We were so naive just four years ago. That was when Olivier Blanchard, one of this generation’s preeminent macroeconomists, gave the presidential address at the American Economic Association meeting. Covering the topic of “public debt and low interest rates,” Blanchard argued that because interest rates were so low, developed economies did not need to worry too much about debt. So long as the economy grew at a faster pace than real interest rates, which were then about zero, governments could spend more. There was little need for austerity.
Financial economists in the room gasped in horror (at least I did). We care about risk; Blanchard was assuming the stability of variables—interest rates and GDP growth—that change over time and in unpredictable ways. Odds are that rates would not stay at zero forever; yet we’d be stuck with the debt for decades. To be fair, Blanchard raised this concern in passing. But his ultimate recommendation was to spend more and worry less.
A few years later, Blanchard has joined the ranks of economists who believe that interest rates may not return to pre-pandemic levels. The 0 percent rates that we saw in the decade after the financial crisis may have been a fluke, the result of decades of low and predictable inflation, as well as unlimited demand for U.S. bonds relative to their supply. Neither circumstance obtains today.
Even if the Federal Reserve starts cutting rates soon, real ten-year rates may settle at 2 percent or 3 percent going forward. And if inflation sits at around 2.5 percent to 3 percent, that means nominal yields will be a steeper 5 or 6 percent—well above their manageable 3 percent when Blanchard made his speech.
Unfortunately, politicians kept ramping up spending on the mistaken assumption that rates would remain low. Even before the pandemic, the Trump administration ran up large deficits for its unfunded tax cuts. But the real spending bonanza came during the pandemic. Spending when the economy was at a standstill could be justified: many people were out of work and losing income. But the size and scope of the government stimulus, which continued even as the economy recovered and began running hot again, suggests that politicians believed that such outlays were free.
Deficits as a share of GDP now stand at levels normally reserved for recessions or wars. The Congressional Budget Office projects the debt to grow to 115 percent of GDP in the next ten years. And that’s before unfunded entitlements hit the budget over the next decade, bringing debt to a projected 181 percent of GDP by 2053. Net interest payments on debt are expected to become one of the biggest sources of spending, representing 6.7 percent of GDP by 2053—more than all discretionary spending, consuming two-thirds of all income-tax revenues. Even this bleak scenario assumes that interest rates will fall from where they are now and then rise only gradually to 4.1 percent.
Policymakers were convinced that rates would not go up. As a consequence, the government financed most of its debt by issuing short-term bills. This is like taking on a variable-rate mortgage when mortgage rates are at record lows: it may be a reasonable decision if you think rates will remain steady or fall, but it will prove extremely shortsighted if rates rise. Yes, the effective maturity of U.S. debt increased by about two years last decade, as the government locked in some of the rates—meaning that the bill is not due immediately. But the effective maturity is still just above five years, and about one-third of outstanding debt matures in the next year. Governments cannot dodge the problem for long. And any benefit of extending the government’s debt maturity was largely undone by quantitative easing, in which the Federal Reserve bought long-term debt by issuing short-term liabilities to banks.
Now the taxpayer faces exposure to interest-rate risk. The Congressional Budget Office projects that every percentage point of higher rates will increase projected deficits by $30 trillion over 20 years. High rates can become a vicious circle, as a hike in rates further increases debt, which pushes rates up even higher as more debt gets issued.
My colleague Brian Riedl argues persuasively that this dynamic is not sustainable. More money to pay off debt means less capital to invest in the economy. Growth will suffer as a result—and if higher debt ends up undermining productivity, then deficits will grow further as tax revenue falls. Monetary policymakers, too, will face a new set of challenges. High debt levels can make the public nervous about inflation—creating another vicious circle, as higher expected inflation pushes up interest rates and puts pressure on the Fed to be more hawkish. Once the government feels more fiscal pressure, it will have less space to keep the economy afloat during the next crisis.
It may be tempting to blame one speech, like Blanchard’s, or another fad, such as the enthusiasm for modern monetary theory, for our current predicament. But there’s lots of blame to go around. Politicians will always take the opportunity to spend, especially if they’re not worried about paying for it. Low interest rates for such a long period enabled many bad financial decisions. The government-spending bonanza was just one of them, but it may prove the most consequential.
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