Anyone who follows the DC budget game at all knows that the Congressional Budget Office (CBO) is supposed to be its referee. Any proposal that involves new spending or revenue is scored by the CBO for its impact on the federal debt over the next ten years. That score normally sets the terms on which the proposal will be debated and voted on. This ritual is sufficiently established that most spending proposals are described in terms of their cost over the next ten years – the CBO’s scoring window.
The CBO doesn’t only assess individual bills, it also gives a baseline, producing regular forecasts of major economic variables and the path of the debt under current policy. In a sense, these forecasts are the playing field on which budget proposals compete. So it ought to be a big deal when the CBO changes the shape of the field.
In their most recent 10-year budget and economic forecast, the CBO made a big change, reducing their long-run forecast of the interest rate on government bonds by almost a full percentage point, from 3.7 to 2.9. (See Table 2.6 here.)
Most directly, the new, lower interest rate reduces expected debt payments over the next decade by $2.2 trillion. It also significantly reduces the expected debt-GDP ratio. Under the assumptions the CBO was using at the start of this year, the debt ratio under existing policy would reach 120 percent by 2040. Using the new interest rate assumption, it reaches only 106 percent. With one change of assumptions, a third of the long-run rise in the federal debt just disappeared.
Debt-GDP Ratio with CBO Interest Forecasts of January vs August 2019
While this downward revision is exceptionally large, it’s hardly the first time the CBO has adjusted its interest rate forecasts. In April 2018, they raised their estimate of the long-run rate on 10-year bonds from 3.1 percnet to 3.8 percent. But that upward move is an exception; for most of the past decade, the CBO has been steadily adjusting its interest rate frecasts downward, adapting — like most other macroeconomic forecasters — to the failure of the economy to return to pre-recession trends. As recently as February 2014, they were predicting a long-run rate of 5 percent. And it’s likely the interest-rate forecast will continue to decline; the current 10-year Treasury rate is less than 1.8 percent.
The newest forecast was released in August, and as far as I can tell the change in the interest-rate assumption has gotten almost no attention in the two months since then. But it really should.
At the very least, this means that anyone arguing that federal debt is a climate-change-level threat to humanity needs to update their talking points. The claim that federal debt “will be close to 150% of GDP by 2050” is, as of August, not even close to correct. With the new interest assumptions, the figure is less than 120 percent.
To be fair, an argument that doesn’t go beyond “oooh, big number, scary” isn’t likely to be much affected by this revision. But the new interest estimate has broader implications.
If the term “fiscal space” means anything, lower expected interest rates have to mean that there is more of it. That $2 trillion in interest savings the new CBO estimate has handed us, could presumably be used for something else. As a downpayment on single-payer health coverage, say, or as public investment in decarbonization as part of a Green New Deal. Whatever spending we think most urgent or politically practical, we could borrow an extra percent of GDP or so a year to pay for it, and leave the long-term debt picture looking no worse than before.
Whatever level of federal spending you thought would keep the debt on a reasonable path a year ago, you should think that number is $2 trillion higher today.
To be clear, CBO scoring doesn’t actually work this way. Budget proposals are evaluated relative to the baseline, wherever that happens to be. So the change in the interest assumption will have only a marginal effect on the score for individual bills. But if there is any rational content to the CBO scoring ritual, it has to involve some sort of judgement about what level of debt is reasonable, relative to GDP. If you take CBO debt forecasts seriously – as almost everyone in the policy world at least claims to – then lower interest rates mean more space for new borrowing.
Lower future interest rates also have implications for stabilization policy. They mean that in the next recession, whenever it comes, there will be even less space for the Federal Reserve to lower rates to boost demand, and a correspondingly greater need for fiscal policy – a point that, fortunately, members of the House Budget Committee seem to understand.
There’s one more, even broader, implication of the new forecast. What does it mean that the CBO keeps revising its forecasts of future interest rates downward, even as federal debt itself continues to rise? Obviously there is not the tight relationship between a high debt-GDP ratio and rising interest rates that austerity-promoting economists like to predict. Which should raise a question for anyone interested in macroeconomic policy or public budgets: If high federal debt doesn’t have any reliable effect on interest rates, then what exactly is its economic cost supposed to be?
(Cross-posted from the Roosevelt Institute blog.)
More generally, what is the problem of high debt if the government can always roll it over? Even if the interest rate increases, the government just has to go more into debt to rollover, so the only problem of more government debt is that it leads to even more government debt.
But if the debt to gdp ratio can just rise to infinite then there is no problem at all.
So the question is, why can’t the debt to gdp rise to infinity?
Sounds like a stupid question but it is hard to answer.
One answer is that as long as the interest rate is less than the growth rate of GDP, the government can run deficits forever and the debt ratio does not go to infinity.
Specifically, if the p[rimary deficit (deficit not cunting interest payments) is d, the growth rate is g and the avergae interest rate is r, then the debt rati approaches d(g-r). So for instance, in the US right now nominal growth rates are around 4 percent, the federal government today issues debt with an average interest rate of 1.5 percent, and under current policies the primary deficit over the next ten years (again, accoring to the IBO) will average 2.4 percent. That implies that if this situation continued to eternity, the debt-GDP ratio would eventually reach 96 percent and then just stay there.
There is a separate question of what would happen if you were on a path where the debt ratio really did rise without limit -w hat would happen to stop it? But as long as we are in a world where the interest rate facing governments is less than the growth rate, we don’t have to struggle with that difficult question.
I understand your point that, under some parameters, the government can run deficits forever without increasing the debt to gdp ratio.
However, as running deficits is generally beneficial both politically and economically, the main question is how much deficit should the government run.
So a lot of policies that sound bad would be good if really there was no limit to fiscal space.
For example, a common idea is that deficits incurred by increased government spending have a greater multiplier than deficits incurred by lowering taxes. But if there is no upper limit to debt the government could simply reduce taxes more and have the same effect.
Why couldn’t the government simply set taxes to 0 and still continue spending?
One drawback could be inflation but, if as I believe keynesian inflation is only due to wageprice spirals, this would happen anyway approaching full employment.
In my opinion the main problem is not inflation or a government debt crisis, but rather that this kind of economy would be super bubbly.
To put it in other words, I think the main problem is private balance sheet expansion and that government deficits and keynesian policies in general can only stop the problem of a balance sheet crisis, so the problem of the debt to gdp ratio cannot be examined separately from private balance sheet dynamics.
IMHO.
I’m insisting in a vaguely OT line of argument. Apologies, however I insist on this because I think this is a big theoretical hole.
Going at it from a different angle:
There is an intuitive view that says that inflation is caused by the government printing money, let’s call this the quantity theory.
But if we ask: how much money did the government print, the answer is that it is the sum of all government deficits. In other words, government debt IS the fking quantity of money (I think this is called M2).
So if we ask what is the relationship between debt and gdp, we are speaking of the relationship between the quantity of money and prices (adjusted by productivity and level of activity).
This is true by definition.
So either the quantity theory is completely, 100% wrong, at which point there is no relation whatsoever between government debt and gdp so that we can totally ignore the debt level and only care of inflation, which however cannot be caused directly by deficits but must be caused exclusively by other indirect effects like wage price spirals. If this is true we can ignore any question of fiscal policy and just target our preferred employment / inflation level.
Or there is some relevance of the debt to gdp level, at which point there might be something like fiscal space, so it might make more sense to spend more during slumps. But I never met an explanation about fiscal space that didn’t rely on the idea the government could go bankrupt.
Or there is some other drawback in permanent deficits, different from both inflation and government bankruptcy.
My personal belief is that the third option is the correct one, but I’m curious of your opinion.