The trajectory of our federal budget recalls the folks who bought a $1 million house they thought they could afford with an ARM mortgage in 2007. The inevitable deluge struck when rates reset a couple of points higher. “It didn’t take much of a change to bury them,” says Brian Riedl of the conservative-leaning Manhattan Institute, who compares our reckless approach to debt and deficits to that of the hapless families swamped by ARMs. Today, U.S. debt is growing by the trillions and Treasury has got to refinance those multiple trillions at far higher rates going forward. That’s a roadmap to disaster.
That looming catastrophe went mostly unmentioned in an optimistic new report from the Congressional Budget office, released on February 1. The CBO foresees a much more robust revival than its downbeat forecast of just a few months ago. The non-partisan agency finds that recovery started earlier and proved far stronger than they had posited in a June outlook. The economy outperformed big time, shrinking just 2.5% last year, less than half the 5.7% pullback the CBO projected. It now expects national output to rise at a healthy 3.7% clip this year, regaining its peak, 2019 levels by mid-year. In June, the CBO reckoned that the U.S. wouldn’t hit that benchmark until well into 2022. The outlook for next year also got an upgrade, with the CBO pegging 2.6% growth, a nice improvement on its previous read of 2.4%.
The report also offered welcome tidings on employment. The number of people working, says the CBO, should return to its pre-pandemic levels by 2024, earlier than expected. The markets cheered, as investors mostly erased big losses on January 29 by pushing the S&P higher by 1.6%.
What looks like an upbeat call, however, isn’t nearly as positive when you examine the trends for deficits and debt. The new report points to danger ahead because the CBO is now forecasting future interest rates that are higher than in its previous release. It’s also projecting GDP growth in future years that’s a lot lower than expected, a signal that tax receipts will fall short of its forecasts.
In its previous reports, the CBO hasn’t been showing future interest expense as much of a problem. That’s because the U.S. is now borrowing at such extraordinarily low rates that the cost of our federal debt is forecast to shrink considerably at the same time borrowings are rising by trillions. But it’s now clear that the debt will rise much faster than in previous forecasts, and that rates will be higher, especially several years out––so much so that without major reforms, a crisis is all but inevitable.
Let’s look at the two ruling numbers, first the future size of our debt, and second, the trend in interest rates. For fiscal 2020 (ended in September), federal borrowings totaled $20.3 trillion, a jump of $3.5 trillion, or over one-fifth, from last year’s $16.8 trillion. In the new report, the CBO projects that Trump’s $900 billion stimulus package will swell the expected shortfall of $1.810 trillion to $2.710 trillion. That doesn’t include any of the Biden team’s proposed $1.9 trillion plan; Republicans in the Senate have countered at $600 billion. If the final number finishes in the middle at $1.25 trillion, the U.S. will face a deficit of at least $4 trillion in 2021.
That’s optimistic for this year. The measure’s also likely to boost future deficits well beyond what’s now expected. “Biden’s $1.9 trillion plan includes what will become permanently higher costs, such as expansions of the Earned Income Tax Credit and Child Tax Credit,” says Riedl. Those increases and lingering costs from the pandemic could raise the deficit by an extra $200 to $300 billion a year.” The CBO’s outlook as of September called for one-trillion-plus deficits every year going forward. Add the the enduring expenses likely to be enacted this year, and the U.S. could easily see an extra $16 trillion added to its debt load over this and the following nine years.
That scenario would bring total debt held by the public, by Fortune‘s estimates, to $38 trillion by 2030. That’s a staggering 123% of GDP, and well over twice the burden in 2019.
To hold interest costs in check, the U.S. is borrowing heavily at super-short term rates, mostly in Treasury bills with maturities of less than six months at rates of around 0.1%. Last year, around two-thirds of the over $4 trillion in new borrowings was raised on Treasury bills. But that emergency strategy won’t last long. To avoid the absolute catastrophe from a sudden jump in Treasury bill yields––they stood at 2% at the start of 2019––the U.S. will gradually roll those bonds into safer, longer maturities. That will most likely include big purchases of the benchmark 10-year Treasury.
They better move fast. The fresh CBO report expects the long bond yield to rise from the current 1.1% to 1.5% by 2023, then wax rapidly from there, hitting 3.1% in 2029, and 3.4% in 2031. That’s much steeper than the ramp-up forecast in September, when the CBO saw the long bond hitting 3.1% a decade hence. Three-year Treasury bills won’t be nearly as big a bargain either; their yield should be back at 1% by 2026. This picture looks “best case,” to say the least. These forecasts constitute a “world has changed” view that put Treasuries at at much lower rates than those that have prevailed in recent years. If the CBO is wrong, the error is virtually certain to be in calling rates too low.
The Trump Administration, the Biden Team, and economists Larry Summers and Jason Furman, argue that the size of the debt doesn’t matter much. What matters is interest expense relative to GDP. So we should keep borrowing trillions to stimulate the economy, and not fret over the weight of the debt load. But the burden that’s already baked in assures that interest will be a huge problem even if rates remain unusually low, which is already a risky bet. Let’s assume that average interest is just 2% in 2030. On a total borrowings of $38 trillion, that’s interest expense of 2.5% of GDP, well past the danger point of 2% identified by Summers and Furman.
My forecast is that the number will be a lot higher than $760 billion, because the U.S. will need to keep rolling its huge existing stock of Treasury bills as well as borrowings to fund future deficits, into longer-term bond whose rates are now projected to rise rapidly. The scenario gets much worse from after 2030, with the Treasury financing deficits by floating a 10-year yielding 3.4%, over three-times the current cost. It’s the ARM syndrome all over again. Only this time, it’s not just reckless homebuyers who’ll pay the price, but hundreds of millions of middle-class taxpayers. And especially, their kids and grandchildren.