President-elect Biden’s plans for sparking the economy by borrowing fresh trillions might seem reckless when the U.S. is facing the biggest debt and deficits in post-war history, with no relief in sight. But a prestigious braintrust of Democratic economists-cum-officials, inside and outside the new Administration, are endorsing the program as sound policy on the theory that we’ve entered a new paradigm where interest rates will stay so low, for so long, that mountains of new debt pose no threat.
The danger: The outlook for rates has indeed shifted dramatically, but it’s impossible to know how long that downward shift will last. Put simply, what Biden is proposing amounts to one of the most daring wagers ever in U.S. economic policy. If hard times strike again, the gigantic scale of our borrowings and shortfalls could provoke just the opposite of what the sages predict, a flight from U.S. Treasuries that causes rates to soar, driving the U.S. into a deep recession where the only escape a growth-crunching hikes in taxes. “You can’t run massive deficits forever and ever,” says John Cochrane, an economist at the conservative think tank the Hoover Institution. “No magic low rates can pay for that. And doing that runs the risk rates will spike, and the interest on all the debt driven ever higher by the new trillions lavished on ‘stimulus’ causes what I call the ‘nightmare scenario.'”
Three weeks after the presidential election, two of the most prominent Democratic economists issued a working paper that’s supplying intellectual firepower for the Biden agenda of turning a torrent of new spending on infrastructure, education, aid to families, and assistance to cities and states. In their study, “A Reconsideration of Fiscal Policy in the Era of Low Interest Rates,” former Treasury Secretary Larry Summers and Jason Furman, President Obama’s top economic advisor, argue that America needs “a revolution rather than an evolution” in fiscal policy, and what makes that both necessary and affordable is the new world of super-low rates that they expect to last for a decade or longer.
Janet Yellen, Biden’s nominee as Treasury Secretary, seems to share their views. At an American Economic Association event in January, Yellen declared that our interest burden is manageable even if debt rises substantially, and that she sees an opportunity for more stimulus in the event of another slowdown.
Summers and Furman note that you’d expect interest rates to be rising in the current climate. It’s logical to think that today’s towering deficits and debt would be worrying investors, and that reductions in corporate and capital gains taxes that make investments more profitable would be sparking heavy competition for capital that would push up yields on both corporate and government bonds. But that opposite’s happening. Newly-issued 10-year Treasuries are now paying around 1%, which is far below the current level of inflation, meaning we’re in a world of negative “real rates.” The authors say that the market expects that scenario to remain constant for a long time, citing that the yield on 10-year inflation-protected bonds is also in the minus range, showing that investors expect the rates of Treasuries bills to lag inflation for at least the next decade.
What accounts for these ultra-low rates, and the confidence they’ll stretch far into the future? Summers and Furman state that American business has learned to use assets a lot more efficiently, pointing to how professionals frequently work from home and even while in offices use less space, and how Airbnb and Tesla generate get a lot more use out of cars and houses. Shareholders’ demands that companies return more of their earnings in buybacks instead of investing the cash in plants and fabs may lower spending on Capex, and the tech companies that make IT equipment have greatly lowered their costs, reducing the dollars businesses need to spend on new computers and routers. Another factor is demographics: Because Americans are living longer, they need to invest more of their earnings when they’re working, so that the “savings glut” swells the pool of capital that companies can tap to grow, keeping credit cheap.
Rates are already so low––and bound to stay there––they argue, that the Federal Reserve has run out of room to use easy money to fire the economy. The Fed, they say, “‘is pushing on a string’ when it comes to accelerating economic growth.” Nations need to pass the torch to fiscal policy. For Summers and Furman, the right course is to spend freely on social programs to boost demand when the economy is weak without worrying about deepening debt and deficits.
Their core thesis holds that social spending makes the economy grow by putting more money in consumers’ pockets, and that adding trillions is no longer a threat because we can borrow at such low rates. All that new stimulus, they claim, will boost GDP a lot faster than the interest on our national debt, meaning that interest as a share of national output will keep falling even though our debt load is virtually exploding––all through the wonder of rates that are not only super-low, but will fall from here. In the past, the standard measure of a nation’s debt burden has been borrowings as a share of the national income that’s servicing that debt. Don’t get spooked when our debt-to-GDP soars over 100%, as just happened, say Summers and Furman. Forget about it. The new metric that counts is interest as a share of GDP. And that number will stay in the safety zone while the trillions in social spending put a fresh spring in our step. “These views,” they observe, “represent a departure from the orthodoxy of the last generation.”
Summers and Furman acknowledge that a danger zone exists for their pet yardstick, and that interest to GDP begins to look dangerous when it passes 2%. Keep that number in mind.
The two economists accurately recap the downward-trend in rates that’s been happening for years, and recently accelerated. They also present a plausible argument for why borrowing costs could stay low for a long time––indeed, that’s what the markets are saying. The potential downside to their call for a cycle of new spending is that first, it’s hard to predict where rates will be in a year or five years, since everyone from bondholders could demand yields exceeding inflation just as they did for years before the drop in 2020. A guide to how hard it is to call the future trajectory is the sudden shift the forecast from the Congressional Budget Office. As recently as January of this year, the CBO predicted that the average cost of U.S. debt held by the public would be 2.1% in 2021, hitting 2.4% in 2016 and 2.6% in 2030. But by December, the CBO had shaved its forecast by 50%. The CBO now forecasts that instead of rising relentlessly, rates will average just 1.3% this year, falling to 1.1% or below from 2023 to 2006, and not reaching 2% for a decade. If that scenario happens, the Summers-Furman forecast that interest expense to GDP will stay well below 2% is in the bag.
A major reason the U.S. can hold interest cost so low: We’re moving to shorter and shorter maturities, meaning that we need to keep redeeming a bigger and bigger portion of fast-rising debt load each year. The that shift was so big last year that the average term on federal debt dropped from six to five years. To U.S. can only hold the interest bill in check by issuing the vast bulk of new debt required to fund our $1 trillion-plus-and-growing recurring deficits before the pandemic, plus the extra trillions in new spending, at maturities of less than a year. It’s also likely that the Biden Treasury will be rolling more expensive 10 and 30 year borrowing that matures into the likes of 6 week treasury bills.
The numbers, available in recent report from government watchdog the GAO, are alarming. For the September 2019 fiscal year, the U.S. had $2.4 billion in outstanding treasury bills coming due in a year or less that were paying an average of 2.1%. Those ultra-short-term offerings represented 17% of our borrowings. At the end of the 2020 year, Treasury bills plus floating notes had jumped to over $5 trillion, or 27% of all federal debt. More than two-thirds of the extra $4 trillion the U.S. borrowed during the spending explosion of 2020 was funded by Treasury bills. The current rate on those bonds is .2%, one-tenth the number just 12 months before.
Even today, more than half of U.S. debt is in 10 and 30 year bonds that as of September 30, were respectively paying 3.5% and 1.9%. To get our average interest cost to the number the CBO projects and Summers and Furman are counting on, the Treasury needs to keep financing new and maturing loans at less-than-one year maturities.
The “go big on spending to go big on growth” solution could go wrong in two ways. “It’s really an issue of risk management,” says Cochrane. “This course means taking on a lot of risk.” First, it may be probable, but it’s by no means certain that rates remain lower than inflation for years to come. It may be that the steep, crisis-driven shrinkage is partly responsible for the collapse in yields. Over time, real rates tend to be positive even when growth is moderate. From 2013 to 2019, the 10-year rate toggled between 1.5% and 3%, averaging .5% adjusted for inflation. So when GDP goes above 2019 levels sometime late this year or in 2022, it’s possible that yields on the long bond could rise above the 1% range the CBO and Summers-Furman are predicting.
If in just 6 years, the average rate on U.S. debt reached the 2.3% the CBO was projecting in January of last year, our interest tab, by Fortune‘s estimates, would be well over $600 billion. That’s at least 2.4% of GDP, in part because by then total debt would stand at around $27 trillion, from $16.8 trillion in 2019. That share of national income could even be higher if Biden raises borrowings even more by following Summers-Furman. That’s 20% above the 2% that the two economists warned would signal danger.
What if something goes wrong?
The second, more dire threat is the one that most troubles Cochrane. He disagrees that more social spending is a tonic for the economy. “Does borrowing a ton of money and sending out checks really make the economy grow faster?” he asks. “It hasn’t made France richer. Their per capita income is $40,000 a year versus $60,000 in the U.S.” Cochrane reckons that real rates could well remain negative for the next four or five years. But in the interval, we’d still be running huge and growing deficits driven by the relentless expansion in Medicare and Medicaid, on top of the extra trillions in social spending pledged by Biden. “What if something goes wrong?” he says. “We have another pandemic or Italy goes bankrupt or we get into a conflict with China. “We’ve borrowed trillions to supposedly fund growth and we need to roll over $5 trillion in Treasuries in a few months. We haven’t reformed Medicare and Medicaid at all. At some points the bond market will have had enough. Foreign investors will say, ‘We need 5% rates.’ Big countries can have a debt crisis, too.”
Cochrane concludes by stressing the perils of a classic mistake in made by businesses and families alike: short-term borrowing to fund our long-term commitments. Because we’re funding so much new borrowing with Treasury bills that mature in months, our interest expense can explode if rates spike. “It’s not like when America was issuing 40-year bonds in World War II,” he says. “This is more like buying a $1 million house in 2006 using an adjustable rate mortgage,” he says. “Those borrowers thought rates would never go up just like Summers and Furman, and they did. What if they surprise everyone by going up this time, too?”
Summers, Furman, and the Biden team headed by Janet Yellen, are right in one respect. A spending splurge designed to revive an economy already deeply in debt amounts to a revolution. The big risk is that the world they believe has fundamentally changed goes back to normal, and their revolution brings not prosperity, but destruction.