Are low interest rates masking the deficit?

Thanks to artificially low interest rates, the United States has been able to finance deficits exceeding $1 trillion every year from 2009 through 2012 at very low cost. Throughout the period, the ratio of interest to the GDP has remained almost stable and is not expected to start rising until 2015. Some argue that this has encouraged the Congress to be fiscally irresponsible, although others believe that deficits have not been large enough given the severity of the recession.

But low interest rates will not last. In June, Federal Reserve Chairman Ben Bernanke gave the impression – apparently unintentionally — that the Fed would soon reduce its purchases of Treasury debt and mortgage-related securities. That helped propel a major increase in bond yields. The 10-year Treasury rate rose from under 2.0 percent to over 2.8 percent in a matter of days.

The Congressional Budget Office (CBO) baseline assumes rates will gradually rise over the next few years until the 10-year rate stabilizes at a more normal 5.2 percent in 2018 and thereafter. The implications for federal interest payments are alarming. The bill is assumed to rise almost four-fold between 2013 and 2023 or at a rate of 14 percent per year. Interest would become the fastest growing expenditure item in the budget by far, leaving health costs in the dust.

CBO’s baseline must assume that current law does not change. For example, numerous tax reductions, such as the research and experimentation tax credit, are temporary under current law and the CBO must assume that they expire, even though Congress has routinely extended them over the years.

CBO provides an alternative fiscal scenario that incorporates more realistic policy assumptions. Before the fiscal cliff deal that made most of the “temporary” Bush tax cuts permanent, the alternative fiscal scenario and the baseline were very different. They have come together recently, but the alternative is still more pessimistic than the baseline, implying a debt-GDP ratio of 83 percent at the end of 2023 compared to the baseline’s 74 percent. That would make interest costs grow even faster than 14 percent per year, though the difference is small relative to the usual error in forecasting interest rates.

Countries are often pushed into a sovereign debt crisis because of growing interest payments.  It becomes politically impossible for them to increase taxes or reduce noninterest spending fast enough to keep up with rising interest costs. The debt-GDP ratio begins to explode. A debt crisis is sure to follow.

Today, it is hard to see that happening in the U.S. over the next 10 years. But throw in another recession and/or an increase in interest rates above normal levels and the risks grow.  Recent good news on the fiscal front has caused CBO to project a fall in the baseline debt-GDP ratio from 75 percent in 2013 to 71 percent in 2017. However, it begins to rise after that at an increasing rate. Given these downside risks, a growing interest bill would severely limit government flexibility. And  no one should be happy with that.

Rudolph G. Penner is an Institute Fellow at the Urban Institute.