What Are the Dangers of Too Much Debt?

Release Date
March 20, 2012

Topic

Gov't Debt & Spending
Description

The United States currently pays 3 percent interest on the government debt. Economics professor Antony Davies shows that this year the U.S. government owes $440 billion in interest alone. This is three times the annual operating expenses of the Iraq and Afghanistan wars.
Using data, Professor Davies shows that the situation is likely to get worse. Today the interest rate is the lowest it’s been since the 1960s. If the rate rises to 8 percent, which is what it was 20 years ago, interest payments on the debt will be larger than the annual cost of every war the United States has ever waged combined. The more money the government is spending on interest, the less money it has available to provide other services.
So what should be done? The government should take advantage of today’s low interest rate and pay off as much of the principle as possible now, before interest payments rise to unsustainable levels.

What Are the Dangers of Too Much Debt?
As of 2011, the federal government owes $10.1 trillion to people, corporations, and foreign governments and another $4.6 trillion to the Social Security Trust Fund. This doesn’t count an additional $50 trillion or more that the government has promised to current and future Social Security and Medicare recipients that it will not have the money to pay.
Let’s ignore unfunded Social Security and Medicare obligations and just focus on the official debt. What does it mean for the government to carry this much debt? The interest rate the government pays on this debt is currently about 3 percent. That means that this year the government will rack up $440 billion in interest charges alone.
According to the Congressional Research Service, the Iraq and Afghanistan wars cost about $140 billion per year. That is less than one-third the amount of money the government spends on interest on the debt.
Remember that the government must go to financial markets to borrow, just like everyone else. So the interest rate the government pays on the debt is determined by market forces. Today, the interest rate that the government pays on its debt is the lowest that it’s been since the 1960s. In fact, just three years ago the interest rate was 50 percent higher than it is today.
What would happen if the interest rate the government had to pay on its debt rose? At the current debt level, a 1 percentage point increase in the interest rate would cost the government an additional $147 billion a year in interest charges. That’s more than the annual cost of the Iraq and Afghanistan wars. In fact, comparing the government’s annual interest expense to the annual cost of all the wars the U.S. has fought, we see that the interest rate on the debt costs us more than half of what World War II cost annually. At the time, World War II was the costliest effort the government had ever undertaken.
Three years ago the government was paying a 4 percent interest rate. Ten years ago, it was paying a 6 percent interest rate. Twenty years ago it was paying an 8 percent interest rate. If the interest rate rises to 6 percent again—which historically is not only likely but virtually inevitable—the interest charges the government accrues will equal the annual cost of World War II. If interest rates rise to 8 percent, a level we saw only a generation ago, the amount of interest the government will pay each year will be the equivalent of waging all the wars it has ever waged combined.
There are only two direct consequences of debt: the principle payments and the interest expense. Other consequences flow from these. The more the government pays in interest, the less able it is to provide services that people need. This means that the government needs to take advantage of low interest rates by paying down as much of the national debt as it can, while there’s still time.