Panic Alert: The Financial Apocalypse Awaits Washington

Editors Note: Brian Riedl, a senior fellow at the Manhattan Institute, warns that a government shutdown poses a threat to Washington's AAA credit rating. The past fiscal irresponsibility has led to downgrades by both Fitch and Standard and Poors. This downgrade indicates to investors that the bond issuer is at a higher risk of default, resulting in an increased interest rate demanded by investors. This is concerning as interest rates are already on the rise, putting federal finances at risk.

Brian Riedl

In the past week, the 10-year Treasury bond's interest rate reached 4.5% for the first time since 2007. This increase in interest rates not only impacts the expenses of home loans, car loans, and business loans, but also poses a threat to Washington's debt situation. It significantly raises the annual interest cost of managing the growing federal debt, potentially pushing the nation towards a debt crisis. Lawmakers have been placing bets on the federal budget and the US economy, assuming that interest rates will remain stagnant, but this may no longer be the case.

Between 1990 and 2021, the federal government's average interest rate on its debt decreased from 8.4% to 1.7%. This decline can be attributed to a dovish Federal Reserve, a sluggish economy, and increasing global savings. As a result, Washington politicians were able to increase the public debt from $5 trillion to $25 trillion, while keeping annual interest costs relatively stable at around $350 billion (adjusted for inflation). This was made possible by the continuous decrease in interest rates, allowing Congress to accumulate more debt without a significant increase in interest costs. Furthermore, as the economy and tax revenues grew, these stable interest costs became even more affordable. Consequently, progressive politicians and leaders started treating falling interest rates as an unchangeable law of science, using it to justify proposing massive amounts of new spending as if it were a consequence-free endeavor.

However, the argument in favor of a debt-financed spending spree based on low interest rates was flawed for two main reasons. Firstly, Washington never took advantage of these low interest rates by securing them for the long term. The average maturity of the federal debt, which determines the length of time it takes for the government to repay bondholders and replace them with new bonds at the prevailing interest rate, is currently at just 76 months. Additionally, the majority of the debt needs to be replaced with new bonds within the next decade. This means that if interest rates were to rise in the future, it would have a significant impact on almost the entire national debt.

The second reason is that, even without any additional spending expansions, Washington is already on track to borrow $119 trillion over the next three decades, pushing the debt to nearly 200% of the economy. Even with the low interest rates projected by the Congressional Budget Office (CBO), a debt of this magnitude would result in interest payments becoming the largest federal expenditure, accounting for over one-third of all federal taxes. Any further borrowing would only exacerbate the problem.

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Speaker of the House Kevin McCarthy speaks to reporters in Statuary Hall at the U.S. Capitol September 26, 2023 in Washington, DC.

Drew Angerer/Getty Images

It is unacceptable that Congress would receive payment during a shutdown while the majority of federal workers would not.

Two years ago, I penned a comprehensive report raising concerns about the potential increase in interest rates and the significant impact it would have on the federal budget. In my analysis, I emphasized the crucial role of interest rates remaining below 4% indefinitely for long-term fiscal stability in Washington. Even the Congressional Budget Office's projection of a gradual rise in interest rates to 4% over three decades would result in budget deficits of 10% of GDP, assuming a state of peace, prosperity, and no additional tax cuts or spending expansions.

In the event that interest rates exceed those projections, it could have significant financial implications. According to a model I developed using CBO data, an additional percentage point increase would result in a cost of $2.8 trillion over the course of a decade, and a staggering $30 trillion over three decades. This cost is comparable to adding another Defense Department. Furthermore, my model predicts that within three decades, interest costs alone would consume more than half of all federal taxes. It is important to note that these figures are based on a scenario where interest rates are only one percentage point higher than the projected baseline.

At the time, my warnings were largely disregarded by the economic policy community, who believed that interest rates would not reach 4% in the foreseeable future. However, only two years later, the 10-year bond has already surpassed 4.5%, leading to an almost doubling of annual interest costs to approximately $700 billion.

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The 1970s and 1980s serve as a cautionary example. Despite the Federal Reserve's success in combating inflation during the 1970s, interest rates remained high in the following decade due to cautious actions by the Fed and market expectations of inflation. The anticipation of a 2-to-3% inflation rate today is unlikely to result in the return of pre-2021 interest rates or 3% mortgage rates.

In the end, Washington's interest rates may settle at around 4% to 5%, leading to a gradual increase in the national debt, potentially exceeding 200% of GDP. However, Congress has not presented any contingency plans in case higher interest rates worsen the already high national debt. The era of excessive debt is coming to an end, and the consequences will be painful.