Will the United States Default?
Bryan Taylor, Chief Economist, Global Financial Data
The cost of interest payments on government debt in the United States has just reached its highest level in the past 225 years. Interest rates shot up to 5% during the past month. There has been an unprecedented increase in bond yields over the past three years. The yield on the 10-year government bond has risen from around 0.50% in March 2020 to 5.00% in October 2023. This has driven bond prices down imposing losses on fixed-income investors. During 2022, many analysts believed that the Fed would raise interest rates to slow inflation, then gradually reduce interest rates in 2023 as the economy fell into a recession. This did not happened. Instead, the economy grew steadily, growing at the rate of 4.9% per annum in the third quarter of 2023. Whether analysts are still predicting a recession or a soft landing, they all agree that interest rates are likely to remain high for some years to come, perhaps for the rest of the decade. The era of low interest rates is over.
The Impact on the Government Expenditures
What impact will higher interest rates have on government expenditures? In 2020 when Covid struck, the government spent money like it was free, in part, because it was. The yield on treasury bills was close to 0% and the yield on the 10-year bond was under 1%. With inflation at 2%, real interest rates were negative, so if the government’s outstanding debt exceeded GDP, there was little concern. The government could afford it.
Then inflation rose to 9% during 2022 and the Fed followed up, raising the Fed Funds Rate from 0-0.25% to 5.25-5.50%. The yield on Treasury Bills rose from being close to zero to being over 5% and the yield on the 10-year Treasury Bond rose from 0.50% to 5.00%. Bond yields had been declining during the previous 40 years. Yields peaked at 15.84% in September 1981 and declined for the next 40 years. That decline, unfortunately, is ancient history.
If outstanding government debt were low, there would be little concern, but currently federal government debt is greater than GDP. During the fiscal year ending on September 30, 2023, interest costs on federal government debt totaled $879 billion, an increase over the $717 billion in FY 2022. This represented about 14% of total federal government outlays. Interest costs in FY 2024 will probably exceed $1 trillion. About 80% of federal debt is held by the public. The rest is held by federal government agencies such as the Federal Reserve. Can the government afford it?
The best way to measure the cost of government interest is to calculate it as a percentage of GDP. With interest costs at $1 trillion and US GDP around $26 trillion, the federal government is allocating almost 4% of GDP to paying interest on the debt. Figure 1 approximates the cost of interest on government debt since the 1790s. The graph multiplies the yield on the 10-year government bond times the amount of outstanding federal government debt and divides that by GDP.
As the graph shows, interest costs were about 2% of GDP when Alexander Hamilton reorganized America’s finances in 1792. The share gradually declined until the Civil War in the 1860s. Interest costs rose once again to 2%, then declined again until World War I. The United States was only in the World War I for about a year, but this pushed the ratio close to 2% once again. The government ran deficits during the Great Depression and during World War II. During World War II, government expenditures were equal to about 40% of GDP. Although federal government debt exceeded GDP, by 1945 low bond yields kept the interest costs to the government low.
Between 1945 and 1980, federal government debt shrank relative to GDP, but higher bond yields pushed up the cost to the government, increasing interest costs on government debt to the 4% range by the 1980s and 1990s. Federal government expenditures have been around 20% of GDP since the 1980s. Declining bond yields in the twenty-first century pushed the interest cost back to the 2% range by the time that bond yields bottomed in 2020. Since then, however, the interest on government debt as a percentage of GDP has shot up, and currently it is at the highest level it has been in history. Higher bond yields will mean higher government expenditures.
How much more can the interest cost to government rise before there is a concern over the government’s ability to pay interest on the debt?
Figure 1. United States Interest on Government Debt as a Percent of GDP, 1792 to 2023
British Government Debt
To understand how much interest costs a country can bear, we want to look at Great Britain. The United Kingdom provides us with more history than the United States, with data going back to 1700, and higher levels of government debt than ever occurred in the United States. After both the Napoleonic Wars and World War II, British government debt was more than twice GDP! The United Kingdom had a high credit rating because it was one of the few countries that did not default during the Napoleonic Wars, and it had been on the gold standard since the 1700s. The yield on British government bonds were among the lowest in the world despite its government debt being so high. Investors throughout the world were happy to own British consols because they knew that the bonds were risk free. Britain would not default on its bonds. In fact, the British were able to lower the yield on its consols from 3% to 2.5% in the decades before World War I.
Figure 2 shows the cost of interest on central government debt in the United Kingdom from 1700 to 2022. You can see the impact of wars in the 1700s on the cost of interest in Great Britain. The amount of outstanding debt and the interest cost rose during the War of the Spanish Succession (1701-1714), the Seven Years’ War (1756-1763), the American Revolutionary War (1775-1783) and the French Revolutionary and Napoleonic Wars (1792-1815). British government debt exceeded GDP after both the Seven Years’ War and the American Revolutionary War, but between 1818 and 1824, British central government debt was over 200% of GDP. Bond yields were over 4% in 1819 and 1820, pushing the cost of government interest over 9% of GDP. Government expenditures were over 20% of GDP during the Napoleonic Wars. By 1820, government expenditures were down to 5% of GDP, so 9% in interest was tolerable.
Figure 2. United Kingdom Interest on Government Debt as a Percent of GDP, 1700 to 2022
For the rest of the nineteenth century, Britain was only involved in small wars and the government debt to GDP ratio continually shrank. By 1914, the debt/GDP ratio had shrunk to 27% and the cost of interest relative to GDP was only 1%. However, in 1914, World War I began and the debt/GDP ratio rose to 180% by 1923. By 1946, it was 238%. The interest to GDP ratio rose to 8% by 1923, dropped below 4% by 1940, then rose back to the 7% level by 1949. Thence there was a steady decline as the government debt/GDP ratio shrank, declining to 21% by 1991. Double-digit interest rates kept interest expenditures high between 1973 and 1991, but yields declined below 1% by 2019. This lowered the cost of interest to the government to less than 1% of GDP since the debt/GDP ratio had risen to around 100% by 2020. Government bond yields are now over 4% in Britain and this has raised the interest/GDP ratio to around 4% in 2023. Either central government debt will have to double or bond yields will have to double for the interest cost/GDP ratio to reach the 8% levels that Britain reached after the Napoleonic Wars and after World War I. That seems unlikely.
Will the United States Default as a Result of Higher Debt and Bond Yields?
Assuming the United States is able to raise its debt ceiling, no.
As we have seen, the United Kingdom was able to tolerate government debt twice its GDP and the interest cost/GDP ratios over 8% without risking default. Currently, Japanese government debt is over twice its GDP, although the majority of the debt is owned by the government and the central bank and the Bank of Japan controls bond yields to keep the interest cost down. Either bond yields will need to rise dramatically and government debt double as a share of GDP before the US government would face the prospect of default. This seems unlikely to occur in the near future. So treat US government bonds as risk-free.