All the talk lately about the size of the national debt is obscuring the real problem: The US government made the wrong bet on interest rates, and that will cost taxpayers for years to come.
The government took on an unprecedented amount of debt in the last five years. Reasonable people can disagree about the level of spending, but the clear policy error was choosing to finance that spending with short-term debt while rates were at record lows. Now that rates are rising, so are the costs of financing all this debt.
It didn't have to be this way. We could have locked in rates when they were low. But at the time there was a pervasive belief that rates would never increase — even though, eventually, they always do. Now, as we face high debt service costs for decades, we can't afford to ever forget this lesson.
We got used to low rates, since they have been well below 5% for nearly two decades and only seemed to go down. Now rates are rising and causing all kinds of disruption in many sectors of the economy. One saving grace is that many households have a fixed-rate mortgage that shields them from interest-rate risk. The government could have made a similar choice when it took out its debt. Borrowing short is the basic equivalent of taking on an adjustable-rate mortgage when a fixed-rate loan could have been obtained at an absurdly low interest rate. Now the government — and its taxpayers — face interest-rate risk that may limit spending in the future.
Outstanding US debt increased to $30.5 trillion from $19.8 trillion between 2017 and the second quarter of 2022. A lot of that spending was used to get the economy through the pandemic disruptions. But in the years before, macroeconomists argued governments should spend more and not worry so much about debt because interest rates were so low. When rates are low, they said, the economic growth generated by the spending would more than pay for the cost of borrowing. If you borrow at 2% and invest the money in something that pays 8%, you’ll make a big profit.
But that thinking — just like many an asset manager selling a leveraged bet — was based on an assumption of no risk: that growth would be positive and interest rates wouldn’t increase. The government might have reduced its risk by locking in the low rates and issuing more long-term debt. A 20-year Treasury was yielding only about 1% in 2020. Instead, the government mostly financed its spending with debt that would mature in less than five years.
Financing its spending with short-term bonds means the government must roll over the debt as it comes due. The yield on a one-year Treasury is now more than 4.7%; compared with a 20-year rate of 1.46% the government could have locked in in 2021.
If rates continue to rise, even as inflation falls, this will impose big costs on the government and potentially tax payers. The Congressional Budget Office calculated that if 10-year rates gradually rise to 4.6%, then servicing the debt will cost 7.2% of GDP by 2052. It was only 1.6% of GDP last year and hasn't exceeded 3.2% since 1960. We should be so lucky. Interest rates already far exceed the CBO’s 2021 forecast, and are going up much faster. If rates rise to their historical average — above 5% — servicing the debt will cost far more.
The government had its reasons for issuing the short-term debt. If interest rates had stayed low forever, issuing short-term debt and rolling it over would have been cheaper than financing the spending with long-term bonds. After all, short-term rates tend to be lower than longer-term debt, and we saved a few basis points. Larry Summers co-authored a paper in 2016 examining the wisdom of financing debt with short-term bonds, weighing the benefit of lower costs against the risk of interest rates rising. If rates were anywhere close to their historical average, that is a reasonable question. But when rates are near zero, the risks clearly outweigh the benefits. Rates were at historic lows, which meant odds were they would eventually go back up. And they did.
The Trump administration’s Treasury Department also claimed that there was not much demand for long-term bonds. Though it’s not clear that’s true. The UK issues more long-term bonds. The average maturity on their conventional bonds is about 14 years, compared with about 5.5 years on US debt. And the UK treasury (until very recently) found ample demand for long-term debt. Both insurance companies and pension funds tend to need more duration in their portfolios as they issue very long-term liabilities. Longer-term debt helps them hedge their risk.
But when rates were at historic lows, we made a different choice. And now we are all vulnerable to rising rates becoming a fiscal burden. It’s worth noting that average maturity on debt increased in the last year as spending fell and some short-term debt matured and didn’t need to be refinanced. But the average maturity of marketable debt has remained around five years, no matter the interest rate.
There are sharp divides among policymakers and economists on how much money was spent, how it was spent and if we should spend even more. But one important lesson they should all learn is no matter how much you spend, always lock in low rates when you can.
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