Forum Post: interest and the debt by dean baker

While our debt-to-GDP ratio is approaching levels not seen since the years immediately following World War II, there is another key ratio that has been going in the opposite direction. This is the ratio of interest payments to GDP. This fell to 1.3 percent of GDP in 2009, its lowest level since World War II. While it has risen slightly in the last couple of years, the ratio of interest payments to GDP is still near a postwar low.

Furthermore, even this low number overstates the actual burden that interest poses for the government. Much of the government's debt is held by the Federal Reserve Board. The interest the government pays on this debt is refunded right back to the Treasury. In the last two years, the Fed has refunded roughly $80 billion a year to the Treasury (more than 0.5 percent of GDP), bringing the actual interest burden down to around 1 percent of GDP. In terms of the actual commitment of economic resources, it is the ratio of interest payments to GDP that will matter, not the debt.

If this seems like a sleight of hand after all the hoopla that we have seen around the debt in recent years, then some more careful thinking can clear matters up. Suppose that we issue $4 trillion in 30-year bonds at or near the current interest rate of 2.75 percent. Let's imagine that, in three years, the economy has largely recovered and that long-term interest rates are back at a more normal level; let's say 6 percent for a 30-year bond.

In this case, the bond price would fall by over 40 percent, meaning, in principle, that it would be possible for the government to buy up the $4 trillion in debt that it issued in 2012 for just $2.4 trillion, instantly lowering our debt burden by $1.6 trillion, almost 10 percentage points of GDP. If we had been flirting with the magic 90 percent debt-to-GDP ratio before the bond purchase, we will have given ourselves a huge amount of leeway by buying up these bonds.

Of course, this would be silly. The interest burden of the debt would not have changed; the only thing that would have changed is the dollar value of the outstanding debt. Fans of the 90 percent debt-to-GDP twilight zone theory may think that the debt burden by itself could slow the economy, but in the real world, this doesn't make any sense.

Is it possible that many of the world's leading economists are completely missing the boat in their understanding of the way in which the debt poses a burden on the economy? While that may seem far-fetched, almost all of the world's leading economists completely missed the housing bubbles, in the United States and elsewhere, and the dangers the housing bubbles posed to the economy. In fact, the reason that the United States and other countries are facing large deficits today is almost entirely the result of the failure of the economists who were guiding policy in the years preceding the crash.

And that was not the only time in recent years that this crew has been out to lunch. Back in the late 1990s, almost all of them thought the stock market could continue to produce 7 percent real returns even as the price-to-earnings ratio soared past 30, more than twice its historic average. One of the main reasons that so many private and public pension funds face shortfalls today is that leading economists gave the green light to absurd assumptions on the returns on pension assets.

In fact, they were anxious to put Social Security money in the stock market. The Republican economists wanted to get the money into the market through private accounts, and the Democratic economists wanted to do it by investing the Social Security trust fund directly. Either way, both got their arithmetic wrong.

Given the recent history, we don't have to ask whether the world's top economists can really be completely out to lunch in their understanding of something as basic as the burden of the debt. The real question is: when did they stop getting it wrong?