The Economic Fallacy of Borrowing at Low Interest Rates
By Veronique de Rugy and Jack Salmon, courtesy of the Mercatus Center
Recessions and national emergencies often cause large increases in government spending, soon followed by higher levels of deficit and debt. While this makes sense during an economic or other crisis, it should not generally be encouraged or perpetuated, particularly using ignorant and irresponsible arguments.
The recent surge in government spending offers a good case in point. Many not only justify the trillions already spent but are calling for more, arguing that now is a perfect time to borrow and accumulate debt because interest rates are low. As evidence, people point to Japan, which has an extremely high debt-to-GDP ratio of 227 percent but has not experienced hyperinflation or a default. They ignore that, for decades, Japan has had dreadfully slow growth, wages that have stagnated, and the government has had to increase taxes several times in recent years. In fact, despite low interest rates, now is not a good time to be enthusiastic about accumulating debt.
Interest Payments Are Expensive Even When Interest Rates Are Low
One problem with an oversized and growing public debt is that the government must allocate a large part of its spending to paying the interest on the debt. This means that fewer federal funds will be available for other programs. For example, this crowding-out effect harms investment in R&D and infrastructure, which are important for future growth prospects. With current growth, debt, and interest rate projections, total interest payments will reach $1.7 trillion by 2037. Even assuming that historic low interest rates of 2 percent are sustainable long-term, total interest payments will still exceed $1 trillion by 2037.
Increased government borrowing to finance debt obligations doesn’t just crowd out other federal spending priorities; it also competes for funds in the nation’s capital markets, which in turn raises interest rates and crowds out private investment. With individuals and businesses in the private sector facing higher costs of capital, innovation and productivity are stifled, which reduces the growth potential of the economy. Over time, this pattern of crowding out private investment, coupled with higher rates of interest, drives down business confidence and investment, which drags down productivity and growth even further.
To predict the negative effects of high public debt levels on growth rates, we use estimates from three academic studies on the debt drag effect to project future real GDP growth for the period 2020 to 2037. We find that over the next 17 years, the effects of a large and growing public-debt-to-GDP ratio on economic growth could amount to a loss of $6 trillion in real GDP, or $17,000 per capita. Alternatively, the Congressional Budget Office (CBO) estimates that if budgetary changes included measures to reduce the debt-to-GDP ratio to 42 percent over 30 years, then GDP would be 4.3 percent higher by 2049, and GDP per person would be about $4,200 higher (in 2019 dollars) against the baseline.
Likewise, the idea that lower interest rates make excessive borrowing essentially painless ignores the future costs of the total stock of debt and debt service repayments. While a 2 percent interest rate on $20 trillion in debt equates to a little more than $400 billion in interest payments every year, this amount rises to more than $600 billion for $30 trillion in debt and $800 billion for $40 trillion in debt. Low interest rates may lower the fiscal cost of borrowing more debt today, but this cost is simply shifted into the future in the forms of both higher levels of debt repayment and crowded-out private investment.
Interest Rates Will Likely Increase
Another problem with the United States continuing its excessive borrowing is that it rests on the false assumption that current low interest rates will remain at these same levels into the foreseeable future. While population aging, low productivity growth, and unconventional monetary policy have resulted in years of low interest rates, the empirical research finds that the growing public debt burden will put upward pressure on interest rates.
One CBO study in 2014 found that for each $1 increase in the federal deficit, the effect on investment ranges from a decrease of 15 cents to a decrease of 50 cents, with an estimated median decrease of 33 cents. Similarly, other studies have found that while factors such as productivity, demographics, and monetary policy have put downward pressure on long-term nominal interest rates since 2001, rising deficits have continued to put countervailing upward pressure on interest rates. Fiscal policy economist Ernie Tedeschi found that a one-percentage-point increase in the ongoing cyclically adjusted federal deficit raises the 10-year Treasury yield by 18 basis points and the ACM 10-year term premium by 20 basis points.
While these studies reveal the upward pressure that a large deficit places on interest rates, similar pressure comes from a large and growing public debt, which results from running large deficits over the long-term. A recent CBO working paper found that the average long-run effect of debt on interest rates ranges from about 2 to 3 basis points for each one-percentage-point increase in debt as a percentage of GDP. With current public debt levels projected to reach 220 percent of GDP by 2050, this could amount to upward pressure of 284 to 426 basis points on interest rates from 2019 levels. This will significantly outweigh any downward pressures exerted by other factors.
Ultimately, arguments by economists and policymakers for increased government spending while interest rates are low are misleading and flawed for several reasons: (1) They overlook the economic costs of crowding out productive investment and thus slowing economic growth. (2) They ignore the underlying cost of the total stock of debt and compounding growth. (3) They do not acknowledge the fact that significantly higher debt service repayments are passed on as costs to future generations. (4) They falsely assume that interest rates will remain low, against all empirical evidence.
If policymakers continue to act based on these badly informed economic arguments, then the United States will be at serious risk of falling into the fiscal trap of Japanese style economic stagnation. Our current and projected debt levels are already negatively impacting economic growth to the tune of $17,000 real GDP per capita over the next 17 years, producing a significant drag in living standards for the average American. To avoid leaving future generations with a broken economy of low growth and wage stagnation, we have to recognize the ignorant and irresponsible arguments that underlie the fallacy that low interest rates are a valid excuse to pass these costs on to future generations.
Veronique de Rugy is a Senior Research Fellow at the Mercatus Center at George Mason University and a nationally syndicated columnist. Her primary research interests include the US economy, the federal budget, homeland security, taxation, tax competition, and financial privacy. Jack Salmon is a staff writer for the Mercatus Center.