Debt Accumulation Risks Economic Growth, Experts Warn
Federal debt continues to rise, but experts caution that unchecked borrowing could lead to higher interest rates, slower growth, and reduced private investment.
4 min read
As federal debt held by the public reaches the size of the annual economy and continues to grow, the question of when markets will react to this debt has become a subject of debate. Some argue that the federal government’s history of running large deficits proves it can keep borrowing without consequence. Yet, experts warn that this assumption is flawed and that the risks of unchecked debt accumulation are significant.
The Illusion of Market Indifference
Despite the growing size of the federal debt, investors continue to buy Treasury securities, and no government bond sale has failed. This has led some to believe that the U.S. can sustain a debt-to-GDP ratio of 100% today and potentially reach 175% by 2056, assuming no reform to Social Security and Medicare and only modest interest rate increases.
However, the idea that this debt won’t lead to a reckoning is questionable. Markets have already reacted to the $5 trillion flood of deficit spending, which contributed to the 2021-2022 inflation spike, the worst in four decades. This inflation was the result of the price level adjusting to the massive deficit spending. If Congress continues its current trajectory, borrowing nearly 16 times what it did during the pandemic, plus interest payments, without a repayment plan, another market response is likely.
Interest Rates and the Term Premium
Interest rates are currently well above the levels seen from 2009 to 2021, when fiscal doves believed rates would remain low. Some of the recent increases are due to AI investment raising the demand for capital, but a higher term premium is also at play. With inflation still an issue and no fiscal austerity on the horizon, investors are seeking more compensation for holding long-term treasuries.
Scenarios for Avoiding a Market Crisis
Even if Washington continues its current path without provoking a bond-market response, there are potential scenarios that could prevent a crisis. One is that investors expect Congress to eventually reform entitlements by raising taxes, reducing benefits, or both, thereby reducing the need for further borrowing. Another is that investors still value treasuries as the safest and easiest assets to trade, especially given the global reliance on the U.S. dollar and the financial instability in Europe and the UK.
A third possibility is that AI-driven economic growth could supercharge productivity, leading to higher incomes and a larger tax base, making debt more manageable. However, even if AI leads to significant growth, the higher interest rates associated with AI investment could make refinancing existing debt more expensive as it matures.
The Hidden Costs of Debt
Even in the best-case scenario, the accumulation of debt is not without cost. A bond-market crisis is not the only risk; government borrowing competes with private borrowers for the economy’s available savings, which can lead to higher interest rates and reduced private investment in sectors like manufacturing, software, housing, and even AI itself. Financing government spending through high and distortionary taxes also carries its own economic costs.
Moreover, higher government debt is associated with slower growth, even in a world where AI could make us richer. This means that while AI may help offset some of the negative effects of debt, it is not a free lunch. The combination of AI investment and the need to refinance existing debt at higher rates could lead to a situation where the cost of borrowing continues to rise, even as the economy grows.
The Fiscal Arithmetic of Debt
The fiscal arithmetic of debt is complex. While faster growth can improve the fiscal outlook, whether it is enough depends on the rate of economic growth, how high borrowing costs rise, and whether Washington continues running larger primary deficits. The Congressional Budget Office projects that interest payments will become the largest federal expenditure by 2040, consuming roughly 40% of the government’s revenue by 2056.
Annual net interest payments now cost more than national defense, and older, cheaper debt is being refinanced at today’s higher rates. These are dollars that could otherwise be used to shore up entitlements or help during the next emergency, when the ability to borrow matters most.
The Path Forward
Without action and a more obvious cue to complacent legislators, the damage from unchecked debt accumulation will continue, sometimes quietly, and the danger will grow. Experts warn that the current trajectory is unsustainable and that the risks of higher interest rates, slower growth, and reduced private investment are real and significant.
Source: PJ Media
