Surging Federal Debt Hurts the Economy – Jessica Riedl

It has become commonplace to dismiss concerns about soaring government debt as much ado about nothing—a modern case of the boy who cried wolf. Indeed, voters have cycled through catastrophic warnings about runaway deficits as far back as the Reagan administration, the 1992 Ross Perot presidential campaign, the mid-1990s “Republican Revolution” in Congress, and the early-2010s Tea Party era. And yet, continually rising budget deficits have not brought a debt crisis.

Instead, hysterical deficit concerns have been cynically deployed by minority parties to attack the agenda of the party in power—right before they seize power and start running up deficits of their own. These politicians do not truly care about budget deficits because their voters do not. Sure, voters tell pollsters they would prefer smaller deficits—right after expressing support for more tax cuts and spending expansions. They are not willing to sacrifice for deficit reduction because they do not see runaway federal debt as affecting the economy or their personal finances.

Yet surging government debt is harming the economy and our fiscal priorities—and its rapid growth poses an existential threat to the long-term American economy. Economists have a cliché that compares government debt to the unnoticed termites quietly eating the foundation of a home. A better analogy: Indulging in escalating debt is like indulging in a lifestyle of fast food, cigarettes, and no exercise. It may be occasionally manageable—and one may avoid feeling the effects for years or even decades—but the damage accumulates until a day of reckoning becomes virtually inevitable. With government debt, the effects are already being felt, and the U.S. is approaching a point at which reversing course will require substantially painful reforms. Those negative effects fall into two broad categories: macroeconomic and budgetary.

Let’s start with the basics. Economic growth—which simply means an economy producing more output that consumers demand—is driven by increasing the number of workers and making those workers more productive through education, training, capital investment, and technology. Productivity gains rely in part on the financial system converting savings into investment. We put money in the bank or invest in a company, and those savings are transferred to someone else to expand a business, start a new one, or fund a home or auto loan. These investments fund the innovation, tools, and business expansions that make workers more productive, raise wages, and grow the economy. And it all starts with converting savings into investments.

Government debt hijacks this process. Washington’s $31 trillion in publicly held debt—a number now higher than the United States’ annual gross domestic product—represents $31 trillion in savings lent to the government for spending rather than to businesses, innovators, and homebuyers—with the exception of $4 trillion that the Federal Reserve financed through monetary expansion. The process of the government absorbing savings that would otherwise have financed private investment is known as “crowding out.” 

While the government could borrow to finance pro-growth investments of its own—such as infrastructure, research and development, or education—most federal borrowing instead finances current consumption, such as government benefits for seniors. Temporarily borrowing for productive investments can eventually yield returns sufficient to repay the debt, but large-scale, long-term borrowing to finance permanent consumption is unsustainable and economically destructive.

This large government borrowing also drives up interest rates, which are simply the price of borrowed money. Baseline interest rates balance the supply of savings against the demands of businesses and families seeking loans. A government demanding trillions in borrowing of its own causes demand for savings to far exceed the available supply—pushing up its price.

Determining the magnitude of the interest rate effect involves two countervailing factors. On one hand, the pool of savings has been globalized, allowing capital to move easily across borders. A government borrowing $100 billion will have a smaller interest rate effect on an enormous global savings pool than it would as a large fish in a single nation’s smaller pond. And holding the world’s reserve currency guarantees some degree of demand for dollar-denominated debt. On the other hand, the federal government’s borrowing needs are so vast—with debt currently at $31 trillion and projected to add $200 trillion more over the next three decades under current policies—that even global capital markets may struggle to absorb this without a meaningful rise in interest rates and reduction in pro-growth investment.

Moreover, the vast majority of this borrowing will come from domestic savings. Of the current $31 trillion in federal debt, China and Japan each hold only roughly $1 trillion, and they likely have neither the capacity nor the interest to absorb much of the $200 trillion in additional scheduled borrowing over the next three decades. Other nations will surely purchase Treasury bonds, but projected U.S. borrowing may eventually exceed the entire GDP of many potential creditor nations. That leaves domestic investors—insurance companies, pension and retirement funds, mutual funds, and state and local governments—to finance Washington’s escalating borrowing demands, or the Federal Reserve to do so while expanding the money supply. At this scale, significant upward pressure on interest rates seems difficult to avoid.

While many studies have attempted to quantify these effects, the general economic consensus is that each 1-percentage-point rise in government debt as a share of GDP pushes up long-term interest rates by approximately 3 basis points (or 0.03 percentage points). This may not sound like much, but it means the federal debt’s jump from 40 to 100 percent of GDP since 2008 has already pushed up interest rates by approximately 1.8 percentage points (some of which was offset by other factors such as a global savings glut). And the projected further leap to more than 240 percent of GDP over three decades under current policies would add yet another 4.2 percentage points of upward pressure—absent offsetting factors. Perhaps other economic forces will push rates all the way back down. But are we prepared to bet the economy on that hope—especially when the coming surge in AI investment may also compete for available capital and put further upward pressure on rates? And in the meantime, all of this government borrowing means significantly fewer savings available to finance home loans, auto loans, and pro-growth economic investment.

These economic costs are not theoretical, as the public’s broad dissatisfaction with the economy can attest. Productivity growth averaged 1.6 percent annually between 1996 and 2010, but has averaged just 1 percent over the past 15 years—a gap that compounds to an economy roughly 9 percent smaller than it might otherwise be. While federal debt is certainly not the only driver of that decline, it is surely a contributing factor. Cross-national research from the International Monetary Fund finds that debt levels above 85 percent of GDP are associated with slower economic growth—and U.S. debt approximates 129 percent of GDP when state and local government debt is included.

With the Organization for Economic Co-operation and Development’s largest budget deficits, U.S. government debt as a share of GDP has leaped to the fourth highest among the 38 advanced economies in the OECD. As debt continues rising steeply, the economic drag is likely to intensify. CBO recently compared a long-term debt-stabilization scenario with one broadly maintaining current policies, finding that the higher-debt path would trim 27 percent off total per-capita income growth over the next 25 years, and that by 2050 per-capita income would be growing at just over half the rate as in the stabilization scenario. Overall, CBO projects that the higher-debt scenario would reduce the growth of annual national income by approximately $10,000 per person—or $40,000 per family of four—by 2050 in today’s dollars.

Similarly, economists at the Penn-Wharton Budget Model project that a package reducing the 30-year debt projection by 38 percent of GDP would expand GDP by 21 percent and significantly raise wages. To be sure, these are model-based estimates. Yet the underlying logic—that government borrowing crowds out the private investment necessary to raise productivity and living standards—is economically inescapable. And today’s sluggish wage growth, underwhelming economic growth rates, and elevated interest rates are surely affected by the prolonged surge in government debt.

Beyond these broader economic costs, rising debt also inflicts direct and immediate damage on the federal budget itself. These fiscal consequences of Washington’s debt spree are even more direct. Escalating interest costs are devouring federal revenues and pushing the government toward a reckoning of sharp tax increases and spending cuts.

The federal debt held by the public has jumped from $6 trillion in 2001 (the last time there was a budget surplus) to $31 trillion—from 32 percent of GDP to 100 percent. And with rising debt—and rising interest rates—come rising interest costs. This year, net interest costs will reach approximately 3.3 percent of GDP for the first time in modern American history.

Put differently, interest costs consumed an average of 10 percent of annual federal revenues between 1940 and 2022, topping out at 18.4 percent in 1991. This year, interest costs will consume a modern record of approximately 18.8 percent of all federal revenues—on a trajectory toward 31 percent of all revenues within a decade, and 54 percent within three decades if current policies continue. Imagine every dollar in federal taxes you pay through July 16 going to service interest on the debt rather than Social Security benefits, school lunches, veterans’ benefits, infrastructure, or education. If interest rates swell even 1 percentage point above CBO’s projections, the three-decade interest spending surge will reach approximately 83 percent of all annual federal revenues—equivalent to every dollar you pay in federal taxes through Halloween.

Since 2022 alone, net interest costs have roughly tripled—from $351 billion annually to more than $1 trillion—surpassing the budgets of both defense and Medicaid and approaching Medicare as the second-largest budget item behind Social Security (which itself is projected to be surpassed by 2040). The federal government has entered a vicious cycle in which the majority of this year’s $1.8 trillion budget deficit will go to paying interest on past deficits—and those continuing deficits will further swell interest costs, which will further enlarge future deficits.

Ultimately, these escalating interest costs crowd out other spending priorities and force up taxes. The combined jump in Social Security, Medicare, and interest costs has already contributed to defense spending falling—as a share of GDP—to roughly half its 1980s levels. The combined budget for other discretionary priorities such as education, infrastructure, housing, and social services has fallen by roughly one-quarter as a share of GDP. And as interest costs are set to double and eventually triple their claim on federal revenues, dramatic cuts to spending programs and higher taxes become essentially inevitable. Under current policies, federal spending over the next three decades is projected to rise by approximately 2.4 percent of GDP—yet interest costs alone are projected to soar by 6.4 percent of GDP, from 3.3 to 9.7 percent, driving the debt toward more than 240 percent of GDP.

And the previous section represents the rosy scenario—yes, you read that correctly. That CBO-based projection assumes no additional tax cuts or spending expansions beyond current policies, no major wars or sustained economic downturns, and—crucially—that the average interest rate on the federal debt (currently around 3.4 percent) never again exceeds 4.2 percent. Yet the dynamics described above suggest that the accelerating surge in government debt should itself put significant upward pressure on interest rates. Is it safe to assume that Washington can borrow $200 trillion more over the next three decades with its average interest rate growing by less than 1 percentage point? We should hope so, because Congress and the White House have essentially bet the future of the U.S. economy on that optimistic assumption.

Anyone with a mortgage or student loan understands that when your debt is large, even small movements in interest rates produce substantial costs or savings. Now apply that logic to a federal debt heading from $31 trillion to $232 trillion. Government bond auctions are already regularly exceeding the CBO-projected interest rates. If the average interest rate on the federal debt runs even 1 percentage point higher than CBO projects over the next three decades, the resulting additional interest costs would approach $57 trillion—the equivalent of adding a second Defense Department. The total national debt projection would jump well past 300 percent of GDP over three decades, with interest costs consuming approximately 15 percent of GDP out of roughly 18 percent of GDP in projected revenues. Again, that is the consequence of interest rates exceeding CBO’s projections by just 1 percentage point.

That scenario is unlikely to fully materialize—not because it is fiscally sustainable, but because the stretched-thin bond market would force adjustment long before that point. Congress and the White House would face no alternative but to significantly reduce primary deficits through painful tax increases and spending cuts. Otherwise, a vicious cycle of rising debt and rising interest rates would paralyze both financial markets and the federal government. The result will almost certainly be taxpayers bearing a much heavier tax burden and receiving notably fewer government benefits than today, as increasing shares of their tax revenues flow to bondholders rather than public programs.

Yet there is one other path already tempting the current administration. Fiscal dominance—pressuring or compelling the Federal Reserve to maintain artificially low interest rates in order to reduce the government’s borrowing costs—has obvious political appeal: Why accept unpopular tax increases or spending cuts when the Fed can simply be directed to keep rates low? The problem is that fiscal dominance disables the Federal Reserve and prevents it from using monetary policy to stabilize the business cycle and contain inflation. The resulting inflation would lead holders of longer-term bonds to demand even higher rates to compensate for expected purchasing-power losses—pushing some of the government’s borrowing costs back up regardless. 

The Federal Reserve operated under fiscal dominance during World War II to help finance wartime borrowing, but when the Treasury refused to restore the Fed’s independence after the war, inflation predictably surged until the Fed was finally liberated in 1951. President Donald Trump’s attacks on the Fed and Chairman Jerome Powell have been motivated in part by his stated desire of “saving us $1 Trillion per year”—a figure that substantially overstates what lower rates could realistically achieve.

Finally, all of this accumulated debt steadily erodes the federal government’s capacity to respond to genuine emergencies—wars, deep recessions, and natural disasters—that have historically required federal outlays running well into the trillions of dollars.

Yes, these fiscal scenarios sound dire. But don’t just take my word for it. When economists at the Penn-Wharton Budget Model tried to model the long-term economy under current debt trajectories, their economic models crashed. 

Unfortunately, no one can credibly tell us exactly when the bond market will reach its breaking point. If you gradually raise the temperature in a room to 220 degrees, you can be certain that at some point life will be extinguished—even if you cannot pinpoint the exact temperature when it occurs. Similarly, somewhere between a federal debt of today’s $31 trillion and the 30-year projected level of $232 trillion, a brutal cycle of rising interest rates followed by even faster-rising debt will likely be unleashed. Responsible lawmakers and taxpayers should not want to find out where that point is.m

Yes, critics will note that we have been hearing about an impending debt crisis for 30 years. But beyond the reality that Americans are already experiencing some of the economic effects—and the crowding out of key federal budget priorities—the largest costs were always likely to materialize after all 74 million baby boomers had retired into Social Security and Medicare, a process that will be essentially complete around 2030. Social Security trustees have been projecting trust fund insolvency in the early- to mid-2030s as early as the 1990s.

So why then were deficit hawks so aggressive in the 1990s and early 2000s? After all, that era’s 40 percent of GDP federal debt burden was not especially problematic, and its elevated interest costs were merely a temporary artifact of high interest rates. Yet the deficit hawks recognized that any plan to manage the looming cost of 74 million baby boomers retiring between 2008 and 2030 would require gradually phasing in Social Security and Medicare adjustments while the boomers were still young enough to adapt their retirement plans. 

Unfortunately, those forward-thinking reforms were not enacted, and that window has largely closed. This leaves the deeply unpalatable options of either cutting benefits for people already in retirement or exempting from reform the very generation whose retirement costs are driving the fiscal train off the cliff. The lesson, as always, is that delaying fiscal adjustments only makes them larger, more abrupt, and more painful—a lesson that lawmakers and voters still refuse to confront.