louise sheiner, is the policy director of the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy. Thanks to David Wessel for comments and Kadija Yilla for research assistance.
illustrations by andrew baker
Published April 26, 2021
The U.S. federal debt — the amount Washington owes the public, the Federal Reserve and other governments — equaled 98 percent of GDP at the end of the last fiscal year, which is almost as much as the historic high of 106 percent reached during the total mobilization of World War II. If the Biden administration gets anywhere near as much as it is asking for pandemic relief, the debt-to-GDP ratio is likely to set an historic record in the 2021 fiscal year. And with the population certain to age rapidly for decades to come, rising spending on Medicare and Social Security will almost guarantee big deficits for the indefinite future unless taxes are raised. Yet there is certainly no reason to panic — and maybe no reason to worry. For even as the debt has been increasing, the cost of financing the debt has been in a free fall as interest rates on government securities near record lows. Indeed, the declining cost of servicing debt has led many economists to conclude that, at least for now, the debt is not a problem — or at least not a priority. There are a host of more important policy priorities to tend to if we want to strengthen the economy and give future generations a chance to shine.
Debt increases over time if the federal government continues to borrow to pay its bills — that is, if Washington runs budget deficits. But when thinking about long-term trends, it makes intuitive sense to look at the federal debt as a share of the economy (that is, as a percentage of GDP) rather than in absolute terms: the larger the economy, the more able the government to service the debt without raising taxes or cutting programs.
As suggested above, big changes in the debt have occurred during times of great financial stress such as wars and recessions. In wartime the government borrows to finance military efforts. In recessions, debt increases automatically because tax revenues decline and spending on safety net programs like unemployment insurance and food stamps rise. Moreover, Congress usually goes further, lowering tax rates and raising spending to reduce household hardship and stimulate the economy.
From 1960 to 2007, the debt-to-GDP ratio hovered between 23 percent and 48 percent. Alan Auerbach of the University of California, Berkeley, found that, during this period, Congress generally took what was widely regarded as the responsible course, tightening fiscal policy when deficits were increasing and loosening it when they were shrinking.
As a consequence, increases in the debt were tempered.
In 2019, Social Security spending (the pension and disability provisions) equaled 4.9 percent of GDP. CBO projects that, without changes in the entitlement formulas, it will increase to 6.3 percent of GDP by 2040.
But that was then. As might be expected, the debt rose sharply in response to the Great Recession that began in 2007. But it continued to grow rapidly deep into the recovery, reaching 76 percent of GDP by 2016. And rather than retreating during years of low unemployment that followed, it continued climbing (albeit more slowly) through 2019.
Then, with the onset of the pandemic, all bets were off again. In the 2020 fiscal year, which ended on Septeber 30, Congress enacted over $2.5 trillion in spending increases and tax cuts to provide financial relief to households and businesses. The debt ballooned to the aforementioned 98 percent of GDP.
Reading the Tea Leaves
The Congressional Budget Office projects federal deficits and accumulated debt under so-called “base line” assumptions that tax and spending policies (and current law) will remain unchanged. Its most recent long-term projection was released in September 2020.
It incorporates the impact of the Coronavirus Aid, Relief and Economic Security Act and other legislation enacted last spring — but not the $900 billion in spending added in December 2020 nor, of course, the Biden relief package that is pending as this is being written. Nonetheless, the September 2020 projection by the CBO shows the debt climbing steadily in the years ahead, with debt reaching 109 percent of GDP by 2030 and 195 percent of GDP by 2050.
What’s Driving the Numbers?
Three main factors contribute to this rise. First, as noted, population aging. The share of Americans over 65 was 12 percent in 2000. Today, it is 16 percent, and by 2030 it will reach 20 percent. A large portion of federal outlays cover transfers geared toward the elderly that do not require annual appropriations — especially Social Security and Medicare. In 2019, Social Security spending (the pension and disability provisions) equaled 4.9 percent of GDP.
The CBO projects that, without changes in the entitlement formulas, this spending will increase to 6.3 percent of GDP by 2040. Meanwhile, revenue from Social Security taxes will rise, but not nearly enough to cover outlays.
Second, rising health costs. Total health spending as a share of GDP has been mounting for decades, and the CBO expects this trend to continue. This puts fiscal pressure on Medicare and Medicaid (and a handful of other lower-profile programs). What’s more, the combination of aging and rising health spending constitutes a double whammy for Medicare. Not only will a larger share of the population be eligible for Medicare, but outlays per person covered will rise. The CBO projects Medicare spending to balloon from 3.7 percent of GDP in 2019 to 5.3 percent of GDP by 2040.
Finally, even before Covid-19, the federal government was running large deficits. (And these were made much larger by big tax cuts enacted in the Tax Cut and Jobs Act of 2017.) The deficit in 2019 was 4.6 percent of GDP, and there’s no good reason to believe the percentage will fall in the near future. Since nobody who’s paying attention believes the economy can grow in the long run at anything like 4.6 percent, the debt-to-GDP ratio is bound to rise.
The Real Cost Of Red Ink
The costs of deficits can be seen through more than one lens. If the economy is operating near its maximum capacity and if foreigners are not especially willing to lend dollars to Americans, when the government borrows it soaks up funds that would otherwise have gone to private investment. In other words, deficits “crowd out” private investment.
This happens through market forces. When the government runs a deficit, government demand adds to the economywide demand for loanable funds, pushing up the “price” that borrowers pay savers — the interest rate. With higher interest rates, fewer private investment projects make economic sense, and so private investment falls.
If the government deficits are financing consumption rather than investment (more on this below), then an increase in deficits (and therefore debt) leads to a decline in overall (that is, public plus private) investment. This leaves future generations poorer than they would have been if they had inherited more capital. When we borrow from foreigners, domestic investment is less likely to be crowded out (instead, investment is crowded out globally). But interest payments that we will need to make to foreigners will still make us poorer than would otherwise have been.
The costs of deficits and debt can also be seen from a budget perspective. When the government borrows, it increases the federal government’s debt. Future taxpayers will have to pay interest on that debt, meaning that tax revenues will be diverted from spending on items that benefit them toward making payments on debts accumulated from previous spending. Assuming future taxpayers haven’t benefited from that previous spending (for example, by having access to better mass transit or getting a subsidized education), they are made worse off. This is the conventional beef many people have with deficit spending — as a burden that we are leaving our grandchildren.
In addition, there may be other, less direct costs of debt. Some people worry that if debt is too high, the government could lose the ability to borrow large amounts easily, making responding to future crises — like another pandemic — more difficult. This is often referred to as a lack of “fiscal space.” In addition, even unwarranted concerns about debt may lead policymakers to make bad economic decisions. As David and Christina Romer showed in a 2019 analysis, OECD countries with higher debt-to-GDP ratios were less likely to borrow during financial crises — even when they could do so at relatively low cost — leading to worse macroeconomic outcomes.
Assuming future taxpayers haven’t benefited from previous spending, they are made worse off. This is the conventional beef many people have with deficit spending — as a burden we are leaving our grandchildren.
The Fed’s Back Door
To lower long-term interest rates and improve the economy, the Federal Reserve has been buying a lot of bonds issued by the U.S. Treasury in what is known as “quantitative easing.” Between mid-March 2020 and mid- January 2021, the Fed’s portfolio of long-term Treasury securities rose from $2.3 trillion to $4.4 trillion. Over this same period, the Treasury borrowed about $4.1 trillion. Thus, the Fed effectively bought about half of the additional Treasury securities issued to finance the increase in the debt.
But the fact that the Fed bought the debt by means of brain-bending electronic accounting wizardry doesn’t mean the debt has no cost to taxpayers. When the Fed buys longterm Treasuries from banks (or other private holders), it increases bank reserves — the deposits banks have at the Fed. The Fed pays interest on those reserves.
Right now, interest rates are near zero, so the Fed isn’t paying much on those reserves. But as the economy recovers, the Fed will presumably raise interest rates to prevent the economy from overheating and generating unacceptable rates of inflation. As it raises rates, the Fed will start paying banks more for those reserves. And since the Fed turns over its operating profits to the Treasury, any increase in interest payments made to banks will lower the amount the Fed hands over to the Treasury. Thus, the Treasury will effectively have to pay interest on the debt at prevailing interest rates regardless of whether the Fed buys the debt.
Why Is the Cost of Debt so Low?
The cost of debt is driven by the interest rate on federal government borrowing. That rate is both what the federal government has to pay to borrow and a measure of the lost benefits of forgone private investment.
One of the most striking changes in the economy in the past few decades is the steady decline in interest rates around the world on government debt and other assets. Some of this decline represents falling expected rates of inflation. But real rates (rates adjusted for inflation) have declined as well. For example, the rate on 30-year Treasury Inflation-Protected Securities, or TIPS bonds (securities that are adjusted by the changes in consumer price inflation to yield a guaranteed real rate of return), has declined from over 2 percent in 2010, to 1.5 percent by 2014, and to minus 0.3 percent in January of 2021. (A negative rate means that lenders to the government will get back less in inflation-adjusted dollars than they put in.)
This decline is not the result of the Federal Reserve artificially keeping interest rates low. Instead, it is the result of problematic structural changes in our economy, including rising inequality, population aging and lower productivity, which have increased the supply of saving relative to the demand.
When the Cost of Debt Is Zilch (or Less)
The federal government isn’t like a household: it doesn’t ever have to pay down debt. But let’s say we want future taxpayers to simply make payments sufficient to ensure that the debt doesn’t grow. What would that entail? That depends on what we mean by the debt not growing.
If taxpayers made payments on debt equal to the nominal interest payment due, the face value (not adjusted for inflation) of the debt would remain the same. For example, if the federal debt was $100 and the interest rate was 5 percent, then if taxpayers paid $5 each year, the debt would remain at $100. Under this scenario, the nominal values of the debt and the interest payments are constant, while the real (inflation-adjusted) values are declining over time. Future taxpayers would be paying less than current taxpayers in real dollars.
Now bear with me here — there will be a payoff. If, instead, taxpayers paid only the real interest costs of debt, the real value of the debt would remain constant. If in the above example the inflation rate was 2 percent, and the taxpayers paid $3 in interest and borrowed the additional $2 that was due, the nominal debt would increase from $100 to $102 in the first year, but the real debt would stay constant at $100. Even so, the debt-to- GDP ratio would decline over time, because real GDP is increasing while real debt would remain the same. So future taxpayers would pay the same real interest costs as current taxpayers, but those payments would represent a smaller share of their income.
For the debt-to-GDP ratio to remain constant and all taxpayers pay the same share in interest costs is for them to pay off the amount equal to the debt times the interest rate less the growth rate of GDP and borrow the rest.
The way to ensure that the debt-to-GDP ratio remains constant and that taxpayers (as a group) pay the same share of their income in interest costs is for taxpayers to pay off the amount equal to the debt times the interest rate less the growth rate of GDP and borrow the rest. This way, nominal debt rises at the same rate as nominal GDP.
Indeed, by this logic, when interest rates are well below the growth rate of the economy, as they are now, debt is “free.” Of course, interest rates are unlikely to remain below the growth rate of the economy forever. Eventually, higher debt and underlying structural factors of the economy will undoubtedly push interest rates higher, and so the debt will eventually have fiscal costs. Under CBO projections, for example, the interest rate on federal debt will first exceed the growth rate of the economy in 16 years.
When the payments on the federal debt that would have to be made in any given year for the debt to stay constant as a share of GDP is negative the government can actually keep borrowing to cover some of its non-interest expenses without the debt-to-GDP ratio rising. But the chickens are inclined to come home to roost: with rising interest costs and rising debt, this situation reverses. And once it does, required debt payments begin to escalate. Still, it isn’t until mid-century that required interest payments reach the levels experienced during the late 1980s and early 1990s, though the debt-to-GDP ratio will be far higher.
What Do We Owe the Future?
Although federal debt appears likely to be free or close to free for a long time, most economists are not advocating a wholesale abandonment of the idea that the federal budget should be constrained. Predicting the path of interest rates is very difficult — indeed, most economists had not predicted the decline in interest rates we have experienced over the past few decades. And while structural changes in the economy that have driven up private savings are plausible explanations for the declines in interest rates, there is still much uncertainty about how the structure will evolve over time.
Nonetheless, the best guess is that interest rates will remain low for a long time, meaning that the amount of debt that the U.S. can sustain is a lot larger than people used to think. That means there should be less fearmongering about the debt, and more focus on other national priorities.
Spending Free Money
One immediate priority is for the government to ramp up public health spending to fight the spread of the pandemic and to spend more to support the economy during the recession and recovery. Public health outlays that allow the economy to reopen safely sooner would yield huge benefits in terms of higher GDP — which in turn means higher tax revenues and lower debt. But in addition to easing the immediate pain, providing financial help during the recession is also likely to yield long-term benefits. By replacing much of the income lost by households, businesses, and state and local governments, the federal government could set the stage for a robust economic recovery once the threat of the pandemic fades.
Furthermore, it is essential that the government does not remove fiscal stimulus prematurely in response to deficit worries. That’s what Congress did after the Great Recession, and as a result the recovery was much weaker and took much longer (four years). Given the fact that the CBO expects the pandemic to hold down GDP for almost a decade, now is certainly not the time to raise taxes or cut spending in some grand bargain that addresses long-run fiscal challenges or attempts to roll back the recent rise in the debt. To the contrary: full speed ahead and damn the torpedoes. Policymakers should focus on doing everything they can do to get the economy back to its full potential as quickly as possible.
Another priority of the government should be to increase public investment. At very low borrowing costs, many government programs are likely to yield benefits that exceed the service costs of the debt and the growth rate of the economy, suggesting that future generations will be made better off — not worse off — from deficit-financed public investment now. In other words, even if such deficit-financed spending lowers private investment, the increase in public investment means that future income will be higher, not lower. Thus, this is an ideal time to repair transportation infrastructure, improve the safety of drinking water, increase the quality of schools and invest in R&D with a potentially large payoff. Similarly, steps taken now to reduce climate change would yield large benefits to future generations.
Consider, too, a host of programs that are not always viewed as investment have proved to yield sizable long-run returns. Evaluating more than 100 high-quality studies, Nathaniel Hendren and Ben Sprung-Keyser of Harvard concluded that aid to poor families — particularly in the form of in-kind benefits like subsidized health insurance and housing — leads to much-improved adult outcomes for the children. These improved outcomes include better health, more education, higher wages, higher labor force participation and lower incarceration rates. Obviously, the recipients would benefit — but so would future taxpayers.
• • •
The United States faces a lot of problems that would take a lot of money to solve. Arguments that we cannot afford the fixes because of our high public debt simply don’t hold up to close examination. We care about the debt because we care about future generations. Addressing these problems — even if we do so through deficit financing — will do more to improve the well-being of future generations than will tackling the debt when the costs of the debt are so low.
Of course, there are risks to such a strategy, but those risks are ones we should take. If interest rates do rise more than we expect, we have ample room to make adjustments — taxes can be increased and spending can be cut. The bigger risk is that we let the fear of debt prevent us from making the investments that make the future brighter for all of us.