How far out are the CBO's rate assumptions?

Far out

The Economist’s fiscal scold out this week features some scary looking graphs. Net interest payments, displayed in red, are projected to dominate the federal budget.

In the leader even, we find a correctly detrended but suspiciously linear forecast. What is going on here?

Turns out, the CBO is assuming for its baseline scenario that the average rate on federal debt held by the public will rise from 1.8% today to 4.2% over the next 30 years (in nominal, not real terms). This is the vector of assumptions about long-term rate levels. How reasonable is this rate path assumption?

For reference, the median FOMC member’s long-term rate assumption is 2.6%. Indeed, the highest rate any FOMC member gave for the long run in 3.8%. That’s right: the FOMC’s most pessimist member is substantially less pessimistic than the CBO.

As former CBO director Doug Elmendorf told the Economist: “Every bit of higher interest rates matters a lot more when debt is about 100% of gdp.” In effect, since the CBO is the principal technocratic instrument through which Congress disciplines itself, their extreme rate assumption amount to an ill-considered regime of fiscal discipline on Congress.

If it has to, the United States can bear an interest rate burden many times more than the CBO’s projection. Moreover, debt levels do not determine the level of rates; not for any center country, and certainly not for the United States. Furthermore, there is no 90 percent or whatever threshold beyond which a crisis becomes more likely. In fact, the US can almost certainly bear a greater burden than Japan, which has a debt-to-GDP ratio north of two hundred and fifty percent.

The fact that the fiscal scolds are easily dismissed does not mean that Washington has plentiful room to keep splurging on tax cuts, corporate welfare, and expensive toys for the military boys. Too much fiscal stimulus can be counterproductive if inflation wipes out the income gains, as Biden discovered, so the room is limited by the constraints of macroeconomic stability.

More importantly, fiscal spending or tax expenditures mechanically rebalance real resources, including and especially, human talent and skill, away from some projects and towards others. Some of these projects are more valuable to us to further the welfare of Americans and compete with rising powers; others not so much. If you’re making an F-16, you consume the valuable time of very many skilled workers and professionals. If instead you spend the same tax expenditure on building cleantech that helps the world transition, you still consume as many scarce resources, but now you have a lot more to show for it.

There’s the fake discipline of moralistic, emotional, and folksy ‘balance your books’ Swabian ideology. And then there’s the real discipline of recognizing that no matter how large the resources available at our disposal, we are still constrained by scarce resources—especially skill—and these should not be squandered on low NPV projects but channeled towards for high NPV projects. This is the correct governing idea for industrial policy done right. It is also at the heart of what motivated my proposal with Tim Sahay, to create a public ratings agency for green finance. Whereas there, we were worried about greenwashing, here I am concerned with the general problem of constrained fiscal policy-making without resorting to the fiction of the Swabian ideology.

The replacement of Swabian ideology by this idea of responsible public finance is how, not just the UK, but also the US can get out of the ‘Treasury brain’. Although, brain here should be understood in a dual sense. First, as the ideology of fiscal discipline, represented by the British Treasury. Second, as Roberts’ logic of discipline in the cabinet, whereby finance ministries acquired the mandate to discipline ‘spending ministries’, and thereby become the ‘brain’ of the government. This development took place in the 1990s, whereas finance had already become the ‘brain’ of the economy by the 1980s. The second was no doubt inspired by the first. But I digress.