June 30 — For years, budget deficit hawks have warned that a return of interest rates to their historical norms could create a catastrophic debt spiral.
But in a world where events like the U.K.'s vote to leave the European Union regularly bring down interest rates, there’s now a debate whether rates will be lower for longer and provide an unexpected dose of good news for the fiscal picture.
The implications could be enormous. Interests costs, while low now, are a major component of long-term debt projections. And unlike either the annual funding bills dealt with by Congress or the harder-to-change Medicare and Social Security programs, there is little lawmakers can do to affect interest payments.
But whether to greet the prospect of lower-than-projected interest rates with hope or dread divides experts. Some are wary that the idea will give lawmakers reason to further delay deficit-cutting efforts, but others say it would be a mistake to ignore the possibilities that more maneuvering room on the debt would open up.
Chad Stone, chief economist with the Center on Budget and Policy Priorities, said counting on low long-term rates could leave policy makers complacent about the trajectory of debt. “But there's also opportunity, and in a sane-policy world, we take advantage of the opportunity,” he said.
In February, former Congressional Budget Office Director Douglas Elmendorf gave the issue a higher profile, authoring a paper with Louise Sheiner, a senior fellow at the Brookings Institution, that argued that federal investment, paid for by debt, may need to be higher given the possibility of lower long-term federal interest rates (See previous story, 02/08/16).
“Given the budgetary pressures of population aging, reductions in federal spending or increases in taxes relative to what would occur under current law eventually will be needed, and the desirability of increasing fiscal space argues for making those changes sooner rather than later,” Elmendorf and Sheiner wrote.
“But persistently low interest rates imply that policy changes should be deferred and reduced in size, a consideration that has received far less attention from analysts and is not well understood by policy makers. Similarly, persistently low interest rates imply that increasing government investment should be an important current priority for policy makers.”
Interest costs are determined by the amount of outstanding debt and the interest rates paid on that debt. The effect of the latter in recent years has meant that federal interest spending—measured in proportion to gross domestic product—actually fell to 1.3 percent of GDP in 2015 from 1.7 percent in 2007, even as the amount of debt as a percentage of GDP doubled, from 35.2 percent to 73.6 percent in 2015.
But the nonpartisan CBO expects those rates to rise over the next 10 years. In January, it projected the yield on the 10-year Treasury note to be 2.8 percent in 2016, rising to 3.5 percent in 2017 and then to 4.1 percent from 2021 to 2016. For the sake of comparison, the Treasury 10-year yield slid below the 1.50 percent level in the wake of the surprise British vote to leave the European Union.
Over the long term, lower rates would have a substantial impact. In its long-term budget outlook released in June 2015, the nonpartisan CBO said a 75-basis point lower long-term rate—resulting from a larger-than-projected difference between federal and private borrowing rates—would mean interest payments of 3.2 percent of GDP in 2040, instead of 4.7 percent. The 2040 public debt-to-GDP ratio would 89 percent, instead of 107 percent currently projected.
But not all low interest rates are created equal. It matters why long-term rates would be lower, not just their level. In the Elmendorf-Sheiner paper, the authors say in most cases where rates are low, debt should be higher to provide for more consumption and investment than otherwise. But if the reason for low rates is that investors see private assets as riskier, it said there should be no policy change.
William Gale, senior fellow at the Brookings Institution, said if rates are low because economic growth is also expected to be low, the positive impact of low rates on the budget is diluted because GDP growth will also be slower.
Another problem is that under an even more optimistic scenario—that rates stay as low as they currently are—the debt-to-GDP ratio still goes up. In a February paper Gale co-authored with Alan Auerbach, a professor at the University of California, Berkeley, the pair concluded the debt-to-GDP ratio would still rise to 110 percent. The CBO forecasts that under current law, the debt-to-GDP ratio will rise to almost 86 percent by 2026, the highest since 1947, just after the end of World War II.
Gale said policy makers should be more ambitious. “Are we OK with maintaining the current debt-to-GDP ratio for the next 25 years?” he asked. “Personally, that's a weak goal.”
Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget, said lower long-term interest rates would probably be the result of slower long-term growth. “As is the case with economics so often, one piece of seemingly good news is often counterbalanced with another piece of not-so-good news,” she said.
The CBPP's Stone said the long-term budget picture has improved in recent years and moved away from projections of long-term debt-to-GDP ratios above 200 percent. “We're not there anymore, for a variety of reasons. One of them is policy action. One of them is slowing in health-care spending growth. And the third is what we've been talking about, the likely path of interest rates going forward is much lower, so there will be a smaller interest burden on the debt,” he said.
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