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Can We Afford This Spending?

May 19, 2021

Might the Federal Reserve be keeping interest rates artificially low?

Washington borrowed $4 trillion in 2021, and national debt as a percentage of GDP is higher than at the end of World War II.  And the Biden administration is proposing spending trillions on infrastructure and families bills.  Are our politicians bankrupting America?

Economists Jason Furman and Lawrence Summers argue no.  These prominent economists – Summers was Treasury Secretary under President Bill Clinton and Furman head of the Council of Economic Advisors under President Barack Obama – contend that the national debt, appropriately scaled, is not at an all-time high due to today’s historically low-interest rates.

Their paper covers a lot of ground.  I will start with interest rates and borrowing.  Lower interest rates allow home buyers to get larger mortgages.  Lenders compare the monthly payment and a borrower’s income.  With lower interest rates, more of the monthly payment can go toward principal.

The debt-to-GDP ratio does not consider the interest rate.  Furman and Summers argue that the interest-to-GDP ratio (preferably adjusted for inflation) is a better measure, akin to monthly mortgage payment relative to income.  The interest-to-GDP ratio is not historically high because of low-interest rates.

Can interest rates possibly remain so low?  To evaluate this, remember that real interest rates (meaning adjusted for inflation) are more relevant than the official rate.  And the risk of a loan not being repaid in full, or default risk, must be priced into the real interest rate. Loans with high default risk, like payday loans, face high real interest rates.

Economists refer to the risk-free real interest rate, what lenders would charge on a loan sure to be repaid.  The risk-free real interest rate has been zero, and real interest rates have been trending downward since the 1980s across all major industrial economies.  Furman and Summers argue that this must be due to fundamental economic factors.

Might the Federal Reserve be keeping interest rates artificially low?  As a matter of principle, almost all economists believe that money must be “neutral” in the long run.  Neutrality means relative to production, which depends on real factors, things like labor, machines, raw materials, and technology.  Dollars are ultimately green pieces of paper that cannot magically transform into cars or houses.  Any impacts of money on production must be short-term.

A thirty-year trend qualifies as the long run.  Furman and Summers observe further that long-term interest rates are not anticipating an increase.  Interest rates are market-determined prices based on the interplay of the demand for borrowing and the supply of savings.  Markets are forward-looking and smarter than any one expert.

Furman and Summers believe that at current interest rates, Federal debt of 400 percent of GDP (over $80 trillion) is sustainable.  

Economists who believe that markets work well, like me, must accept the market’s judgment on low risk-free interest rates.  But although Treasury securities have always been the quintessential risk-free investment, Uncle Sam may not always qualify for this interest rate.

Loans are voluntary transactions between willing borrowers and willing lenders.  Lenders who think that politicians are bankrupting America can choose not to purchase Treasury securities at the risk-free rate.

Furthermore, because our debt is always refinanced, investors must sell in Treasury securities to get out of the investment.  Investors must believe that Uncle Sam is a good risk and that future investors will as well.  The risk-free status of Federal debt depends on investor sentiment, not just economic fundamentals.

Because markets are forward-looking, long-term interest rates on Treasury securities should start rising as soon as investors think the national debt is excessive.  Markets show no sign of this, as Furman and Summers note.  Political talk can be cheap; pundits predicting an impending Federal bankruptcy may still be invested in Treasury securities.

Investors lend on favorable terms to the U.S. government because of its ability to tax us.  Despite recent record deficits, investors still think that we are good for Washington’s borrowing.  But investor sentiment can change far quicker than economic fundamentals.

[Originally posted on Alabama Today]

Daniel Sutter is Affiliated Senior Scholar at the Mercatus Center and Professor of Economics at the Manuel H. Johnson Center for Political Economy at Troy University.