When it comes to the Federal Reserve and monetary policy, there are no shortages of talking heads who say the central bank can’t raise interest rates too much or else it would trigger a “debt bomb.” What this means is that because the federal debt is so high, even a relatively small increase in rates might force the government to borrow even more just to service the debt. This is a nice theory, but the numbers don’t add up. Interest rates paid to service the debt would need to double to get back to the 1991 peak of debt financing costs as a percentage of GDP — which didn’t touch off a debt bomb then —and much further for financing costs to explode.
Government bailouts in response to the 2008 financial crisis and, more recently, spending to support the economy during the pandemic has caused U.S. federal debt to jump to $28 trillion last year, or 123% of gross domestic product. The amount outstanding has risen from $3 trillion two decades ago. And debt should continue to climb with annual budget deficits forecast to be around $1 trillion or more annually over the next decade.
But the rise in borrowing hasn’t caused a big jump in market rates and Modern Monetary Theory says there’s virtually no limit on federal borrowing and deficits. Indeed, money to fund the deficits has been ample. Much of it came from consumers who saved $1.9 trillion from their April 2020 fiscal stimulus checks, $508 billion from the January 2021 payments and $1.4 trillion out of what they received in March 2021, according to the Federal Reserve Bank of New York. Congress appropriated about $5 trillion in pandemic relief, and as those funds circulated, some were used to finance federal deficits. Also, the Fed purchased $4.8 trillion in Treasuries since the pandemic commenced in early 2020 as its assets surged from $4.2 trillion to $8.9 trillion.
Foreigners have also been important buyers and own $7.7 trillion, or 31%, of Treasuries outstanding. They’ll no doubt buy more as they seek a haven after the Russian invasion of Ukraine. Also, Asians are robust producers and exporters but anemic consumers. So, the resulting “saving glut” has resulted in a $975 billion U.S. current-account deficit that is financed by increased foreign ownership of U.S. assets, including Treasuries.
The aging Baby Boomers are another source of funds to finance federal deficits. As people age, they shift their portfolios to less-risky investments, including U.S. government obligations.
All this demand for Treasuries has exceeded the supply, as shown by the drop in the 10-year Treasury note interest rate from 8% in the early 1990s to 1.8% while the yield on 30-year bonds has fallen from 8% to 2.1%. The decline over the years in inflation, the major determinant of Treasury bond yields, also exerted downward pressure on borrowing costs.
Nevertheless, federal deficits and debt will continue to grow. The aging postwar babies will draw more Social Security payments. Together with Medicare and Medicaid, these costs will jump from 10.9% of GDP in 2021 to 15.6% in 2050, according to the Congressional Budget Office.
Federal debt-to-GDP ratio reached 106% at the end of World War II, then fell to 23% in 1975, not because of debt repayment but due to rapid postwar economic growth. But that’s all over, and explosive future growth isn’t in the cards despite more rapid growth in productivity-soaked new technologies such as biometrics, AI and self-driving vehicles. Low birth rates, declining labor participation rates and early retirement will curb employment and economic growth. Also, skyrocketing government deficits and debt pushed the debt-to-GDP ratio up to 96% in the third quarter of 2021, close to the early 1940s peak.
The main reason that exploding federal deficits and debts haven’t bothered financial markets is low and declining interest rates, which have held down the cost of financing the debt. With an average maturity of almost six years for Treasury obligations, the average interest cost of financing the debt is 1.4% and interest costs were the equivalent of 1.5% of GDP last year. The highest postwar ratio of interest costs to GDP was 3.1% in 1992, but that didn’t generate an upward spiral in which interest on the debt adds so much to the deficit and, consequently, to the debt that the financing costs and the debt explode. But with rising interest costs, the risks escalate since financing costs compound.
We simulated the interest costs-to-GDP ratio over the next 10 years with interest rates on Treasury debt ranging from 2% to 8%. In each calculation, we assumed 4% annual nominal GDP growth, 2% real plus 2% inflation. We also assumed a $1 trillion federal deficit in each of the next 10 years. With a 2% interest rate, the debt-to-GDP ratio actually falls slightly from 2% to 1.7% in 2032. But with an 8% interest rate, the ratio jumps from 7.5% to 12.9% in a decade with the rate of increase climbing over time. So very high interest rates would generate a debt bomb.
To get to those high rates would probably take a leap in inflation to double-digits or a nosedive in confidence in the full faith and credit of the U.S. government. And the crisis would need to last long enough to roll over the present six-year average debt maturity to those higher rates.
Of course, as the Fed hikes interest rates and the interest costs of financing the federal debt compound, Congress and whoever is occupying the White House might get scared enough to doubt the free lunch promised by Modern Monetary Theory and curtail federal spending and deficits. As usual, however, it will probably take a shock to stimulate meaningful action.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, a Registered Investment Advisor and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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