Low interest rates on the federal debt have allowed the government to borrow more in recent years without seeing the cost of servicing that debt rise as a share of the economy (GDP). As the debt has climbed from 39 percent of GDP in 2008 to 78 percent in 2018, interest costs have actually dropped slightly from 1.7 percent of GDP in 2008 to 1.6 percent last year.
This has led to an easing of concerns about the growing debt. If the economy continues to grow faster than interest rates, as has been the case, some have concluded that the high debt and its troubling projections might not be such a problem after all.
But a new analysis by the Congressional Budget Office (CBO) illustrates why continued low interest rates would not alone be sufficient to put the debt on a sustainable path.
The CBO analysis looked at two factors: primary deficits, which measure the difference between non-interest spending and taxes, and the average interest rate paid on federal government debt.
In CBO’s baseline of current spending and tax policies, the primary deficit averages 1.7 percent of GDP over the next 10 years while interest rates on the debt rise from an average of 2.6 percent to 3.3 percent. The baseline thus assumes that debt and interest rates on the debt will both rise.
To show the effect of interest rates on the debt, CBO modeled four primary deficit scenarios under which interest rates do not rise but remain at an average of 2.6 percent.
According to CBO, “One clear takeaway emerged from the analysis: Even if the average interest rate on federal debt remained at its relatively low 2019 level of 2.6 percent, primary deficits would have to average less than 1.0 percent of GDP—significantly less than CBO projects they would average under current law—to keep debt from rising as a share of GDP.”
One scenario shows the debt path if primary deficits remain at the baseline level. The other three scenarios show what would happen if the primary deficit fell from 1.7 percent of GDP to 1.2, 1.0 or 0.5 percent of GDP.
The analysis found that even if interest rates remain at current levels, baseline primary deficits would still push the debt-to-GDP ratio up by nearly 8 percentage points over the next 10 years.
It would require a primary deficit of 1.0 percent of GDP each year (down from 1.7 percent in the baseline) to roughly stabilize the debt under this scenario. If that sounds like an easy goal, consider that it translates into a major 10-year deficit reduction plan of $1.8 trillion.
A more ambitious scenario would reduce the primary deficit to 0.5 percent of GDP each year. According to CBO, meeting that goal would reduce the debt-to-GDP ratio by 4 percentage points. However, that goal would require a primary deficit reduction plan of $3.1 trillion.
Of course, interest rates might not remain at the current average. If they rise to the level CBO projects (3.3 percent, which is still below projected nominal economic growth) primary deficits would need to be cut by $3.4 trillion over 10 years to roughly stabilize the debt.
As CBO notes, both interest rates and primary deficits could turn out to be higher than baseline levels. In that case, CBO notes, “reducing debt as a share of GDP, or even keeping it at its current level, would be more challenging than this analysis suggests.”
The message for policymakers is that low interest rates are not a magic bullet. They do make the growing debt easier to finance but they do not dig us out of the hole we’re in.
That task will still require attention to spending cuts and/or tax increases to reduce the primary deficit. Moreover, given the downside risk of higher rates in the future, the more prudent course would be to concentrate on lowering or at least stabilizing the debt-to-GDP ratio before thinking of new ways to add to the debt.