December 6, 2016

Low Interest Rates and Fiscal Policy

Series Information

This essay is the sixth in a twelve-essay colloquium on the effect of low interest rates on the economy. To read other essays in the series, click here.

Ultralow interest rates have made deficit financing virtually free for the federal government, which is probably why today’s policymakers, candidates for political office, the public, and the media seem much less worried about public debt than they were during the 1980s and 1990s when several major deficit-reduction deals were negotiated between Congress and the president. But despite low interest rates, the nation is still on an unsustainable fiscal path as aging baby boomers flood into Social Security, Medicare, and Medicaid, the costs of which already constitute about one-half of federal spending.

Although very low interest rates have not turned our unsustainable fiscal path into something sustainable, they have had extremely beneficial effects on the nation’s budget. In 1981, the average interest rate on the publicly held national debt was almost 11 percent. Since 2013, it has been less than 2 percent. The decline to those low levels brought the interest bill on the debt (which had reached a post–World War II high of 3.2 percent of GDP in 1991) down to 1.3 percent of GDP in 2015, despite a two-thirds rise in the debt-to-GDP ratio. As a percentage of total federal spending, the interest bill fell from almost 15 percent to 6 percent over the same period.

In the mid-1990s, Canada was on the verge of a fiscal crisis as its debt was rising at double-digit rates with no end in sight. Under the leadership of Minister of Finance Paul Martin and with the acquiescence of Prime Minister Jean Chrétien, Canada undertook dramatic fiscal reforms that quickly led to a balanced budget. When asked how Canadian voters were persuaded to accept a period of significant fiscal austerity, leaders of both the Liberal and Conservative parties said that their most powerful argument involved the interest bill facing the nation: it was about 40 percent of revenues. Canadian voters knew something would be very wrong if their households faced interest bills equaling 40 percent of their income.

Today’s low interest rates make it impossible for US politicians to use the same argument. In 2015, the interest bill was less than 7 percent of revenues, and it is expected to be less than 8 percent in 2016.

Not only have low interest rates dampened the enthusiasm for deficit reduction, but they have also led to demands for deficit increases to finance increased infrastructure spending. The most prestigious proponent of such policies is Lawrence Summers, former Treasury secretary and president of Harvard. Proponents of this strategy assume that the return on infrastructure investment is far higher than the interest rate on public debt. The strategy would more likely be profitable if it were accompanied by reforms in US debt management practices and in how the government allocates infrastructure spending.

Current debt management practices leave the United States extremely vulnerable if interest rates return to more normal levels. In its August 2016 Update to the Budget and Economic Outlook, 2016 to 2026, the Congressional Budget Office assumes a relatively small interest rate increase, from 1.8 percent on Treasury 10-year notes in 2016 to 3.6 percent in 2022, with the rate then leveling off. But this modest increase is sufficient to triple the interest bill on the debt by 2026 and will make interest costs rise faster than any other major category of spending, including health costs. Any increase in debt beyond that implied by current law would worsen this interest rate risk.

Because infrastructure investments are expected to last a long time, it can be argued that they should be financed by long-term Treasury debt, say 30 years. The obvious advantage is that it would protect the United States against interest rate increases for a very long time. But Treasury debt managers have never shown any interest in what the increased debt was financing. Under current practices, if infrastructure spending is increased, it is likely to be financed by a mix of short- and long-term debt, thus increasing the immediate effect of increases in interest rates.

The federal government has never been good at allocating infrastructure spending. Remember that it used to be called pork barrel spending. The rate of return on infrastructure investments is depressed because it is a political imperative (a) to spread federal grants for such investments around the country and (b) to include areas where the investment’s return is particularly low or even negative.

For example, one can make a strong case for allocating extra federal highway money to Northern Virginia, where the rate of return is likely to be great, but the federal government cannot do that politically without also allocating extra money to Montana, where highways are pristine and where one can drive many miles without seeing another car.

Unless reforms are made in the way that the government allocates federal money, by modifying the approach to federal grants, it becomes less likely that the return to infrastructure spending will be sufficient to pay the interest cost of the necessary increase in debt. At a more micro level, it is difficult to avoid investments made for blatant political purposes regardless of the nature of the grant system. Bridges to nowhere or their equivalents are bound to be built. Such is the nature of the US political system.

There are other implications of low interest rates that may have long-term negative consequences for the federal budget. Potentially the most important one involves pensions. Interest rates at current levels make it very difficult for people to accumulate adequate pension savings. To the extent that such endeavors fail, there will be strong pressures to increase the generosity of Social Security—already the government’s largest program.

Low rates also increase pressures on the Pension Benefits Guarantee Corporation (PBGC). The PBGC protects employees with defined benefit pensions when plans are forced to terminate. Low rates make failure more likely and increase the present value of the PBGC liability when plans must be bailed out. State and local governments that have defined benefit plans also face severe financial pressures, and although it is improbable that the federal government will bail them out, it is not impossible.

 Of the various effects of low interest rates described earlier, the effect the rates have on debates regarding deficit financing is the most important. Such debates currently attract little attention, and although a lack of attention would probably remain with extremely low interest rates regardless of the state of the federal budget, it is particularly worrisome when the nation is on an unsustainable fiscal path.