I recently wrote about a post by Josh Rauh, of the Hoover Institution, on the dangerously increasing share of our revenue going toward interest payments on the national debt.
Using CBO numbers, Rauh shows that, next year, interest payments on the debt are likely to consume over 20 percent of all revenue. Interest payments as a share of revenue will consume close to 35 percent in 2054.
If you remove the revenue earmarked for Social Security, interest payments as a share of revenue rise to 27.9 percent in 2025 and 45.7 percent in 2054. Just think about it for a minute. Under very optimistic assumptions, almost 50 percent of available revenue will go to paying interest on the debt.
Now, if CBO projections are wrong and interest rates end up 1 percent above the projected baseline over a decade, for three decades in a row, things could get uglier. Rauh calculates that interest payments as a share of revenue would then rise to 62.3 percent. Once we exclude revenues earmarked for Social Security, that share rises to 81.9 percent.
Now, Jack Salmon has a piece at the Liberty Lens Substack arguing that the CBO is indeed likely underestimating the path of interest rates. He writes:
Key to CBO’s long-term budget projections are its long-term projections of interest rates that affect the budget, including rates on various debt instruments issued by the Treasury Department. While the CBO’s interest rate projections for the coming decade show higher rates than over the past 30 years, rates on government securities are only forecast to be about a third of a percentage point higher over the entire 2024–2054 period of the projection compared to the 1994-2023 average (4.2% vs 3.8%).
In that post, Salmon focuses on why he thinks the CBO’s assumption about the impact that the U.S. growing debt-to-GDP ratio — from 100 percent to 166 percent of GDP in 30 years — will have on interest rates is off.
Rising debt ratios have an impact on private investment. Measuring the scale of the reduction is hard because the U.S. hasn’t historically experienced super high debt-to-GDP levels, and countries that have are very different from ours. Nonetheless, recent studies have found “that each percentage point increase in the debt ratio reduces private investment by about 0.23 to 0.24 percentage points.”
That, in turn, increases interest rates. A 2019 CBO paper estimated the impact of a 1 percent point (ppt) increase in the debt ratio on interest rates somewhere between 2 and 3 basis point (bps). The halfway estimate is 2.5. As Salmon explains, “in other words, for every percentage point (ppt) increase in the debt ratio, the CBO model assumes upward pressure on interest rates of 2.5 bps.” Basically, if the debt-to-GDP is 100 percent and interest rates are 4 percent, a debt ratio increase to 110 percent will raise interest rates to 4.25 percent, all else being equal.
A more recent CBO study, however, uses a lower estimate of 2 bps. It’s unclear why, but it is all the more strange that the CBO assumptions of 2.5 bps was already significantly lower than the estimates found in the academic literature. Salmon produces this table:
Of course, if interest rates are higher than projected by the CBO, then interest payments are higher, and the debt accumulation will be larger, too.
There are other potential issues with the CBO estimates, such as a possible overreliance on past demographic trends, which have traditionally put downward pressure on interest rates.
All of this is a big deal considering the short-term maturity of the public debt. As a reminder, over half of the debt must be rolled over within three years. A third of the debt has a maturity of less than a year, and the average maturity is 71 months. Since the U.S. debt is so big and getting bigger by the day, and the maturity of the debt is so short, a small variation of interest rates from the projected path could quickly have large consequences.
Unfortunately, if CBO’s projections don’t correctly model the interest-rate risk we face, politicians will continue to have a false sense of security. They already have too much of an incentive to kick the spending-reform can down the road as it is — they don’t need to be encouraged.
As Salmon concludes:
Applying the CBO’s current debt impact parameter of 2 bps, the CBO forecasts that the nominal rate on 10-year treasury securities will be 4.13% in 2034 and 4.44% in 2054. If we instead apply an impact parameter of 4 bps, then the forecast nominal rate on 10-year treasuries rises to 4.47% in 2034 and 5.78% in 2054. Even modest adjustments to the debt impact parameter can lead to significantly higher long-term interest rates, magnifying the fiscal burden and underscoring the need for more cautious assumptions in long-term debt projections.
And that brings us back to Josh Rauh’s post.