The COVID recession led to a massive fiscal stimulus as reflected by a deficit that ballooned from $984 billion in 2019 to $3.1 trillion in 2020. Strong bipartisan support was given to this tough medicine. Desperate times, after all, called for desperate measures. But just as the long-term effects of COVID led to a chronic condition defined as long-COVID, the economy is experiencing the negative after-effects of the government’s unprecedented fiscal response to the COVID crisis.
Those after-effects relate to the fact that all that stimulus of $3.1 trillion resulted in new debt that needed to be funded by selling bonds. To prevent those bond sales from increasing interest rates and offsetting the fiscal stimulus, the Federal Reserve came to the rescue by buying most of the new debt. That debt monetization led to a 25% increase in the money supply, eventually leading to a sharp spike in inflation. To fight that inflation, the Fed reversed course and began decreasing the money supply. That brought down the rate of inflation. But in its wake, interest rates rose sharply.
Those higher rates ordinarily would have led to a marked slowdown in the economy, perhaps even a recession. But it hasn’t. The massive deficits that were used to get us out of the COVID recession are now being used to offset the long-term negative effects of the initial $3.1 trillion fiscal stimulus.
It’s a vicious cycle: The $3.1 trillion deficit spending resulting from the initial round of fiscal stimulus led to higher rates of inflation and higher interest rates. These problems, in turn, led to more deficit spending. So, after the deficit decreased from $3.1 trillion in 2020 to $2.8 trillion in 2021, deficits are expected to shoot up again and reach $2.0 trillion in fiscal year 2024. The fact that these deficits continue to be high is increasing the debt’s share of GDP, a trend that will have negative economic and political consequences.
The Congressional Budget Office (CBO) appears to be waking up to the worsening debt problem. In February, the CBO announced that its year-earlier deficit projections were revised upwards due to new and higher projected fiscal deficits and interest costs on federal debt. As a result, the CBO raised its projections of net interest costs on debt in 2024 from its year-earlier estimate of $745 billion to $870 billion. That increase of $125 billion in interest costs reflects the fact that the CBO is now factoring into its projections higher average interest payments on its outstanding debt.
By 2027 – big surprise – it gets worse. The average interest rate paid on its debt was revised upwards by the CBO from 2.9% to 3.3%. As a result, net interest costs climbed $137 billion from its year-earlier estimates. Over the entire 4-year period from 2024 to 2027, the CBO raised its cumulative projected net interest costs from $ 3.3 trillion to $3.9 trillion. That represents a whopping upward adjustment of $600 billion in cumulative net interest costs the Treasury will have to pay on its outstanding debt, now projected to hit $34.8 trillion by 2027.
Bottom line, the CBO’s February revisions point to a projected increase in interest payments on the debt from $659 billion in 2023 to $1,049 billion only four years later in 2027. In 2023, the $659 billion in net interest costs represented 10.7% of total government spending. By 2027, the projected $1,049 billion in interest would hit 14.3% of the CBO’s projection of government spending in that year. That 3.6% increase from 10.7% to 14.3 % in the share of federal spending for interest costs will need to be squeezed out of other spending categories.
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A likely suspect for that is defense – not social – spending. In 2019, before COVID hit, defense spending as a share of total federal spending was 15.2%, almost double the 8.4% share accounted for by net interest payments.
Only three years later, in 2023, the defense spending share dropped by 2.1% to 13.1%, while the share for net interest payments climbed 2.3% to 10.7%.
Given CBO’s estimate that the share of net interest out of federal spending will increase by another 3.6%, it’s scary to think about what will happen if that again comes out of the hide of defense spending.
Perhaps President Biden was setting the stage for this when he proposed last month cutting the defense budget in real terms for four straight years.
Jim Doti is President Emeritus and Rick Muth Family Chair in Economics at Chapman University. Raymond Sfeir is the Director of the A. Gary Anderson Center for Economic Research and Anderson Chair of Economic Analysis at Chapman University.