As the debt burden and interest costs rise, investors are likely to become increasingly concerned about the government’s ability to service debt
News headlines are filled with speculations about the U.S. debt limit. Most prevalently, whether Treasury could be forced to prioritize interest payments to bondholders while delaying other government obligations when the debt limit binds, potentially as early as June. If Congress failed to raise the debt limit in time, prioritization of interest on the debt, before other government payments, is one likely outcome.
A more ominous speculation is whether the U.S. government would default on its debt. Treasury has the ability to prioritize interest payments and should be able to cover debt obligations with incoming revenues alone. For the U.S. government to default on debt obligations this year seems highly unlikely.
More productive news coverage would examine whether deficit spending is sustainable on its current trajectory and what the consequences are of high and rising debt for individuals and government policy. That important context is lacking from current debates and undermines the ability of lawmakers and the public to make appropriate trade‐off considerations.
On January 19, U.S. borrowing exceeded $31.4 trillion, the statutory debt limit. To continue borrowing, Treasury Secretary Janet Yellen began using so‐called extraordinary measures (debt limit loopholes), buying the administration and Congress time to negotiate. Both parties are now amid a political showdown that may determine the future of U.S. fiscal policy.
Beyond click‐bait headlines about a debt default, lawmakers and the public should know that if the debt continues to grow rapidly, it will bode ill for the U.S. economy, business investment, and government policy. High and rising debt slows growth, crowds out private investment, limits the government’s ability to respond to unforeseen emergencies, and elevates the risk of a sudden fiscal crisis where investors would lose confidence in U.S. Treasury bonds and the U.S. dollar.
$31 trillion in gross federal debt is unprecedented in U.S. history. This level of debt is greater than the annual economic output of the entire country, as measured by gross domestic product (GDP). Divided among the U.S. population, the total federal debt is at $94,000 per person or $240,000 per U.S. household. Such high debt is a big burden with far‐reaching consequences, including:
Higher interest costs. Rising debt, without a reduction in interest rates, means higher interest payments. As the government borrows more, interest costs rise. Under baseline projections by the Congressional Budget Office (CBO), net interest costs will rise to 7.2 percent of GDP by 2052. That means that interest costs alone will consume 40 percent of federal revenues by 2052. As interest costs make up a larger share of the federal budget, policymakers will be forced to choose between paying interest on the debt and providing funding for other critical spending priorities, such as national defense and public health.
Rising debt further increases interest costs. The American Enterprise Institute’s (AEI) John Mantus and Mark Warshawsky found that a “1 percentage point increase in the federal debt‐to‐gross‐domestic‐product ratio is associated with an increase of nearly five basis points in the long‐term interest rate…double what the Congressional Budget Office uses in its budget projections.” Interest rates that exceed CBO projections by just one percentage point could add another $30 trillion in interest costs over 30 years.
As the debt burden and interest costs rise, investors are likely to become increasingly concerned about the government’s ability to service debt. If investors demand even higher Treasury yields to continue lending after perceiving elevated risk, this means yet higher interest rates. Under the AEI model, higher‐than‐expected interest rates cause the debt‐to‐GDP ratio to rise to 235 percent by 2052 compared to the 185 percent forecasted in the CBO extended baseline.
Foreign investors, who hold approximately one‐third of publicly held federal debt, will receive increased interest payments as interest rates rise. These elevated interest payments to foreign holders of U.S. debt would reduce America’s net international income (the difference between a nation’s income and its total production). Higher interest costs reduce America’s relative international economic standing while making the United States government increasingly dependent on foreign and domestic creditors.
Investment Crowd Out. As debt grows, it also crowds out private investments. When the government borrows money, it does so from the public and businesses. Increasingly, savings purchase Treasury securities instead of going towards productive capital investments like startups and other businesses, research and development, and new technologies. Even assuming possible benefits from increased federal borrowing, such as when the government makes effective public investments in public health or national security, debt crowd‐out results in lower economic output and incomes.
In 2019, CBO estimated the economic effects of high and rising debt under several scenarios. Compared to CBO’s alternative baseline scenario, stabilizing the debt at 2019 levels would result in gross national product (GNP) being $2.7 trillion higher by 2049. That’s an increase of $7,000 per person. Reducing the publicly held debt (the debt the United States has borrowed from credit markets) to 42 percent of GDP would result in GNP being $3.5 trillion or $8,900 per capita higher.
Since 2019, the publicly held debt‐to‐GDP ratio has risen from 78 percent to 97percent at the end of 2022. According to CBO calculations, stabilizing the debt in 2019 and reducing it to 42 percent of GDP required reducing the annual primary deficit (the difference between revenues and noninterest spending) by 1.8 percent and 2.9 percent of GDP, respectively. The economic benefits of similar‐sized deficit reductions today would likely be even larger. Likewise, the economic risks of unsustainable deficit growth will only increase in severity over time.
Increased vulnerability to crises. A large debt burden also constrains the U.S. government’s ability to respond to domestic and international crises. CBO explains:
“Having a small amount of debt outstanding gives policymakers the ability to borrow to address significant unexpected events such as recessions, financial crises, and wars. A large amount of debt, however, leaves less flexibility for government actions to address financial and economic crises, which, in many countries, have been very costly to the government (as well as to residents). A large amount of debt could also harm national security by constraining military spending in times of crisis or limiting the ability to prepare for a crisis.”
Recent federal spending sprees, including the $6 trillion Congress spent to respond to the COVID-19 pandemic, would be considerably more difficult, if not impossible, under the current trajectory. Rising debt weakens economic resiliency by making it harder to respond to economic shocks and harms national security and public health by constraining our capacity to respond to and prepare for emergencies.
Increased risk of a sudden fiscal crisis. If lawmakers allow debt to continue to climb rapidly, the United States could be confronted with a worst‐case scenario in which investors might become increasingly worried that the United States might service its debt by inflating away the value of its bonds. Eventually, bond holders could lose confidence in U.S. Treasury bonds and dump their holdings, triggering a quickly spiraling fiscal crisis. A sudden decline in the market value of outstanding Treasury securities would cause significant losses for mutual funds, pensions, insurance companies, and banks. These losses could cause major financial institutions to fail resulting in widespread economic harm.
If policymakers delay action until a fiscal crisis is on their doorstep, they could be forced in‐between a rock and a hard place of massively cutting spending and or aggressively raising taxes. Studies reviewing the experience with European austerity measures and other measures taken by select OECD countries to stabilize their government finances indicate that the most successful deficit reduction strategies focus on spending cuts, especially to social programs and government bureaucracies. Increasing taxes was less effective at reducing deficits and more economically harmful.
Debt Default and Hyperinflation. Alternatively, policymakers might renege on the terms of existing debt or monetize the debt, thus boosting inflation. Both options are extremely unlikely to achieve the intended result of lightening the U.S. debt load. They are too economically costly. Defaulting on the debt is creditors’ worst fear. In most cases, it results in widespread financial chaos. Even if lenders would be willing to extend additional credit, they would demand much higher interest premiums, putting the U.S. government even deeper into the debt hole. The other bad option of inflating away the debt would worsen overall economic performance by reducing the purchasing power of the dollar and by being a de facto tax on savings and other investments. It would also quickly become priced into future bonds as investors would require higher interest rates to make lending profitable. In the worst case, monetizing the debt could lead to Weimar‐style hyperinflation and economic collapse.
Debt is already at economically damaging levels. According to a review of recent economic literature by the Mercatus Center’s Jack Salmon on behalf of Cato, high public debt—defined as a debt‐to‐GDP ratio above 78 percent—has a consistently negative effect on economic growth. As America’s publicly held debt climbs above 100 percent of GDP, the United States is already experiencing slower economic growth from lower productivity through the crowding out effect, elevated interest rates, and less investment due to expectations of higher future taxes to service the debt. Lawmakers should adopt a concrete plan to stabilize U.S. debt as a percentage of GDP through fiscal restraint to unleash economic growth and boost American incomes before a potential fiscal crisis forces their hands. The debt limit is one such leverage point to significantly change the U.S. fiscal trajectory for the better.
Originally published by the Cato Institute. Republished with permission under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.
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