Rates Were Never Going to Stay Low Forever

On Tuesday, the yield on a 30-year U.S. Treasury bond hit 5.19%. That is the highest it has been since June 2007, before the financial crisis, before the pandemic, before a decade and a half of near-zero rates that reshaped how economists, policymakers, and investors think about government debt.

This makes it a good time to revisit past beliefs and policies.

For the better part of fifteen years, the dominant fiscal narrative in Washington and in many economics departments ran roughly like this: the federal government can borrow cheaply, the economy will grow faster than the interest rate on its debt, and therefore the fiscal cost of additional borrowing is small or even zero. That’s the famous r-g. This argument was deployed to justify the post-2008 stimulus, the pandemic response, and the spending expansions in between. Its most prominent advocates included former Treasury secretaries and the most cited economists of the era.

This argument was wrong, and not only the way forecasts are sometimes wrong. It was wrong in its foundations.

Rates were Always Going to Go up:

When the ten-year Treasury yield fell below one percent, many economists and policymakers concluded that the long-run fiscal constraints their predecessors had worried about had been substantially relaxed. Better yet, rates would always stay this low, demand for government bonds was supposedly insatiable, and inflation was a thing of the past. As such, the logical conclusion was that it was okay to take advantage of cheap money, invest in public goods, don’t worry about the debt.

That was always shaky grounds, in my opinion. Jack Salmon and I wrote about it here among other places. First, it seems doubtful that rates would always stay so low. There were a bunch of reasons for that. First, Social Security and Medicare carrying unfunded obligations in the range of $70 trillion over the relevant horizon. Then, every emergency in recent history has added 20 to 30 percentage points to the debt-to-GDP ratio without the implementation of austerity measures once the crisis is over. In other words, the government was certain to be a very large and increasing borrower for a very long time. To believe that surging borrowing demand will not drive up yields, one must assume that the supply of savings willing to absorb it at low rates is essentially infinite.

It is not. In fact, in 2020, foreign investors had also started to reduce their demand for Treasuries. There was plenty of evidence to suggest that the rate environment of the 2010s was not permanent.

Deficits Were on a Path Going Up, not Staying Constant

Second, the standard claim that when growth exceeds the interest rate, government debt to GDP decline is technically correct in a narrow case. If the interest rate remains below the growth rate and the deficit remains constant, the economy will eventually outgrow the debt. Fair enough.

But the math only works for a constant deficit. The United States does not have a constant deficit. Again, Social Security and Medicare spending rise year after year as the population ages and politicians hand out goodies to seniors like the OBBB did with the senior tax credit. The primary deficit is not a fixed addition to the debt stock each year; it is a growing one. And when the deficit grows, the economy does not outgrow the debt, even if the interest rate stays comfortably below the growth rate. The debt ratio grows in step with the deficit, indefinitely.

This distinction between a fixed deficit and a growing one is not a technicality. It is the difference between a fiscal problem that the economy eventually absorbs and one that it doesn’t. The United States has been on the wrong side of that distinction for at least two decades. The argument that low interest rates made the debt sustainable was being applied to a deficit path it was never designed to cover.

Try to exploit r-g and you change the expectations of future fiscal backings

The entire framework treats the gap between the interest rate and the growth rate as a stable feature of the economy, something fiscal policy can exploit without that gap changing.

What holds Treasury yields at any given level is the expectation that future governments will run surpluses sufficient to service the debt. Markets price bonds against that expectation. When expectations are strong, yields are low. The problem comes when policymakers observing low yields infer that markets are comfortable with much more borrowing. The thing is that new and sustained higher borrowing is itself evidence that the political system is less committed to future surpluses than markets had assumed. The yields supporting the policy are held up by the expectation that it is being disconfirmed. When that expectation is revised, so is r-g.

In other words, the gap between the interest rate and the growth rate is not a parameter of the economy that policy navigates around. It is a joint product of the loan market and the government’s budget constraint. Under a credible fiscal regime, the equilibrium interest rate reflects that credibility. Under an eroding one, it adjusts upward. The act of attempting to exploit cheap borrowing changes the thing being exploited.

The Path to Fiscal Stabilization:

Now is also a good reminder that the federal government does not have a revenue problem. Federal receipts as a share of GDP are near their historical average. There are tax expenditures worth closing on efficiency and moral grounds, and closing them would help. But the deficit is not the result of under taxation. It is the result of a spending trajectory driven almost entirely by two programs: Social Security and Medicare. The entire deterioration in the federal fiscal outlook over the next several decades is attributable to those two programs. Discretionary spending cuts, however aggressive, will not close the gap. Revenue increases will not close the gap. A wealth tax will not close the gap. Structural reform of Social Security and Medicare is the only path to fiscal stabilization.