CBO just came out with their long term budget outlook, and they paint a pretty grim picture. Federal debt is expected to grow to 195% of GDP by 2050, where the short term spike in deficits due to the pandemic is expected to go away, but the budget imbalance that existed before is expected to continue indefinitely. Once that existing deficit gets combined with the rising interest costs from the debt (along with rising health care costs), debt rises at an alarming rate for decades into the future.
My contribution to this debate is to provide some insight into how the path of future interest rates interacts with this long term budget outlook. The standard way of understanding this connection is to say that if interest rates stay low (say near zero) for a long time, then the costs of servicing the debt goes down over time as well, and this could substantially improve the long term budget outlook. I would suggest a different problem, however, where if interest rates are stuck at zero, then interest costs might go down, but the primary deficit (the deficit excluding interest costs) needs to stay high in order to keep the economy at full potential. I estimate then that this need to run high deficits when interest rates are at zero vastly overwhelms any impact on debt service costs, as you can see from the experience of Japan who now has debt as a percent of GDP reaching nearly 240% even though interest rates have been astonishingly low for decades.
The real wild card in the scenario if interest rates stay stuck at zero is determining what the Federal Reserve will be doing during this time. If interest rates are stuck at zero, then the Fed will likely be doing a significant amount of QE, which is just buying up a lot of government debt with printed money. If interest rates stay at zero indefinitely, then the Fed will be doing QE indefinitely, so that even if the federal government is forced to run high deficits every year, the debt that this creates will largely be bought up by the Fed. This then creates a scenario, much like Japan, where debt levels are very high, but so much of the debt is owned by the central bank that there is more than enough available funds from the private sector to buy up any new debt and hold the existing debt issued by the government, and this combination of printed money from the central bank and excess available private funds makes the debt easy to manage with little fear of a debt crisis.
That is one way this long term budget outlook could change, where interest rates stay at zero indefinitely for decades into the future. The other possibility is that interest rates rise above zero again to modest levels, and the Fed stops doing more QE. In this case, the US will likely be able to reduce the extremely high deficits necessary to deal with the pandemic, but then after that, there will still be a remaining deficit that causes debt as a percent of GDP to continue rising over time. CBO estimates that in 2025, the deficit will need to be cut by an additional 3.6% of GDP to get debt back to the levels that existed in 2019 before the pandemic by 2050. This is the real budget danger, where if interest rates rise above zero, then we really do need to cut the deficit, or else debt will continue to grow to alarming levels without the benefit of having the Fed purchase a large proportion of that debt.
The question then is how easily will we be able to achieve that level of deficit reduction. If a Democrat is president, it is seems perfectly plausible, where both Clinton and Obama enacted changes to the deficit worth more than 6% of GDP. Clinton took deficits worth 4% of GDP and turned them into surpluses worth 2% of GDP, and Obama took deficits worth 10% of GDP and turned them into deficits worth less than 3% of GDP. If a Republican is president, then this might prove to be a more difficult task to pull off, where Republicans only seem to be interested in closing the deficit when a Democrat is president, and are perfectly willing to let it grow when a Republican is president.
The real danger then arises not if interest rates stay low in perpetuity, because then the central bank will likely own a good portion of the debt, but if interest rates go above zero, the Fed stops doing QE, and we we elect too many Republican presidents. These are the kind of things that CBO can't talk about, but are likely going to be the true drivers of long term debt risks, and are also very important to understand.
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