The Daily Dish

Interest Rates and the Federal Budget

Everybody knows that interest rates are higher than they used to be. Everyone knows that the federal government has borrowed like a drunken gambling addict on a bender. But it is not immediately obvious that everyone understands what the combination implies.

The first implication is that a lot of federal spending will simply be paying interest on borrowing. In the Congressional Budget Office (CBO) baseline budget outlook, the federal government will spend roughly $80 trillion over the 10 years from 2024 to 2033. Of that amount, net interest costs are roughly $10 trillion or a bit over 12.5 percent of all spending. That is essentially one-half of the total annual discretionary spending decisions made by Congress over that period – bigger than the spending on national defense. (The real money, about $50 trillion, is mandatory spending or so-called entitlements.) No matter how you cut it, a substantial portion of the budget will be consumed by the interest payments necessitated by past borrowing.

The second is that the budget outlook becomes more sensitive to interest rates. In the CBO baseline, 10-year Treasuries ultimately settle at an interest rate of 3.8 percent. Recently, the 10-year yield reached 4.4 percent. What happens to the budget outlook? CBO provides a handy tool to calculate the impact. If every interest rate in the budget window is 60 basis points higher, the cumulative deficit over the 10 years is $1.8 trillion larger and averages 0.5 percent more of gross domestic product (GDP). The federal budget is simply a highly levered entity that is very exposed to interest rate risk.

Finally, the implications for the final destination of the federal budget are enormous. In the baseline outlook, the primary deficit – non-interest spending minus revenues – averages 2.9 percent of GDP, while nominal GDP growth averages 4.1 percent. Suppose we combine those with 3.8 percent interest rates and repeat the budget experience indefinitely. If one literally let this run infinitely long, eventually the debt-to-GDP ratio would settle at 10, or 1,000 percent!

That should not be taken as a literal forecast, but it tells you that the dynamics underlying the current budget are disastrous. Yet bumping interest rates just from 3.8 percent to 4.0 percent implies a long-run debt-GDP ratio of 3,000 percent! (Another implication of these kinds of calculations is that to stabilize the ratio at 125 percent of GDP, one has to run a balanced primary budget. Good luck convincing the Biden Administration to do that.)

The federal government has driven the budget into a fiscal wasteland. The risk of higher interest rates threatens to make matters even worse.


Fact of the Day

Across all rulemakings this past week, agencies published $7 billion in total costs but cut 19.8 million annual paperwork burden hours.

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