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With a Keynesian in the treasury, the “debt and deficits don’t matter” crowd are seemingly excited about pushing our national debt to record levels and beyond. This is an oversized thread where I attempt to explain why this debt narrative is not only wrong, but dangerous.
One of the primary justifications for an open-ended spending spree is based on the fallacy of low trending interest rates infinitum. Proponents of this fallacy will often show you a chart of treasury yields (conveniently) starting around 1980, with a falling trend thereafter.
Economists in Greece used to be under the same illusion (see Greek treasury yields 1997-2005 below) that interest rates could continue to fall infinitum, until rates rose to almost 30 percent in the midst of the sovereign debt crisis.
While it has been observed that demographics and foreign demand for US debt has put downward pressure on interest rates over the years, it is also the case that growing debt and deficits put upward pressure on interest rates.
Several academic studies have found that each percentage increase in the debt-to-gdp ratio raises nominal interest rates by 2 to 5 basis points, while each percentage increase in the deficit-to-gdp raises nominal rates by 20 t0 25 basis points.
Ford and Laxton (1999) find that the coefficient on debt implies that a 1 percentage point increase in world public debt raises each country’s interest rate by 23 basis points. https://academic.oup.com/oxrep/article-abstract/15/2/77/498592?redirectedFrom=fulltext
Engen and Hubbar (2004) find that a 1 percentage point increase in the debt-to-gdp raises treasury yields by about 3 basis points, while a 1 percentage point increase in the deficit-to-gdp raises yields by about 18 basis points. https://www.nber.org/papers/w10681
Kinoshita (2006) finds that a 1 percentage point increase in the government debt-to-GDP ratio raises the real long-term interest rate by about 2 basis points and 20-25 basis points for an equivalent increase in the government consumption-to-gdp ratio. https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Government-Debt-and-Long-Term-Interest-Rates-18866
Laubach (2009) finds a 1 percentage point increase in the projected deficit-to-GDP ratio raises long-term interest rates by roughly 25 basis points and a 1 percentage point increase in the debt-to-GDP ratio raises the interest rate by 2.1 basis points. https://www.jstor.org/stable/40282791?seq=1
Kumar and Baldacci (2010) find an increase in the fiscal deficit of 1 percent of GDP pushes up bond yields by 17-20 basis points, while an increase in the debt-to-gdp ratio pushes up bond yields by around 5 basis points. https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Fiscal-Deficits-Public-Debt-and-Sovereign-Bond-Yields-24130
Cebula (2014) finds that for every 1% increase in the size of the budget deficit (as a percent of GDP), the nominal interest rate yield rises approximately 20-21 basis points. https://www.tandfonline.com/doi/abs/10.1080/00036846.2014.932050
An analysis by Tedeschi in 2019 finds that for every 1% increase in the budget deficit-to-gdp, the 10-year treasury yield rises by 18 basis points, while a 1 percentage point increase in debt-to-gdp raises yields by 4.2 basis points. https://medium.com/bonothesauro/deficits-are-raising-interest-rates-but-other-factors-are-lowering-them-6d1e68776b7a
Gamber Seliski (2019) find that the average long-run effect of debt on interest rates ranges from about 2 to 3 basis points for each one-percentage-point increase in debt as a percentage of GDP. https://www.cbo.gov/publication/55018
It isn’t just the swathes of economic literature that consistently demonstrate how growing debt and deficits raise interest rates. The Congressional Budget Office estimates that interest rates on 10-year Treasury notes and the OASDI trust funds will reach 4.8% by 2050.
Proponents of open-ended spending, deficits, and debt often make the case that other factors such as foreign demand for US debt outweigh the upward pressures of our debt trajectory. Some economists have, therefore, concluded that the growing debt doesn’t matter.
Along these line, Tedeschi argues that each % point increase in foreign holdings-to-GDP lowers the 10-year by 11.2 basis points. However, foreign holdings-to-GDP are at the same level today (%GDP) as they were in 2012.
Why then do economists assume there will be some kind of explosion in the foreign holdings of US debt? Not only have foreign holdings-to-GDP remained around 33 percent since 2012, but the share of public debt held by foreign investors has fallen significantly in recent years.
Assuming the CBOs most optimistic debt trajectory scenario, foreign holdings of US debt would need to increase to at least 70 percent of GDP by 2050 to just counteract the upward pressures of debt on interest rates.
Dare we rest the fiscal health of our nation on such naive assumptions about foreign investors holding unprecedented levels of US debt? John Cochrane says that we shouldn’t. https://johnhcochrane.blogspot.com/2021/01/low-interest-rates-and-government-debt.html
At 4-5% interest rates and a total debt stock twice the size of our economy, we cannot afford to fall for such bad economic arguments. We should not be passing the burdens and risks onto future generations who will have to finance this cumulative debt with exorbitant tax rates.
Putting all of the bad stimulus multiplier arguments aside, based solely on the fallacy of low trending interest rates infinitum, we cannot afford to all be Keynesians now.
