Effect of Interest Rates on National Debt

 Effect of Interest Rates on National Debt

Written by: Aryaman Asthana  

Excluding the year of 1835 when the government’s interest-bearing debt was completely funded under President Andrew Jackson (Treasury Direct), the United States’ national debt has continually risen since the inception of the country. Currently, the United States sits at over $30.1 trillion in debt, rising at approximately $45.486 per second (U.S Debt Clock). We commonly associate a large national debt with prolonged recessions, higher inflation rates, and implications on the value of the dollar as the world’s reserve currency (National Affairs). But oftentimes we overlook the effect of national debt on investors, state governments, local banks, foreign nations, citizens, and other subjects. The United States federal government must do more to lower the national debt in order to prevent economic decline/future recessions and further promote investments and finance. Moreover, it is crucial for investors to be aware of the rising debt dilemma and thoroughly consider the long-term consequences on their investments. 

When the federal deficit of the United States accumulates over time, increasing the nation’s national debt, the federal government must issue more government bonds, or Treasury Securities, at high treasury interest rates in order to cover the budget deficit from the previous year. Due to the high interest rates, the newly issued government bonds appeal to investors because they provide high yields (earnings) over time and they increase the market supply of bonds while decreasing their price. The sale from these treasury securities allows the government to cover the debt/deficit and pay off creditors who hold older bonds. However, high interest rates are detrimental to the stock market and other potential investments. Combined with decreased consumer spending, high interest rates cause businesses to become more reluctant to acquire loans. Businesses also have to offer even higher interest rates for their own corporate bonds (due to the high demand for risk-free government bonds) in order to entice investors, leaving less money for the company to reinvest into other operations. Consequently, the prices of the stocks of businesses decrease and thereby stock returns diminish. Not only do businesses feel strains from higher interest rates, but so does the government. With higher interest payments, “more federal revenues must be directed toward debt repayment, leaving less money for other economically stimulating activities,” says David Primo, a professor of political science and business administration at the University of Rochester. A decrease in gross private domestic investments of businesses, consumer spending, and government expenditure can cause the Real GDP of the nation to decline, given Real GDP = C + I + G + (Xnet). Additionally, as Real GDP declines (economic growth slows down), the debt-to-GDP ratio increases. Currently, the debt-to-GDP ratio of the United States is around 125%, which is far higher than the stable debt-to-GDP ratio of 77%. If the national debt is higher than the gross domestic economic output of a country, then lenders will become more financially insecure and increase interest rates as collateral, further exacerbating the national debt problems. Financial insecurity can also incentivize foreign holders of the United States treasury bonds to sell them off; however, the buying/selling of securities has no impact on Real GDP because it is a non production transaction. Here is a chart showing the debt-to-GDP ratio of the United States over the past 11 years along with major events of that year that contributed to the national debt:

Source: The Balance

Here is a chart illustrating the positive correlation between national debt, interest rates, and percent of federal budget that interest on debt takes up:

Source: The Balance

So what can we do to lower national debt and treasury interest rates? With inflation rates spiking and interest rates rising to keep up with inflation, how can the federal government deal with the national debt? The most practical way to do so is lower the interest rate to as low as it can be held by the Federal Reserve. Otherwise, increasing tax revenues is a viable, short-term solution. Increased tax revenue will lower the accumulated deficits and thus positively contribute to the growing national debt. However, tax revenues slow economic growth because less money is reinvested into the economy and more money is invested towards the national debt and its creditors. Others suggest that Congress should shift its spending to economically stimulating activities that create the most jobs and keep Real GDP increasing. As for investors, those looking for a less risky investment than the government bonds but still one that is lucrative in time of debt, can explore municipal bonds. According to Rhea Thomas, senior economist at Wilmington Trust in Wilmington, municipal debt levels, “have remained steadier because state and local governments, unlike the federal government, have borrowing limits and that helps to control debt.” This allows investors to make less risky investments but still be involved in the market. Overall, the growing national debt is harmful for the economy in many ways, but it can particularly impact investors due to high interest rates and its implications. 

Works Cited

Amadeo, Kimberly. “Interest on the National Debt and How It Affects You.” The Balance, 

https://www.thebalance.com/interest-on-the-national-debt-4119024.

Chen, James. “Government Bond Definition.” Investopedia, Investopedia, 7 Dec. 2021, 

https://www.investopedia.com/terms/g/government-bond.asp.

Barnes, Ryan. “The Importance of Inflation and GDP.” Investopedia, Investopedia, 21 Sept. 

2021, https://www.investopedia.com/articles/06/gdpinflation.asp#:~:text=Over%20time%2C%20the%20growth%20in,than%20detrimental%20to%20the%20economy. 

Peter Wehner & Ian Tufts, et al. “Does the Debt Matter?” National Affairs, 

https://www.nationalaffairs.com/publications/detail/does-the-debt-matter#:~:text=These%20experts%20warned%20that%20large,holdings%20of%20U.S.%20Treasuries%2C%20a.

“Reports.” Government - Historical Debt Outstanding – Annual, 

https://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt.htm#:~:text=The%20U.S.%20has%20had%20debt,1835%2C%20under%20President%20Andrew%20Jackson.

Team, offseo.com. “Irfi.org -> Website Value Calculator & Seo Checker.” Offseo.com, 

https://offseo.com/irfi.org/.

U.S. National Debt Clock : Real Time, https://www.usdebtclock.org/.