Can The Government Afford Economic Growth?

Despite the Federal Reserve’s latest interest rate increase last week, interest rates remain low by historical standards. While rising interest rates are an indication that the economic outlook is improving, the slow climb back to normal rates is a significant risk to the government’s budget.

50 years ago, about 10 percent of the federal, state, and local governments budgets were devoted toward paying the interest costs on public debt. Since that time, the magnitude of government debt has exploded. Even after adjusting for inflation, total federal debt outstanding is now 10 times greater compared to 50 years ago, but, despite this debt explosion, federal, state, and local governments still allocate about the same share of their budget toward interest payments as they did then.

The enabling factor in this seemingly incongruent outcome is today’s historically low interest rates. Near zero borrowing costs allowed the politicians in Washington D.C. to embark on an unprecedented government spending spree, sold on the promise of accelerated economic growth, and financed by a massive borrowing binge. This massive increase in the national debt has now put the federal government in a precarious fiscal position.

Faster economic growth is imperative. Without it, growth in living standards and median household income, which have stagnated since 2000, will continue to disappoint. Stronger economic growth also has an upside for the federal government – it generates more tax revenues from the same tax rates.

However, stronger economic growth puts upward pressure on interest rates, which, if they returned to their historical averages, would, by our calculations, cause debt service to subsume an additional 15 percent of the budget in the long-run.

Addressing this problem requires a combination of pro-growth policies, to accelerate economic growth, and sustainable fiscal management policies, to control the otherwise unmanageable debt costs. Importantly, in order to meaningfully accelerate economic growth in the U.S., the policy reforms must be comprehensive across all of the major policy areas.

These include implementing regulatory reforms that lower the unnecessary government burdens on the economy, expanding international trade opportunities that have benefited both U.S. businesses and consumers, and implementing tax reforms that simplify the overly-complex and overly-punitive corporate and personal income tax systems.

With respect to the federal government’s precarious fiscal position, three reforms are particularly noteworthy.

First, the growth in spending must be constrained with a hard budget limit, preferably limiting expenditure growth to less than the expected growth in the economy. Over time, such a rule would shrink the relative size of government making it more affordable for taxpayers, and more pro-growth for the economy. Such a tight budget limit would also force Congress to start prioritizing spending, just as households must do.

Second, the problem of rising debt costs must be effectively managed, partially, by locking in today’s lower interest rates through the issuance of longer-term bonds. While borrowing at the long end of the curve may increase debt financing costs for the government today relative to current short-term rates, they are still lower than the historical average. And, the government will, in return, gain greater control and certainty over its future interest costs. In combination with spending control, managing the debt costs will help ensure against excessive tax increases that will take a large toll on economic vibrancy.

Finally, the role of monetary policy enabling fiscal profligacy must be reversed. The Federal Reserve cannot continue to cede its fundamental mission (of monetary neutrality) to one driven by the federal government’s fiscal irresponsibility. The government’s deficit-financed spending problem will not be solved if the Federal Reserve continues to enable unaffordable spending via artificially low interest rates. Such a policy misallocates credit and imposes large costs on the economy, without solving the underlying problems. The Federal Reserve’s primary mission must be to ensure a stable price system and the Fed must start correcting the problems created by its past errors.

Past mistakes are painful to unwind, and stabilizing the government’s finances is no different. However, combining a comprehensive package of pro-growth economic reforms, coupled with policies that more effectively manage the costs of debt, can minimize the threat to the government’s budget from rising interest rates while establishing an environment conducive to broad-based and robust economic growth.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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