I’m not ashamed to admit it: I am a card-carrying debt hawk. I also worried about inflation long before it returned, enduring years of mockery and an exasperated editor who condescendingly explained that inflation and interest rates would never again rise. Alas, I have had my day. Inflation came roaring back, and interest rates rose, just as the debt soared. We are now in danger of suffering through a much harsher economy going forward, in which inflation is once again unpredictable (and high) and interest rates are elevated enough that servicing the debt becomes a major fiscal burden.
This week, a few prominent economists tried to reassure the public that such worries are silly. They claim that debt is not too high, that inflation is already falling back to normal levels, and that interest rates will soon join them there. It’s possible that within the next year or two, high inflation will recede into distant memory. Perhaps it will prove transitory after all—if by transitory we mean that it was elevated for three years, made everyone poorer, and forced the Fed to hike rates more than 400 basis points.
I tend to think in terms of risk. In that light, this scenario is only the best of many possible outcomes. As with any risk assessment, it is foolhardy to count on its happening. Maybe we’ve been lulled by the nature of most news cycles, in which every big event seems to end—and end decisively—within a short amount of time. Economic problems rarely work that way.
It is true that inflation is falling, largely because supply-chain issues are getting resolved, energy prices are coming down, and Europe has lucked out so far with a warm winter. But history suggests that inflation does not just go away. It might go down, and then up again, and then down—and this can last for years. One or two months of data is not much of a trend. Optimists point to market expectations that inflation will be back to 2 percent within a few years as evidence that expectations are well-anchored. But bond markets have never had a great track record predicting anything. They certainly can’t foretell another energy shock from the ongoing war in Ukraine, increased demand from a Chinese reopening, or many countries reducing their trade because of deglobalization.
Paul Krugman argues that debt is nothing to worry about, either. He thinks that the Congressional Budget Office has been too pessimistic in its past projections because it assumed that interest rates would go up, and they didn’t. But if anything, the CBO has been too optimistic, largely because it bases its debt projections on current law; it did not account for a global financial crisis or the pandemic. And with entitlements mounting and dominating the debt in the coming years, it’s hard to argue that the debt problem is getting any better.
It’s possible that the U.S. can keep borrowing and rolling over its debt. As long as it has the exorbitant privilege of issuing the only safe asset, the global reserve currency, people will keep buying bonds and want dollars. But as my Manhattan Institute colleague Brian Riedl points out, if rates increase to 4 percent or 5 percent (not much higher than now), over the next few decades, servicing the debt will come to dominate the budget, leaving little room to pay for other services or finance against future negative shocks.
Olivier Blanchard believes that interest rates will soon drop back to pre-pandemic levels. He expects that inflation will fall and that our enormous debt won’t have much impact on bond prices, boosting rates by only 15 to 30 basis points. This analysis also makes many optimistic assumptions. First, past data on the relationship between interest rates and the stock of debt don’t tell us much about today, because the scale of debt is now so much larger. Historical data also don’t account for future spending, whether from the next crisis or from unfunded entitlements. Blanchard also expects continued high demand for U.S. bonds from an aging population and from investors looking for a safe haven. It is true that the population is aging, but much of its consumption will be financed by countries issuing more debt to pay for unfunded entitlements, not by individuals saving more. And foreign demand for U.S. debt is already waning; we can expect it to continue to fade, as more countries age and need to pay their own unfunded pensions.
Further, while many economists have looked at years of falling interest rates and assumed that it meant rates would continue their downward trajectory, research by Ken Rogoff argues that low rates are not a guarantee. He and his coauthors studied 700 years of long-term rate data, going back to the fourteenth century. Using long-term interest rates (more than ten years of maturity) enabled him and his coauthors to consider more history. Longer-term rates are also more influenced by market forces, rather than just monetary policy in recent years. They estimate that, while rates have trended down slightly, there are many deviations from this trend, and an increase in rates can last decades. They estimate that the last 30 years of falling rates were not part of the long-term trend. They also find that an aging population does not ensure low rates, as many economists assume—often, the opposite is true.
We could still get lucky or just muddle through. The U.S. has lots of room for error to avoid a fiscal crunch, thanks to its exorbitant privilege, but it is not immune. My concerns about debt and inflation were never based on certainty that a calamity would happen; they were based on the fact that no one can predict the future. Our spending risks higher interest rates and inflation, which make the economy much less resilient to shocks. If you build a city on a fault line and don’t have an earthquake for 50 years, that doesn’t mean building it there was a good idea.