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Americans should be terrified by the CBO’s new predictions about the federal debt

July 7, 2021, 12:00 AM UTC

In February, the Congressional Budget Office (CBO) issued long-term projections for the federal budget that featured some amazing, and comforting, numbers on where federal interest expense was heading. The report, The Budget and Economic Outlook: 2021 to 2031, predicted that despite the explosion in debt caused by a combination of huge structural deficits and emergency spending during the pandemic, the dollars the U.S. pays in interest would actually fall over the next several years. The reason for that extraordinary scenario: A regime of ultralow interest rates would extend well into the future, more than offsetting federal debt rising at a pace, and reaching a share of the economy, that’s unprecedented in peacetime.

Treasury Secretary Janet Yellen, as well as such influential economists as Larry Summers and Jason Furman, relied heavily on those and similarly optimistic forecasts in their policy recommendations. Their argument: In an era of supercheap borrowing, what matters isn’t the size of the federal debt, but how much the U.S. is paying each year to service that debt. Hence, the times are ideal to greatly increase federal spending and deficits on everything from infrastructure to childcare to subsidies for green energy. Spending, deficits, and debt will rise, but interest expense will keep shrinking, making all the new outlays affordable.

The view that debt levels don’t matter is dangerous

That view, however, exposed the economy to serious risks that those dismissing the importance of fast-expanding shortfalls and borrowings didn’t address. The U.S. has been keeping its interest costs low by adding to and refinancing trillions in debt at extremely short maturities, mostly at less than a year. Hence, a jump in rates could put the economy in grave danger.

In assuming that Treasury yields would stay super-slender for years to come, policymakers are making the same gamble as homebuyers who gorged on big mortgages at teaser rates in 2005 and 2006. When their rates reset upward, their monthly nut suddenly devoured so much of take-home pay that their homes turned unaffordable. The simple reason: Like the U.S. government today, they’d borrowed far too much to begin with, leaving themselves exposed to the inevitable jump in their bill for interest.

On July 1, the CBO issued an update to the February forecast. The agency now predicts much higher rates on the Treasury bills and bonds that fund the borrowings, and federal interest expense overall, than just five months ago. The numbers show that the total size of the debt matters big-time because the larger the borrowings, the more vulnerable the economy to runaway interest costs.

The new report is already flashing red. But it’s still positing that future yields will defy economic gravity. If they go back to anything like normal levels, the outcome will be far, far worse. Put simply, the trend charted by the CBO shows a potential fiscal catastrophe in the making. Where the CBO’s forecasts are pointing should terrify all Americans.

The CBO is now predicting far higher rates than five months ago

Let’s examine how radically the CBO’s view of future interest expense has shifted. In February, it projected that the annual burden would fall from $376 billion in 2019, to $278 billion in 2024, and not exceed pre-pandemic levels until 2027. That outlook was hard to believe, since the CBO was also predicting that total debt would swell from $16.8 trillion at the close of 2019 to $27.6 trillion in 2026, or by $10.8 trillion. But despite a debt load due to mushroom by two-thirds, interest costs would go the other way, dropping by $15 billion a year.

Seemed like a magical outcome. But the magic proved ephemeral. In the July update, the CBO views interest costs jumping far higher, far sooner than foreseen in February. For 2021, it now puts the number at $331 billion, instead of the previous forecast of $303 billion. By 2026, the CBO expects the U.S. to be spending $467 billion annually on interest, $106 billion more than projected five months ago. From 2021 to 2031, total interest expense is now pegged at $5.826 trillion, an 18% leap from the February estimate.

The report gauges the 2031 bill at a staggering $910 billion, for an upward revision of $111 billion or over one-eighth. That figure approaching $1 trillion is almost three times the outlay for this year. If the forecast is correct, interest expense would equal almost half of all payroll tax receipts and 50% of discretionary spending.

The CBO’s forecast is still too optimistic

It’s virtually certain, however, that the economy will bow under a deadweight that’s even heavier. The reason is twofold. First, spending will be much higher in the years to come than the CBO has forecast. Second, if history is any guide, interest rates will greatly exceed the current outlook.

Let’s start with examining why expenses will far exceed the official projections. The CBO is required to run numbers based on current law only. Its outlook doesn’t include the probable cost of programs that are scheduled to sunset, but will almost certainly be renewed, or for any newly legislated spending. Brian Riedl of the Manhattan Institute outlines the expenditures excluded from the forecasts, but bound to continue. Increases and extensions in the child tax credit should add $1.3 trillion over the next decade, while keeping the Trump tax reductions for the middle class would run $400 billion. Tack on the bill for maintaining Obamacare subsidies, and the “baseline” expenditures projected by the CBO jump by $2 trillion over the decade.

The official forecasts show discretionary outlays for the likes of defense and education rising at just 1% a year. That won’t happen. We don’t know much of the Biden spending packages will be enacted. But if the President gets his full wish list on infrastructure, health care, social security, green energy, and the like, total debt, by Riedl’s estimates, could reach the $45 trillion range by 2031. That’s one-third bigger than the CBO’s current forecast of $33.7 trillion, and double the pre-crisis figure.

Danger No. 2: Rates will be much higher than even those in the CBO’s revised forecast

The second problem: It’s almost certain that the looming debt mountain will carry interest rates not just higher than today’s, but well beyond the CBO’s estimates. Just look at how far the agency’s predictions have moved in just five months. Between February and July, the CBO has raised its forecast for the 10-year Treasury from 1.1% to 1.6% for 2021, from 1.3% to 1.9% for 2022, and from 1.5% to 2.0% for 2023. It now pegs the average yield from 2026 to 2031 at 3.2% versus the previous estimate of 2.8%.

Part of that increase reflects the likelihood of stronger inflation. The CBO believes that prices will rise 3.3% in 2021, and 2.5% in 2022, above the 1.9% and 2.0% predictions from February. But the agency still foresees rates that are much too low for that level of inflation. The reason: It’s projecting a continuation of yields that trail consumer and producer prices, that hand investors returns less than the projected rise in the cost of living. In other words, more years of negative “real” yields, a regime the U.S. has seldom experienced or lasted for long. The rate of 2% that the Fed sees for 2023, is below its inflation forecast of 2.5%. If the CBO is right, rates would still be lagging price increases by a wide margin two years hence.

But farther out, the CBO does see “real” rates rising sharply. It predicts that from 2026 to 2031, inflation-adjusted yields will wax from the minus column to around a positive 0.8%. That’s a huge jump. The problem is that it’s probably not big enough. Over most periods, real rates track growth in national income as demand for capital rises in lockstep with an expanding economy. Hence, a real rate of 1.5% to 2.0% would seem more in keeping with past trends. So if rates indeed “normalize,” the 10-year would go to more like 4% to 4.5%.

The U.S. has been borrowing super-short to restrain interest expense as borrowing exploded. Two-thirds of all our current $23 trillion in borrowings comes due in the next three years. Although the average rate on the debt lags the rising yield on Treasuries, the shift to shorter maturities makes the U.S. budget much more sensitive to spikes in rates. As the trends in the new CBO report suggest, the U.S. could easily be paying 3.0% on $45 trillion in borrowings by 2031, sending total interest costs to $1.35 trillion, 50% higher than the CBO’s current number. And 3% is way below the norm over the past half-century.

Riedl puts the problem succinctly: “Huge debt levels make the U.S. much more vulnerable to rising rates.”

The CBO is also assuming no major recessions, no wars, and the willingness of foreigners to keep flocking to the safety of Treasuries even as our debt burden soars to European proportions. The new CBO numbers signal that interest expense could swamp the budget, requiring giant tax increases that would shrink the size of the private sector. A shrinking private sector means shrinking tax revenues and either much bigger deficits or much higher taxes. The view that “the size of the debt no longer matters” has put the U.S. on that treadmill to catastrophe.

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