Economic Consequences of Rising Federal Debt

It has become routine to brush off worries about ballooning government debt as mere drama about nothing—a contemporary variant of the boy who cried wolf. Voters have heard alarming forecasts about runaway deficits dating back to the Reagan era, the 1992 Ross Perot campaign, the mid-1990s Republican Revolution in Congress, and the Tea Party wave of the early 2010s. Yet deficits kept growing, and they have not triggered a debt crisis.

Instead, alarmist worries about deficits have been cynically wielded by opposition parties to criticize the governing party’s program—just before they gain power and begin enlarging deficits themselves. Those politicians do not genuinely care about deficits because their constituents do not. Poll respondents may say they favor smaller deficits, but only after they’ve also voiced backing for tax cuts and greater spending. They aren’t prepared to pay the price for deficit relief because they don’t perceive runaway federal debt as impacting the economy or their own wallets.

Yet swelling government debt is harming the economy and our fiscal priorities, and its rapid growth threatens the nation’s long-term economic health. Economists sometimes compare debt to unseen termites gnawing at a house’s foundation, though a sharper image is akin to a lifestyle of junk food, smoking, and neglecting exercise. It might seem tolerable for a while, even for years or decades, but the damage accumulates until a day of reckoning becomes almost certain. In today’s reality, debt is already taking its toll, and the United States is nearing a juncture where any reversal will demand painful reforms. The effects are mostly felt in two broad domains: the macroeconomy and the federal budget.

To begin with the fundamentals: economic growth—defined as the economy producing more goods and services that people want to buy—depends on adding workers and boosting their output through education, training, capital formation, and technology. Productivity gains also hinge on the financial system turning saving into investment. Money saved in banks or invested in firms flows to others who expand firms, launch new ventures, or finance homes and cars. These investments finance innovations, tools, and expansions that lift productivity and wages, driving economic growth. It all begins with turning savings into productive investment.

Debt crowds out private investment. The U.S. government’s $31 trillion of publicly held debt—the total exceeding the nation’s annual GDP—signifies $31 trillion of savings directed to government spending rather than to private firms, innovators, and buyers of homes, with about $4 trillion of that funded by the Federal Reserve through monetary expansion. When the government soaks up savings that would otherwise fuel private investment, we call that crowding out.

Although the government could borrow to support growth-oriented investments—like infrastructure, R&D, or education—most federal borrowing funds ongoing consumption, such as benefits for seniors. In principle, temporary borrowing for productive projects can produce returns that repay the debt, but sizeable, long-run borrowing to sustain perpetual consumption is unsustainable and harmful to the economy.

Such heavy government borrowing also lifts interest rates, the price of borrowed funds. Normal interest rates reflect the tug-of-war between available savings and the demand for loans by businesses and households. When the government itself seeks trillions, it pushes the demand for savings well beyond supply, driving up the cost of money.

Assessing how much rates will rise hinges on two opposing forces. First, savings are increasingly global, letting capital flow across borders with ease. A $100 billion borrowing by the government might have a smaller impact on interest rates when it competes in a vast international savings pool than if it were a large share of a small national market. Second, the U.S. dollar’s reserve-currency status preserves a baseline demand for dollar-denominated debt. Yet the other side is formidable: debt levels are enormous—$31 trillion today and an expected addition of about $200 trillion over the next thirty years under current policy. In that context, even global financial markets may struggle to absorb such borrowing without pushing rates higher and dampening growth investments.

Further, most of this borrowing would come from within the United States. The current $31 trillion debt is not largely held by a few offshore lenders; China and Japan each hold roughly $1 trillion, and they are unlikely to absorb much more than that over the next three decades. Other countries will buy Treasuries, but the scale of borrowing could eventually eclipse the GDP of many prospective creditors. That leaves domestic entities—insurance firms, pension plans, mutual funds, and state and local governments—to finance the climbing borrowing needs, or the Federal Reserve to step in while expanding the money supply. With a debt this large, meaningful upward pressure on interest rates seems hard to avoid.

Although many studies attempt to quantify these effects, the prevailing view is that for each additional 1 percentage point in debt relative to GDP, long-run interest rates rise by roughly 3 basis points (0.03 percentage points). That may sound modest, but it helps explain why the debt’s rise from about 40% to 100% of GDP since 2008 has already nudged rates up by roughly 1.8 percentage points (even if offset by other factors like a global savings glut). The forecast that debt could climb beyond 240% of GDP over three decades would, under current policies, add another roughly 4.2 percentage points of upward pressure—unless offset by other dynamics. Maybe other forces could push rates back down, but is it prudent to rely on that outcome to sustain the economy, particularly with AI investment likely to compete for capital and push rates higher? Meanwhile, this level of borrowing reduces the pool of savings for mortgages, auto loans, and other investments that drive growth.

These costs are tangible. The public’s dissatisfaction with the economy reflects real outcomes. Productivity growth averaged 1.6% per year from 1996 to 2010 but has slipped to about 1% in the last 15 years, translating into an economy roughly 9% smaller than it could have been. Debt is not the sole cause, but it is a contributing one. IMF cross-country studies show that debt ratios above roughly 85% of GDP tend to coincide with slower growth, and when you include state and local government debt, U.S. debt sits near 129% of GDP.

With the OECD showing the largest deficits among its members, U.S. debt as a share of GDP has surged to the fourth-highest level among the 38 advanced economies. If the debt continues to climb, the drag on growth is likely to intensify. The Congressional Budget Office compared two paths: one where debt is stabilized and another where current policies continue. The higher-debt trajectory would cut total per-person income growth by about 27% over the next 25 years, and by 2050 per-capita income would grow at only slightly more than half the rate of the stabilization scenario. In aggregate terms, the higher-debt path could reduce annual national income growth by roughly $10,000 per person, or about $40,000 for a family of four, by 2050 in today’s dollars.

Likewise, researchers at the Penn-Wharton Budget Model estimate that a policy package that cuts the 30-year debt projection by 38% of GDP could raise GDP by about 21% and noticeably lift wages. Admittedly, these are model-based projections. Nonetheless, the core reasoning—that government borrowing crowds out the private investments needed to lift productivity and living standards—remains economically compelling. And the current pattern of stagnant wage growth, modest growth overall, and higher interest rates are plausibly influenced by the sustained rise in debt.

In addition to broader economic costs, rising debt also inflicts direct and immediate damage on the federal budget itself. These fiscal consequences of Washington’s debt spree are even more direct. Escalating interest costs are devouring federal revenues and pushing the government toward a reckoning of sharp tax increases and spending cuts.

The federal debt held by the public has jumped from $6 trillion in 2001 (the last time there was a budget surplus) to $31 trillion—from 32 percent of GDP to 100 percent. And with rising debt—and rising interest rates—come rising interest costs. This year, net interest costs will reach approximately 3.3 percent of GDP for the first time in modern American history.

Put differently, interest costs consumed an average of 10 percent of annual federal revenues between 1940 and 2022, topping out at 18.4 percent in 1991. This year, interest costs will consume a modern record of approximately 18.8 percent of all federal revenues—on a trajectory toward 31 percent of all revenues within a decade, and 54 percent within three decades if current policies continue. Imagine every dollar in federal taxes you pay through July 16 going to service interest on the debt rather than Social Security benefits, school lunches, veterans’ benefits, infrastructure, or education. If interest rates swell even 1 percentage point above CBO’s projections, the three-decade interest spending surge will reach approximately 83 percent of all annual federal revenues—equivalent to every dollar you pay in federal taxes through Halloween.

Since 2022 alone, net interest costs have roughly tripled—from $351 billion annually to more than $1 trillion—surpassing the budgets of both defense and Medicaid and approaching Medicare as the second-largest budget item behind Social Security (which itself is projected to be surpassed by 2040). The federal government has entered a vicious cycle in which the majority of this year’s $1.8 trillion budget deficit will go to paying interest on past deficits—and those continuing deficits will further swell interest costs, which will further enlarge future deficits.

Ultimately, these escalating interest costs crowd out other spending priorities and force up taxes. The combined jump in Social Security, Medicare, and interest costs has already contributed to defense spending falling—as a share of GDP—to roughly half its 1980s levels. The combined budget for other discretionary priorities such as education, infrastructure, housing, and social services has fallen by roughly one-quarter as a share of GDP. And as interest costs are set to double and eventually triple their claim on federal revenues, dramatic cuts to spending programs and higher taxes become essentially inevitable. Under current policies, federal spending over the next three decades is projected to rise by approximately 2.4 percent of GDP—yet interest costs alone are projected to soar by 6.4 percent of GDP, from 3.3 to 9.7 percent, driving the debt toward more than 240 percent of GDP.

And the previous section represents the rosy scenario—yes, you read that correctly. That CBO-based projection assumes no additional tax cuts or spending expansions beyond current policies, no major wars or sustained economic downturns, and—crucially—that the average interest rate on the federal debt (currently around 3.4 percent) never again exceeds 4.2 percent. Yet the dynamics described above suggest that the accelerating surge in government debt should itself put significant upward pressure on interest rates. Is it safe to assume that Washington can borrow $200 trillion more over the next three decades with its average interest rate growing by less than 1 percentage point? We should hope so, because Congress and the White House have essentially bet the future of the U.S. economy on that optimistic assumption.

Anyone with a mortgage or student loan understands that when your debt is large, even small movements in interest rates produce substantial costs or savings. Now apply that logic to a federal debt heading from $31 trillion to $232 trillion. Government bond auctions are already regularly exceeding the CBO-projected interest rates. If the average interest rate on the federal debt runs even 1 percentage point higher than CBO projects over the next three decades, the resulting additional interest costs would approach $57 trillion—the equivalent of adding a second Defense Department. The total national debt projection would jump well past 300 percent of GDP over three decades, with interest costs consuming approximately 15 percent of GDP out of roughly 18 percent of GDP in projected revenues. Again, that is the consequence of interest rates exceeding CBO’s projections by just 1 percentage point.

That scenario is unlikely to fully materialize—not because it is fiscally sustainable, but because the stretched-thin bond market would force adjustment long before that point. Congress and the White House would face no alternative but to significantly reduce primary deficits through painful tax increases and spending cuts. Otherwise, a vicious cycle of rising debt and rising interest rates would paralyze both financial markets and the federal government. The result will almost certainly be taxpayers bearing a much heavier tax burden and receiving notably fewer government benefits than today, as increasing shares of their tax revenues flow to bondholders rather than public programs.

Yet there is one other path already tempting the current administration. Fiscal dominance—pressuring or compelling the Federal Reserve to maintain artificially low interest rates in order to reduce the government’s borrowing costs—has obvious political appeal: Why accept unpopular tax increases or spending cuts when the Fed can simply be directed to keep rates low? The problem is that fiscal dominance disables the Federal Reserve and prevents it from using monetary policy to stabilize the business cycle and contain inflation. The resulting inflation would lead holders of longer-term bonds to demand even higher rates to compensate for expected purchasing-power losses—pushing some of the government’s borrowing costs back up regardless.

The Federal Reserve operated under fiscal dominance during World War II to help finance wartime borrowing, but when the Treasury refused to restore the Fed’s independence after the war, inflation predictably surged until the Fed was finally liberated in 1951. President Donald Trump’s attacks on the Fed and Chairman Jerome Powell have been motivated in part by his stated desire of “saving us $1 Trillion per year”—a figure that substantially overstates what lower rates could realistically achieve.

Finally, all of this accumulated debt steadily erodes the federal government’s capacity to respond to genuine emergencies—wars, deep recessions, and natural disasters—that have historically required federal outlays running well into the trillions of dollars.

Yes, these fiscal scenarios sound dire. But don’t just take my word for it. When economists at the Penn-Wharton Budget Model tried to model the long-term economy under current debt trajectories, their economic models crashed.

Unfortunately, no one can credibly tell us exactly when the bond market will reach its breaking point. If you gradually raise the temperature in a room to 220 degrees, you can be certain that at some point life will be extinguished—even if you cannot pinpoint the exact temperature when it occurs. Similarly, somewhere between a federal debt of today’s $31 trillion and the 30-year projected level of $232 trillion, a brutal cycle of rising interest rates followed by even faster-rising debt will likely be unleashed. Responsible lawmakers and taxpayers should not want to find out where that point is.

Yes, critics will note that we have been hearing about an impending debt crisis for 30 years. But beyond the reality that Americans are already experiencing some of the economic effects—and the crowding out of key federal budget priorities—the largest costs were always likely to materialize after all 74 million baby boomers had retired into Social Security and Medicare, a process that will be essentially complete around 2030. Social Security trustees have been projecting trust fund insolvency in the early- to mid-2030s as early as the 1990s.

So why then were deficit hawks so aggressive in the 1990s and early 2000s? After all, that era’s 40 percent of GDP federal debt burden was not especially problematic, and its elevated interest costs were merely a temporary artifact of high interest rates. Yet the deficit hawks recognized that any plan to manage the looming cost of 74 million baby boomers retiring between 2008 and 2030 would require gradually phasing in Social Security and Medicare adjustments while the boomers were still young enough to adapt their retirement plans.

Unfortunately, those forward-thinking reforms were not enacted, and that window has largely closed. This leaves the deeply unpalatable options of either cutting benefits for people already in retirement or exempting from reform the very generation whose retirement costs are driving the fiscal train off the cliff. The lesson, as always, is that delaying fiscal adjustments only makes them larger, more abrupt, and more painful—a lesson that lawmakers and voters still refuse to confront.