Let’s assume for a minute that the economy continues to recover and that the interest rate environment follows normal historical patterns. In ten years, the cost of servicing our national debt would triple – from about $200 billion now to $600 billion in 2022.
But what if the markets get nervous and interest rates rise more than expected?
If interest rates on all types of Treasury securities were
1 percentage point higher each year through 2022, compared
with the interest rates underlying the baseline, and
all other economic variables were unchanged, the government’s
interest costs would be substantially higher. The
difference would amount to $13 billion in 2012.
Most marketable government debt is in the
form of Treasury notes, bonds, and inflation-protected
securities, which have maturities greater than one year.
As Treasury securities mature, they are replaced with new
ones. Therefore, the budgetary effects of higher interest
rates would mount each year, climbing to an additional
$117 billion in 2022 under this scenario.
Go back to the CBO’s January 2007 budget projections. According to that report, if interest rates grow by one percentage point across the yield curve, the increase in the budget deficit would top out at around 0.2% of GDP every year.
But if you look at the same calculations today, the budget’s sensitivity to an increase in interest rates is much higher: the effect on the deficit would top out at around 0.6% of the GDP and would continue to rise into the future.
That’s a clear indication that the amount of debt that we have accumulated has the potential to worsen our budget situation substantially. And a one percentage point increase in interest rates is not, by any stretch of the imagination, extreme.
The bottom line is this: We have become much more vulnerable to the downside risk of higher interest rates because we have a larger base of debt now on which we have to pay interest. That vulnerability will continue to increase – until we fix the problem, or the problem fixes us.