In just three years, annual interest payments on federal debt have roughly doubled to more than $1 trillion, and this amount is growing because of rising rates and expanding federal debt. Not surprisingly, the question of whether this is pushing the U.S. towards a fiscal cliff receives media attention.
It is true that interest payments on federal debt consume a significantly higher proportion of federal outlays, but the idea that this is a catastrophe is unwarranted. The interest burden is not outside the historical norm.
As a percentage of total Federal outlays, net interest (the amount of interest the U.S. government pays minus interest it receives) has more than doubled from just over 5% to more than 13% since 2021. But these outlays are dwarfed by other outlays on entitlements, defense, infrastructure and other categories which represent 87% of total outlays. This is also the case for net interest payments as a percentage of GDP, which although it doubled in the same period to just over 3%, it is still a fraction of non-interest Federal outlays which account for 21% of GDP.
Both measures of interest payments by the Federal government are roughly at the same level where they were during the 1980s and 1990s, a period when the stock market enjoyed a huge rally that lasted almost 18 years, from 1982 through 2000, and during which the S&P 500 rose tenfold.
It is important to note, however, that while interest payments as a percentage of GDP have remained little changed for more than 40 years, federal debt as percentage of GDP quadrupled from 30% back in 1980 to 120% today, but that massive debt increase did not cause an explosion on interest payments because interest rates are much lower today than in 1980.
In any case, the level of public debt seems to have a negligible effect on the stock market, which runs contrary to the much-repeated argument that ballooning government debt elbows out private borrowers, drags down economic activity as a result, and hurts company earnings and therefore stock prices. So far, the evidence points to the opposite: falling levels of debt seem to be associated with poor stock performance, while growing levels of debt are associated with rising equity prices.
For example, federal debt as percentage of GDP fell by a quarter between 1965 through 1975, a period that was one of the worst for stocks since the inception of the S&P 500 index in 1956. On the other hand, federal debt doubled from 30% of GDP in 1982 to 60% in 1998 and the S&P 500 rose tenfold, as noted earlier.
Does this mean that the U.S. can or should keep borrowing and spending without fearing any consequence? The answer, of course, is “no.” Interest payments today are entirely manageable because they are well within the historical range and therefore far from the alarming levels some analysts believe are being reached. On the other hand, the idea that “at some point we will have to pay the debt” is also wrong. Public indebtedness is a tool that provides a great deal of flexibility to manage a complex economy effectively, and no country elects to be debt-free (except for Macao, with a population about the size of El Paso, TX).
Yet, not all public borrowing is the same. Some public projects are expected to provide future returns well in excess of the borrowing needed to finance them and can be very effective at raising future productivity. Investment in ports, highways or semiconductor factories fall in that category.
Higher productivity is of crucial importance for GDP growth. According to a report by the McKinsey Global Institute, returning US productivity to its long-term trend of 2.2 percent annual growth would add $10 trillion in cumulative GDP over the next ten years. This is equivalent to every US household seeing a cumulative income gain of $15,000 over that period. Other things being equal, it would also boost median incomes and encourage labor participation. Annual productivity growth just reached 3.2% for the fourth quarter of 2023, well in excess of the 2.2% long-term average, but this is only after stagnating for several quarters in the post-pandemic economy. More progress is needed.
Other government expenditures offer no return of any kind and in that regard they can be considered wasteful spending that adds to interest payments for no good reason. The Heritage Foundation, for example, compiled numerous examples of pure waste, such as $25 billion of unreconciled transactions that have no record as to where they were spent. Even worse, that report is from 2005 – and waste has grown much larger since then. The Small Business Administration estimates that over $200 billion of the $1.7 trillion it disbursed on emergency programs in the wake of the Covid-19 pandemic were made to fraudulent actors.
This brings about an important point. The Heritage Foundation report also labeled Medicare as one “of the most wasteful” expenditures, illustrating that what is and is not wasteful government spending is in the eye of the beholder and, more pointedly, belongs to the category of expenditures that may be socially desirable but do not provide any obviously measurable returns. As such, the growing discussion about the increasing size of Federal interest outlays responds not to a serious problem to U.S. government finances (at least not for the foreseeable future) but to the extent that they help make an argument about Federal spending priorities.
