Federal Debt and Interest Costs

In Krugman's chapter on the budget deficit (Chp. 7) I noticed something that seemed odd: in Figure 17 (pg.96) Krugman notes that net interest on the federal debt makes up 14 percent of the federal budget. That seemed rather large to me -- I would have guessed around 5 or 6 percent -- so I looked into historical data for U.S. net interest as a percentage of federal outlays.

Turns out Krugman was right, but my intuition was not far off. Net interest as a percentage of federal outlays has fluctuated over time, reaching a peak in 1947 (just after the second world war) at 14.4 percent, but then dropping to 7.7 percent and staying there till 1977. From 1977-1999, it rose and remained at or above 14 percent. This is period in which Krugman writes.

From 2000-2003, however, interest payments on the debt as a percentage of federal outlays dramatically declined: by 2003, it reached less than 7 percent. It rose again slightly between 2003 and 2007, but still stayed well below 10 percent.

Net Interest as a Percentage of Total Federal Outlays (1941-2011)
Source: Office of Management and Budget (OMB)

2008 is when things get really interesting (enlarge graph above). The net interest as percentage of federal outlays drops from over 8 percent in 2008 to 5 percent in 2009. From 2009-2011, this number rose slightly but stayed below 8 percent.

This data seems puzzling at first glance. U.S. debt to GDP ratio is substantially higher today (70 percent) than it was even at the peak of the 1990s (50 percent). If debt-GDP is a decent measure of how financially "leveraged" the government is, we would expect interest payments on that debt to be higher with higher debt-GDP ratios. Instead, we find exactly the opposite: interest payments as a percentage of the federal budget today are half as much as they were during the 1990s.

The explanation for this counterintuitive result lies in interest rates. As we discussed in class, in recent years U.S. T-bills have looked increasingly appealing as the rest of the world does worse economically than the United States. The amount of debt interest a government must pay depends on two factors: the amount of outstanding debt and the interest rate on government bonds. While the amount of outstanding debt is much higher than it was during the late-1980s and 1990s, interest rates on government bonds are much lower (enlarge graph below). In the late 1980s, the U.S treasury bond interest rate was 13 percent; by 2011, it had steadily declined to 2 percent. That's an 11 percent drop from peak-to-present day.

U.S. Treasury Bond Interest Rates (Historical)
Source: Dept. of Treasury

The above comparison between 1980s/90s interest payments and present-day illustrates the importance of the interest rates the federal government is charged to finance its debt. Even if the economy's debt burden increases dramatically, as it has since the 1990s, federal interest payments on the debt can still decline if interest rates also decrease dramatically. This is significant because lower interest payments mean that the federal government can use the money "saved" to finance its other obligations -- e.g. entitlements, defense, education, etc.

This analysis also highlights the importance of keeping interest rates low: if net interest rises to levels at the time of Krugman's writing, the United States will face a more severe struggle to meet its spending and debt obligations.  Interest payments have contributed to deficits and helped fuel a rising debt burden in the past. Rising debt, in turn, raise interest costs and cause the federal government to increase debt held by the public to finance these costs. This has been is the so-called "vicious cycle" of ever-increasing interest payments and debt burdens. 

If Congress needed another incentive to reach a grand bargain to solve America's long-term debt problem, the prospect of rising net interest payments provides a strong one.