debt on interest rates ranges from about 2 to 3 basis points for each 1 percentage point increase in debt as a percentage of GDP. In a similar vein, a well-known study finds that each percentage point increase in the debt-to-GDP ratio raises the interest rate by 2.1 basis points.
Other academic studies that observe the relationship between debt levels and interest rates find the effects to be even more pronounced, with each percentage point increase in the debt-to-GDP ratio raising interest yields by as much as 3 basis points according to one NBER study, or 5 basis points according to another IMF study. Studies focusing on the effect of increases in the budget deficit generally find that each percentage point increase in the size of the budget deficit raises yields by approximately 20 basis points.
More recently, a 2019 analysis by former Treasury economist Ernie Tedeschi finds that for every 1 percentage point increase in the budget deficit-to-GDP ratio, the 10-year Treasury yield rises by 18 basis points, while a 1 percentage point increase in the debt-to-GDP ratio raises yields by 4.2 basis points.
It isn’t just the swathes of economic literature that consistently demonstrate how growing debt and deficits raise real Treasury yields. The Congressional Budget Office also estimates that interest rates on 10-year Treasury notes and the OASDI trust funds will grow from around 1 percent today to 4.8 percent by 2050. At these interest rates, future payments on the nation’s debts will constitute more than 8 percent of GDP, a percentage significantly larger than that of both Medicare and Social Security funding—by 2050, almost half of tax revenues collected will be used to pay off interest on the national debt.
Why Does the Debt Matter?
Proponents of open-ended spending, deficits and debt often make the case that other factors such as foreign demand for U.S. debt outweigh the upward pressures of our debt trajectory. Some economists have, therefore, concluded that the growing debt doesn’t matter. Along these lines, Ernie Tedeschi has argued that each percentage point increase in the ratio of foreign holdings to GDP lowers the 10-year Treasury yield by 11.2 basis points. However, foreign holdings of US debt as a share of GDP are at the same level today that they were nine years ago in 2012. Why, then, do economists assume there will be some kind of explosion in the foreign holdings of U.S. debt? Not only has the ratio of foreign holdings to GDP remained around 33 percent since 2012, but the share of public debt held by foreign investors has fallen significantly in recent years.
Assuming the CBO’s most optimistic debt trajectory scenario, foreign holdings of U.S. debt would need to increase to at least 70 percent of GDP by 2050 just to counteract the upward pressures of debt on interest rates. Dare we rest the fiscal health of our nation on such naive assumptions about foreign investors holding unprecedented levels of U.S. debt? Stanford University economist John Cochrane says that we shouldn’t.
Conveniently, many economists completely disregard this empirical literature and instead embrace an Olivier Blanchard view of debt dynamics. Under this view, economists argue that we can simply “grow our way out of debt” so long as interest rates are lower than growth rates. Aside from ignoring the empirical literature on interest rates and debt, this view overlooks one important aspect of the government budget—namely, the primary budget deficit, which is total spending minus total revenues, excluding interest payments.
Even if we assume (dangerously and naively) that interest rates will remain at or around 1.7% for the foreseeable future, the most optimistic projection predicts that U.S. GDP will grow by 5.1% in 2021. While growth rates are larger than interest rates, accounting for an 8.6% budget deficit means that our debt-to-GDP ratio will still grow by 5.2 percentage points. Using the Olivier Blanchard logic, real GDP growth would have to be more than 10.3% in 2021 to “grow our way out of debt.” Using long-term CBO projections for interest rates and budget deficits, real annual GDP growth would have to be greater than 17.6% to grow our way out of debt in 2050. For reference, the U.S. economy has averaged about 3% real annual GDP growth since 1950.
With interest rates on U.S. debt set to reach 4–5% by 2050 and a total debt stock twice the size of our economy, we cannot afford to fall for such bad economic arguments. We should not be passing the burdens and risks onto future generations who will have to finance this cumulative debt with exorbitant tax rates. The fallacy of low-trending interest rates infinitum is a mistaken belief that we can no longer afford.