The United States has the largest, strongest, and most dynamic economy in the world. The strength of the US economy has made the dollar the world’s reserve currency, and the credit of the federal government is currently unquestioned. Even so, the United States should not take the reserve status of the dollar or the Treasury’s credit for granted.1
Key Points:
- Americans are beginning to feel the consequences of Washington’s excessive spending, through both higher interest rates and increasing inflation—problems that will only intensify over the years to come.
- Recent crises and recessions justified fiscal stimuli, but Congress has continued large deficits and growing debt during economic expansions and times of prosperity, creating long-term threats to the nation’s fiscal health.
- Congress should pursue policies that encourage economic growth while slowing the growth in entitlement spending to prevent future generations from experiencing the terrible consequences of unchecked deficits and ever-increasing debt.
The federal government seemingly has an unlimited ability to borrow with little concern about deficits, interest rates, or inflation.2 While inflation has risen recently, markets believe inflation has peaked and the Federal Reserve will retreat from raising interest rates and return them to historically low levels.3 That view, however, poses huge potential risks to both the US economy and the federal government’s ability to carry out its functions. Fortunately, the strength of our country’s economy, particularly relative to its peers, and recent experience suggest the nation has the time and fiscal space to get its fiscal house in order. However, according to the Congressional Budget Office (CBO), the longer Washington delays addressing the problem, the more difficult the task becomes.4
To ensure our country retains the benefits of having the world’s reserve currency, the best credit on the globe, and strong, sustainable economic growth, Washington needs to implement policies that sustain a healthy economy, slow the growth in federal spending, and maintain stable prices.
Background and Outlook
At the country’s founding, it was bankrupt after borrowing to finance the Revolutionary War and struggling with inflation, both of which produced an anemic economy.5 The new Constitution gave Alexander Hamilton, the nation’s first Treasury secretary, the tools to build a lasting financial foundation for the federal government and US economy.6Hamilton recognized the importance of a nation’s ability to borrow, writing in 1781, “A national debt if it is not excessive will be to us a national blessing.”7
Throughout its history, the federal government has relied on its credit for numerous accomplishments, including to service the debt from the Revolutionary War and the Louisiana Purchase and to win the Civil War and World War II. In each instance, the surge in borrowing was temporary, and the government balanced its books and reduced its debt in relation to the economy afterward.
While entitlement programs date back to the nation’s beginning, the New Deal, the Great Society, and subsequent additions to and expansions of entitlement programs have led to these programs dominating the federal budget. In a book on the history of US entitlement programs, John Cogan characterizes the New Deal as the “birth of the modern entitlement state” and notes that “since 1946, entitlement spending has grown at an annual average rate 33 percent faster than the growth in GDP [gross domestic product].”8
Beginning in the late 1960s, federal entitlement spending grew to dominate the federal budget. In 1962, the defense budget represented about half of federal spending (49.2 percent) and mandatory spending about a quarter of the total (26.1 percent). As a share of total spending, defense outlays declined steadily over the next 57 years as entitlement spending, particularly Social Security and health care spending, soared (Figure 1). By 2019, defense comprised 15.2 percent with mandatory spending, equaling 69.9 percent of total spending.9 During this period, federal spending as a share of the economy—gross domestic product (GDP)—fluctuated but steadily rose from 18.2 percent of GDP in 1962 to 21 percent of GDP in 2019.10
Figure 1. Major Categories of Outlays as Percentages of GDP
With the enactment of the Great Society, the expansion of its entitlement programs, the creation of new ones, and a resistance to higher taxes to offset the growing spending, Washington no longer followed the historical norm to balance budgets during peacetime and economic expansions. Except for four years in the late 1990s and early 2000s, beginning in the 1960s, the federal government began to run a fiscal policy of sustained budget deficits, and the debt began a steady rise from its post–World War II nadir of 23.2 percent of GDP in 1974. By fiscal year (FY) 2008, federal debt stood at 39.2 percent of GDP.
With the 2008–09 financial crisis and again with the COVID-19 pandemic that started in 2020, the federal government deployed an unprecedented fiscal and monetary response that was greatly expanded in response to the pandemic. Those two crises produced a huge surge in the federal debt of a magnitude not seen since World War II. Unlike past crises, in which debt receded as a burden on the economy, Figure 2 displays the CBO projection of a continued steady and steep rise in the debt, driven by higher mandatory spending—particularly for health care programs—joined by the growing interest expense to finance this debt.
Figure 2. Debt as a Percentage of GDP, 1950–2052
Despite this enormous surge in the debt, the response in inflation and interest rates has been remarkably subdued. The federal debt soared from 39.2 percent of GDP in FY2008 to 100.3 percent of GDP in FY2020. During that same period, relative to the economy, the financing cost of that debt (i.e., net interest outlays) has remained below 2 percent of GDP. FY2020 best illustrates the huge benefits of lower interest rates to the federal government. Despite the federal debt rising by 25 percent that year alone, the Treasury’s interest costs declined by 7.9 percent.
The Federal Reserve’s actions contributed to this dichotomy. It used its traditional tool, the federal funds rate, to essentially reduce short-term interest rates to zero in 2008 and again in 2020. To provide additional downward pressure, particularly on longer-term rates, it also engaged in “quantitative easing,” the purchase of Treasury and other securities. With a dramatic deployment of quantitative easing, it increased its balance sheet tenfold (from nearly $900 billion in 2007 to nearly $9 trillion in 2022), with its holdings of Treasury securities representing the largest share (64 percent).11 By the summer of 2022, the Fed had purchased a little over half the amount the federal debt has increased since the pandemic.12
Until recently, those policies appear to have been risk free, at least in the short term. That changed over the past year as interest rates rose more quickly than the CBO projected and with recent data demonstrating that inflation is accelerating more rapidly and running at higher levels than the Fed, the CBO, and many economists originally projected. The tremendous surge in debt and its projected future trajectory pose risks that are likely to aggravate the level of debt and stymie future economic growth and Americans’ well-being.
Risk of Higher Interest Rates
The Office of Management and Budget, the CBO, and the Fed all continue to project interest rates that are low in historical terms.
Table 1 compares the average of the CBO’s projection of interest rates on Treasury securities for 2021–30 to the average for the previous five decades. Taking the 10-year Treasury note as an example, in May 2022, the CBO projected that interest rates would average 3.17 percent for 2021–30. Looking back at the average interest rates for the past six decades, the projected 10-year average interest rate falls well below the average for all those decades except the most recent one (2011–20). The difference is not small relative to these five previous decades. For example, relative to 1991–2000, a period of strong economic growth, stable monetary policy, and shrinking deficits and debt, interest rates on average were twice as high in 2011–20 than the CBO is projecting for the next decade. The CBO is not alone in projecting that interest rates will remain low, but economists’ projections tend to be closer to one another than what unfolds in the economy.13
Table 1. The CBO’s Projection of 10-Year Treasury Interest Rate for 2021–30 Compared to Previous Decade Averages
The CBO has developed a workbook that models how alternative economic assumptions would affect the budget outlook. According to this CBO model, a 1 percent sustained increase in interest rates above its projections would increase the deficit by $2.9 trillion through 2032.14 Such a scenario would still result in the 10-year Treasury rate averaging less than the average for four of the previous six decades.
Risk of Higher Inflation
The second risk to the US economy is inflation. Milton Friedman observed that inflation “is always and everywhere a monetary phenomenon.”15 Separate from the recent extraordinary fiscal and monetary stimulus, supply-chain bottlenecks, and the Russian invasion of Ukraine, Charles Goodhart and Manoj Pradhan conclude that a demographic reversal, particularly in China, will lead to higher inflation.16
The surge in inflation clearly caught the Fed by surprise, and it has begun raising rates and has initiated a reversal of quantitative easing. Even so, as inflation rises, the reduction in real interest rates increases the power of the Fed’s ongoing monetary stimulus.17
If the detrimental economic consequences are not incorporated, higher inflation in isolation improves the fiscal picture by increasing nominal GDP and because many tax provisions are not indexed for inflation, pushing taxpayers into higher brackets and increasing revenues. While higher inflation might reduce deficits in the short run, the corrosive effects of inflation erode the economy’s future potential, which is ultimately the source of revenue to the Treasury. In short, inflation in isolation may reduce deficits in the short run but at significant costs to the economy that raise deficits in the long run.18
The CBO generally assumes higher inflation results in higher interest rates, and the net effect is to increase deficits and debt even in the short run. Using the CBO’s workbook provides estimates of the budget impact if interest rates and inflation are higher than its May 2022 budget and economic projections. Assuming inflation and interest rates are 1 percent higher than what the CBO projected in May 2022 increases federal deficits by $2.6 trillion over the next 10 years.19
Risk of Additional Fiscal Policy Expansions
As alarming as the CBO’s projections are for the federal debt’s future path, Congress and the White House will likely worsen the situation. Fiscal policy is increasingly haphazard. Presidents since 2015 have failed to submit their proposed budgets by the statutory deadline, and the congressional budget process is increasingly used as a means to generate partisan reconciliation legislation instead of implementing and enforcing a fiscal framework. There is no bipartisan consensus on a set of budget rules. Further, existing budget rules are rarely enforced. As just one example, the Statutory Pay-as-You-Go Act of 2010 has never been enforced.20
Congress frequently sunsets provisions of legislation to meet budget rules or limit the apparent cost of the legislation, only to extend those provisions when the expiration date arrives without offsetting the cost. The CBO does not include the cost of future extensions of these provisions in its budget projections.
The recent Inflation Reduction Act is a good example. While a preliminary estimate showed a 10-year deficit reduction of $305 billion, the bill includes a three-year extension of a temporary emergency expansion of Affordable Care Act health insurance subsidies enacted during the pandemic. If those subsidies were permanently extended, the deficit reduction in that preliminary estimate of the bill would fall to $156 billion.
In addition to existing provisions of law that are scheduled to expire, President Joe Biden has recently signed two more bills into law with hefty price tags: Legislation to support the semiconductor industry (the CHIPS and Science Act) would increase the deficit by $79 billion over 10 years, and legislation to expand veterans benefits (the Honoring Our Promise to Address Comprehensive Toxics Act) would increase the deficit by $667 billion over 10 years.21 And, on August 24, 2022, the president announced a plan to forgive up to $20,000 in student loan debt per qualified borrower with an estimated cost of $400–$600 billion.22
Finally, in the past 21 years, the country has suffered the worst terrorist attack in its history, the worst economic recession since the Great Depression, and the worst pandemic since 1918, along with hurricanes and wildfires. Congress responded with deficit-increasing legislation to address these emergencies. Importantly, the CBO’s current debt projections do not include the likely cost of legislation to address future emergencies.23
Risk to the Economy
While the enormous increase in the debt has cost the federal government and the US economy little to date, if it continues to grow as a burden on the economy, it will eventually sap economic growth and could hinder the federal government’s ability to finance the already-legislated growth in federal spending and responses to future crises. As the debt grows, it will reduce domestic savings, require a greater reliance on foreign borrowing, and increase the risk of a future fiscal crisis, as the CBO warned in March 2021:
Debt that is high and rising as a percentage of GDP boosts federal and private borrowing costs, slows the growth of economic output, and increases interest payments abroad. A growing debt burden could increase the risk of a fiscal crisis and higher inflation as well as undermine confidence in the U.S. dollar, making it more costly to finance public and private activity in international markets.24
It is becoming increasingly clear that excessive debt-financed economic stimulus to counter the pandemic’s economic downturn significantly contributed to the recent rise in inflation.25 Inflation has produced large increases in prices, particularly for gasoline, other energy bills, and food, adding $450 a month to household bills.26 Inflation imposes a cost on all households but imposes a disproportionate burden on lower-income families.27 In 2020, the CBO estimated that if debt were reduced to its pre-pandemic level of 79 percent of GDP by 2050, it would boost GDP per person by $4,600 in today’s dollars.28
A Path Forward
The best way to address our grim long-term fiscal outlook is to maintain a strong and growing economy while slowing the growth in federal spending. Federal-spending growth is driven by mandatory spending, particularly for non-means-tested entitlement programs, such as Social Security, and health care mandatory spending.
Despite the recent surge in borrowing, the federal government’s financing costs remain low. Abrupt and large changes in fiscal policy are politically difficult to make and may harm the economy in the short run. Phasing in changes can demonstrate to financial markets that the US is on the case to get its fiscal house in order, and the savings from those changes, particularly in mandatory programs, compound powerfully over time. In addition, it gives individuals and organizations the time to adjust to those changes.
With a stronger economic recovery than anticipated, FY2021 federal revenues grew by $626 billion, or 18 percent, and reached a level of 18.1 percent of the GDP, well above what the CBO projected and the 50-year historical average of 17.3 percent of GDP.29 Even without tax increases, the CBO projects revenues will remain above their historical average. That is not the case with spending, which was above the historical average of 20.8 percent of GDP the year before the pandemic; that gap is projected to widen dramatically in the future.
Congress has shown reluctance to tackle the major drivers of spending—Medicare, Medicaid, and Social Security. Moreover, any implemented long-term mandatory reforms are more likely to be sustained if enacted with bipartisan support that likely will require revenue increases to be part of the equation. Before revenues are raised through legislation, however, budget enforcement tools or demonstrated success in spending restraint are needed. Otherwise, spending reforms could be reversed, higher revenues could be spent, and the drivers of deficit and debt could remain in place or be expanded. If revenues are pursued, the focus also should be on revenue raisers that are the least detrimental to economic growth.
If Washington pursues policies that slow the growth of federal spending, promote economic growth, and bring down the federal debt burden, it reduces the risk of one of two potential bad outcomes. In the less pessimistic case, inflation and interest rates rise, hampering economic growth and Americans’ well-being. The more troubling scenario is a fiscal crisis in which the federal government has trouble financing its debt at reasonable interest rates.
Reforms to entitlement programs are usually cast as harming the beneficiaries. However, if properly structured and implemented, putting these programs on sound financial footing can preserve the safety net and ensure future generations can continue to benefit from these programs. Most importantly, those same beneficiaries who are frequently cast as victims of reforms tend to be the ones hardest hit by the consequences of doing nothing—rising inflation, rising interest rates, and slower economic growth. And in the event of a fiscal crisis in which the federal government’s ability to borrow is limited by financial markets, addressing it will require drastic and immediate actions that probably would impose the greatest harm on those who rely on government assistance the most.