The debt ceiling is a legislative limit set by Congress on the total amount of money the U.S. federal government is authorized to borrow to meet its existing financial obligations, such as Social Security, Medicare, and interest on the national debt. When the government reaches this limit, Congress must raise or suspend it to allow for continued borrowing, or the U.S. could default on its debt, which would have catastrophic economic consequences globally. 

Key Aspects of the Debt Ceiling

• Purpose: To allow the Treasury to borrow money to pay for spending that Congress has already approved. 
• Trigger: The debt ceiling is triggered when the government’s accumulated borrowing reaches the maximum amount set by Congress. 
• Consequences of Inaction: If Congress fails to raise or suspend the debt ceiling, the U.S. government would be unable to borrow more money to pay for its existing obligations, leading to a default. 
• Impact of Default: A default could lead to widespread economic consequences, including a potential recession, job losses, a falling stock market, and increased borrowing costs for consumers and businesses. 
• Not New Spending: Raising the debt ceiling does not authorize new spending; it simply allows the government to continue to pay for programs and services that Congress has already decided to fund. 
• Origin: The concept was introduced in 1917 to provide the Treasury with greater flexibility in managing war financing during World War I, replacing the need for Congress to approve each individual loan. 

The Origins of the US Debt Ceiling

The debt ceiling, set by Congress, is a cap on the total amount of money the Department of the Treasury can borrow.  The ceiling applies to nearly all debt accrued by the federal government, including over $28 trillion in debt held by the US public, and $7 trillion in debt the federal government owes itself for programs like Medicare and Social Security. 

It should be noted that debt and deficit have different meanings.  The deficit refers to the difference between revenue the federal government takes in from taxes and other sources across each fiscal year, while the debt refers to deficits accrued across multiple years. 

The debt ceiling wasn’t always around.  Originally, Congress signed off on all debt by authorizing individual bonds through legislation.  However, the cost of financing America’s involvement in World War I led Congress to establish a debt limit though the Second Liberty Act  to simplify the borrowing process and allow the Treasury Department to issue as many bonds as needed instead of waiting for Congress to approve every single bond. 

As part of the Second Liberty Bond Act of 1917, the United States Congress established a $15 billion debt ceiling, providing a process to control the amount of US Government bonds the country could issue. Prior to 1917, Congress needed to pass a legislative act that approved the amount and purpose of each debt issuance.

In 1939, the Public Debts Act was passed, which created a limit on all federal debt, eliminating separate limits on individual forms of debt. However, this limit has not remained fixed. According to the US Treasury, since 1960 the US Congress has raised the debt ceiling on 78 separate occasions. It has never reduced the ceiling.  

In recent years, rising national debt and an increasingly polarized Congress have made the process of raising the debt ceiling much more contentious.   Parties have occasionally sought policy concessions from one another in exchange for agreeing to raise the debt limit, leading to a few occasions where political brinkmanship has actually caused the federal government to hit the debt limit and trigger debt ceiling crises in 1995-1996, 2011, and 2013, when the government became uncomfortably close on defaulting on its debt. 

The last time the debt ceiling was raised was on June 2, 2023, to its current level of $36 trillion in the Fiscal Responsibility Act. 

The debt ceiling was established to create a more efficient way to finance the US government’s outstanding financial obligations, as well as a way to prevent runaway debt raising.

What is a Debt Ceiling?

Government spending and the debt ceiling are two distinct concepts. Government spending refers to the new commitments made by the government for various activities such as defense, education, and infrastructure. On the other hand, the debt ceiling represents the total amount of debt accumulated by the US government to finance both current and past obligations that surpassed the government’s revenue, known as the budget deficit.

The fiscal deficit of the US was $1.38 trillion in 2022 and the US has approximately $31.5 trillion in outstanding total public debt as of May 2023. 

The government’s credit card limit

Think of the debt ceiling like a credit limit on a credit card — just as you have a limit on the amount of money you can borrow, the U.S. government has a limit on the amount of money it can borrow to fund its spending.

As of May 2023, the US debt ceiling stood at $31.4 trillion, which was the limit set by the Biden government in 2021. However, a bill passed in June 2023 has suspended the debt limit until 2025.

What happens if the government hits the debt limit?

Once the government hits the debt limit, in theory it can no longer borrow and since the US runs an annual fiscal deficit, that means it may soon run out of money and might temporarily default on its obligations, including paying government staff and military personnel.

Failure by the US Treasury to raise additional debt to cover interest payments on its existing debt could result in a default on the government’s debt obligations. This would have severe repercussions for the US economy and global financial markets, potentially leading to a credit rating downgrade and even a government shutdown.

Hitting the debt ceiling would mean the federal government would eventually be unable to make its debt payments after a certain period of time.  This would result in the government defaulting on its debt obligations, something that has never happened in US history. 

With the government unable to pay its debts, millions of daily obligations including Social Security payments, salaries for federal civilian employees and military servicemembers, veterans’ benefits, utility bills, and others, would have to be at least temporarily defaulted.  Next, global financial markets would enter a state of turbulence, as both international and domestic markets rely on the stability of US financial instruments and the economy.  Additionally, interest rates would rise and the demand for Treasury securities would fall as investors begin to reconsider the safety of Treasuries and either pull back or stop investing entirely.  Higher interest rates would in turn have strong reverberations across the economy, impacting credit cards, mortgages, car loans, and other forms of borrowing and investment. 

Even if the government doesn’t actually default on its debt obligations, the mere threat of default could result in some negative economic consequences.  During the debt ceiling crisis of 2011, Standard & Poor’s downgraded the US credit rating from AAA to AA+ with the rationale that the debt limit fight was a sign of “America’s governance becoming less stable, less effective, and less predictable.”  During the 2013 debt ceiling crisis, credit agency Fitch warned it may cut the US credit rating due to political gridlock, and Chinese rating agency Dagong downgraded the US from A- to A.  In 2014, Fitch did however restore the US credit rating to AAA. 

The Debt Ceiling as a Political Tool

Changes to the debt ceiling require majority approval by both Congress and Senate, so it is a politically difficult thing to do. While members of both parties have acted quickly in some instances, there is always brinkmanship and political posturing involved. For example, in 2011, a standoff between President Obama’s Democrats and the Congressional Republicans only reached a deal to raise the ceiling two days before the date that the Treasury forecasted it would run out of money.

The frequency at which the US Congress passes a debt ceiling increase can vary widely depending on a number of factors, including the political climate, economic conditions, and the level of national debt. In recent years, the frequency of debt ceiling increases has increased due to rising levels of national debt and political gridlock in Congress.

The potential “Biden Default” of 2023

As of late May 2023, the US didn’t have a debt limit increase agreement between the two parties.  

House Speaker Kevin McCarthy indicated that he and his fellow Republicans are planning to use the debt limit standoff to push through their agenda of spending cuts and national debt reduction, as well as other non-financial agenda items like crackdowns on illegal immigrants.

Meanwhile, President Biden and his Democratic lawmakers insisted on raising the debt limit with “no strings attached”.  

Treasury Secretary Janet Yellen warned that a default could happen as soon as June 2023. Known also as the “X-Date”, that would be the day the US government runs out of money to pay its obligations.

However, on June 5, President Biden signed a bill passed by both the US House of Representatives and US Senate after much standoff between the two parties.  This bill suspends the debt limit until 2025 – after the next presidential election – with some restrictions on government spending over the new two years.

Is a Default Serious?

Yes, a default is very serious. Using our credit card analogy from earlier, that would mean the creditworthiness of the world’s largest economy would be called into question.  

Not only would the borrowing costs for the US government skyrocket, but all borrowing costs for US businesses and households would also jump. Researchers estimate that the national debt would increase by $850 billion in debt servicing costs and an average mortgage loan would cost an additional $130,000.

Impact on the US government’s credit rating

A prolonged stalemate or potential default of the US government would also impact its credit rating. The US government has had its credit rating downgraded only once in history, and that was in August 2011, by the credit rating agency Standard & Poor’s (S&P).  

At the time, the US was also in the midst of a debate over raising the debt ceiling, and S&P cited the political gridlock and uncertainty surrounding the issue as the main reason for the downgrade. S&P lowered the U.S. government’s long-term credit rating from AAA to AA+, which is still considered a very high credit rating but was the first time the US lost its AAA rating from S&P. 

Impact on markets

The negative impact would also extend to investors globally, as we saw in the 2011 standoff. Stock prices fell, and market volatility spiked as investors tried to find safe harbors to park their investments.  

The US economy would also suffer, with as many as 3 million jobs lost in a “self-inflicted economy catastrophe” and more harmful to the US economy than the 2008 Global Financial Crisis[7]. If a “Biden Default” were to happen, Goldman Sachs chief US political economist, Alec Phillips, estimates at least a 10% hit to the US economy.

Holders of US government debt, including the foreign governments of China and Japan, may also look to offload some of their holdings, which could cause a massive calamity in fixed income markets. Lastly, the US dollar, which has been the safe haven currency and global reserve currency and monetary unit, will also lose some of its luster.

This “risk-off” sentiment may be positive, however, for precious metals and other commodities. Other government bonds in the Eurozone may also benefit. And finally, it is also entirely possible that cryptocurrencies may benefit as investors look to move away from centralized traditional fiat currency into decentralized digital currency.

Whatever the outcome of a potential US government default, it would certainly be a financial catastrophe, which means the stakes are even higher for both sides to find a resolution.

What Can Be Done to Prevent Default Without a Deal?

Things the US Treasury can do

There are some things that the US Department of the Treasury can do to ensure that the US government doesn’t run out of money before Congress passes an increase, albeit only for a short while.  

The US Treasury can use so-called “extraordinary measures” to delay the breach of the debt ceiling. These measures include temporarily suspending investments in certain government funds and programs and delaying the issuance of new debt. These measures can provide some additional time for the government to operate under the existing debt limit.

It may also prioritize its spending to ensure that debt service obligations are met. This means that if the debt ceiling is reached, the government can prioritize payments to bondholders and other creditors to avoid defaulting on its debt. This can help prevent a crisis while Congress works on passing a debt limit increase. 

What Will Congress Do? 

If the federal government does hit the debt ceiling in July, it won’t immediately default on its debt.  That’s because the Treasury Department can take so-called “extraordinary measures” that were previously deployed during the debt ceiling crises in 2011 and 2013.  Extraordinary measures are accounting maneuvers that allow the federal government to continue to borrow money and pay bills without exceeding the debt ceiling.  These measures usually involve not fully investing federal employees’ Thrift Savings Plan and civil service retirement plan funds in special Treasury securities.  For example, if federal employees have invested $100 billion in the Thrift Savings Fund, the Treasury could opt to issue only $90 billion to the fund, creating $10 billion that could be used to auction more debt to the public and raise more money for the Treasury.  After the debt ceiling is raised or suspended, investments in those funds would resume and lost interest is credited back to the accounts, leaving the savings and pensions plans unaffected. 

But extraordinary measures only provide a temporary means for the government to pay its bills after the debt ceiling is reached, and it’s not clear how long the Treasury Department can exercise extraordinary measures after July.  For example, a March 2025 report from the Congressional Budget Office (CBO) projected that extraordinary measures would probably run out sometime at the end of September 2025.  However, CBO said it could be as soon as August 1, 2025, if borrowing levels remained the same.   

Suspending the debt ceiling

Congress may also choose to temporarily suspend the debt ceiling or allow the Treasury to go over the limit in order to provide additional time for negotiations and prevent a breach of the debt ceiling. This has been seen much more commonly of late, with Congress suspending the debt limit seven times in the past decade — the latest being the Bipartisan Budget Act of 2019, which suspended the debt limit until July 31, 2021.

The debt ceiling debate has now made its way into budget reconciliation.  The compromise budget resolution includes instructions for a $5 trillion debt limit increase.  During the debate, Sen. Rand Paul (R-KY) offered an amendment to strike the proposal and replace it with a $500 billion increase, providing a limited, 3-month extension to force Congress to vote again on the debt ceiling before what he called “continuing down the road of fiscal irresponsibility.”  His amendment was shot down 5-94, with fellow Republicans Sens. Lee and Curtis from Utah voting for it. 

The debt ceiling is a bipartisan problem that should involve a bipartisan solution.  That said, Republicans have teed up resolving the debt ceiling using the partisan budget reconciliation process.  What happens if reconciliation fails, or is delayed to the point that the federal government comes close to defaulting on its obligations?  How will Democrats react if Congressional Republicans and the Trump administration need their votes to raise the debt ceiling when they’ve been left out in the cold during the budget negotiations? 

The US government can also work to reduce spending and/or increase revenue to decrease the need for borrowing. This can be achieved through a variety of policy measures, such as spending cuts, tax increases, and economic growth.

Interest Payments and Sustainability

Interest payments on the U.S. national debt are the costs the government incurs for borrowing money, and these payments are projected to be a record $952 billion in FY 2025 and will climb to $1.8 trillion by 2035, totaling $13.8 trillion over the next decade. This significant increase is driven by both a rising national debt and higher interest rates. These costs are a growing portion of the federal budget, projected to equal the second-largest category of spending and become the largest budget item by 2035. 

What are interest payments?

• The U.S. government borrows money by selling Treasury securities. 
• Lenders who buy these securities receive interest payments for the use of their money. 
• These payments are an essential cost of financing the national debt. 

Why are interest payments increasing?

• Rising National Debt: The total amount of money the government has borrowed has grown significantly over time. 
• Higher Interest Rates: The interest rates on these securities have increased since 2020. 
• Combined Impact: The combination of a larger debt and higher rates has caused the cost of servicing the debt to increase sharply. 

What is the impact of these rising costs?

• Increased Federal Spending: Interest payments are consuming a larger share of the federal budget, rivaling programs like defense and Social Security. 
• Economic Strain: More government funds dedicated to interest mean less money is available for other crucial programs and investments. 
• Record Levels: Interest payments are on track to reach historically high levels, both in dollar amounts and as a percentage of the economy (GDP). 

Interest Costs on the National Debt

Every month, the U.S. Department of the Treasury releases data about the federal budget, including the interest costs that the federal government pays on the national debt. The following contains budget data through July 2025, the tenth month of fiscal year (FY) 2025.

Interest Payments in FY25

The rapid accumulation of federal debt, in addition to higher interest rates on that debt (relative to longer-term rates that existed just a few years ago), has pushed up the federal government’s cost of borrowing. As would be expected, through the ten months of FY25, interest payments on the national debt have been higher compared to previous years.

$841B

Cumulative FY25 Interest Payments

$763B

Cumulative FY24 Interest Payments

(through July 2024)

As interest payments continue to rise, the federal government will likely devote a larger portion of the federal budget to such costs; the rising debt leading to such increases may crowd out opportunities for investment in other important priorities in both the public and private sectors. Interest costs so far in FY25 are the second-largest spending category for the federal government — outpacing outlays for all budget functions other than Social Security.

Interest Payments Over the Next 10 Years

The nation’s rising debt, and relatively high interest rates, will continue to put upward pressure on federal borrowing costs — interest payments are projected to be the fastest growing portion of the federal budget in upcoming years. The Congressional Budget Office (CBO) projects that if current laws generally remain the same, net interest payments will total $13.8 trillion over the next decade, rising from an annual cost of $1.0 trillion in 2026 to $1.8 trillion in 2035.

In fact, by pretty much any measurement, interest on the national debt will soon exceed the highest levels recorded in the post-World War II period:

• In dollar terms, interest costs reached an all-time high of $476 billion in 2022 and have risen rapidly since then. CBO projects that such costs will total $952 billion in 2025.
• Relative to the size of the economy, interest costs would reach 3.2 percent of gross domestic product (GDP) in 2026 — eclipsing the previous high set in 1991. Interest costs would climb to 4.1 percent of GDP by 2035, under CBO’s projections.
• As a share of federal revenues, federal interest payments would rise to 18.4 percent by the end of 2025, exceeding the previous high set in 1991. They would reach 22.2 percent by 2035.
• As a percentage of total spending, interest costs would reach 15.6 percent by 2031, surpassing the previous high of 15.4 percent set in 1996.

Even excluding interest costs, the federal government spends more money than it collects, creating a structural problem in the budget, known as a primary budget deficit. The increase in debt generated by that structural gap is exacerbated by ever-increasing interest payments, which endanger other priorities and could risk a fiscal crisis. To avoid such outcomes, the Administration and Congress should implement options to put the budget on a sustainable path.

Interest payments on the U.S. national debt are becoming unsustainable due to rising interest rates, increased debt levels, and a structural deficit between government spending and revenue, which could lead to a fiscal crisis. Recent Federal Reserve interest rate hikes to combat inflation have significantly increased these costs, now exceeding spending on defense and threatening to crowd out other vital programs. Experts suggest that policies such as tax and spending reforms and deficit reduction are necessary to put the U.S. on a sustainable fiscal path and avoid negative consequences. 

Factors Contributing to Unsustainability

• Rising Interest Rates: The Federal Reserve’s efforts to curb inflation have led to higher benchmark interest rates, increasing the cost for the government to issue new debt and service existing debt. 
• Increased Debt Levels: The national debt has grown significantly, partly due to the structural mismatch between government revenues and outlays, exacerbated by an aging population and rising healthcare costs. 
• Higher Interest Costs as a Share of the Economy: The combination of higher debt and interest rates is projected to cause net interest costs to grow sharply, potentially becoming the largest federal spending “program” in the future. 
• Risk of Crowding Out Spending: As interest payments consume a larger portion of the federal budget, they risk “crowding out” spending on other critical areas like defense, infrastructure, or education. 

Indicators of an Unsustainable Path 

• Growth of Debt Faster Than the Economy: The federal debt held by the public is projected to continue growing faster than the economy, a key sign of an unsustainable fiscal path.
• Fiscal Future at Risk : Organizations like the U.S. Government Accountability Office (GAO) identify the nation’s fiscal future as unsustainable due to the current trajectory of debt and interest costs.

Potential Solutions

• Fiscal Reforms:Implementing thoughtful tax and spending reforms could help control interest costs and improve debt sustainability. 
• Deficit Reduction:Policymakers need to enact deficit reduction measures and ensure new spending priorities are paid for with offsets to stabilize and ultimately reduce the debt as a share of the economy. 

What are the main consequences of the National Debt?

• Decreased savings and income
• Higher interest costs
• Lack of flexibility
• Risks of a new crisis

The sheer magnitude of the federal debt is hard to wrap one’s mind around, and federal revenues aren’t keeping up with federal borrowing. The current federal debt represents 621 percent of annual federal revenues. The ratio of the federal debt to the GDP will be around 113% in 2020 according to Trading Economics econometric models. This ratio hasn’t exceeded 70 percent since World War II, a sign that federal spending has spiraled out of control.

Main consequences of National Debt

There are some extremely concerning consequences to the current level of federal debt.

Decreased savings and income

The government borrowing money means that more treasury securities are issued and compete against securities issued by the private sector. The government’s need to borrow will eventually exceed the savings available, and even though more households and businesses are purchasing treasury securities, national savings will reach a low point in comparison to the size of the federal debt.
Treasury securities with high-interest rates will make saving more appealing than investing for businesses. The private sector will stop seeking investments that can generate growth due to the incentive to save. This includes the lower amount of capital available once individuals stop investing in securities offered by businesses due to treasury securities being more attractive.

This lack of investment will result in low productivity and create an environment where work produces little value and wages decrease.

Higher interest costs

Interest rates are still low, so this consequence isn’t felt yet. However, the current rate of federal borrowing will eventually lead to higher interest costs. The federal funds rate will have to be increased in the near future to make up for inflation. This means that the federal deficit will grow exponentially, and reducing it will become increasingly difficult.

The only way to lower the deficit will be to implement high tax rates and reduce federal spending. This situation will result in a lower disposable income for Americans, whether high tax rates reduce their paycheck and incentive to work, or whether a future administration cuts expenses by reducing Social Security benefits.

Lack of flexibility

A small federal deficit gives an administration plenty of room to borrow at low rates in the short-term. This is a strategy that an administration might have to use in case of a recession, natural disaster, or war.
This flexibility is reduced as the federal debt increases. We are in a situation where it would be difficult for the current administration to secure additional funding at a low rate in the short-term. This considerably limits the government’s ability to prepare and respond to an event.

During the 2008 Recession, the debt-to-GDP ratio was under 40 percent. The government was able to secure additional funding to make up for reduced tax revenues and increase spending. This type of response would be more difficult to implement with the current debt-to-GDP ratio.

Risks of a new crisis

The current borrowing rate will eventually create a situation where it will become increasingly difficult for the administration to secure more funds. Interest rates will go up, which means the pace at which the federal is growing will accelerate.

This is a cycle that can’t be sustained, which means a major economic correction will have to happen. Possible scenarios include the U.S. debt being discounted, other countries no longer buying the U.S. debt, or the stock market performing poorly due to a loss of confidence in federal fiscal policies. The crisis could also take the form of a high inflation rate or devalued dollar.

It is unclear where the tipping point is since the current rate of government borrowing hasn’t been matched in recent history. Balancing the budget doesn’t seem to be a priority for the current administration, but you can make a difference by drawing attention to this issue and advocating for new spending policies. 

When Does Federal Debt Reach Unsustainable Levels?

Introduction

This introduction to this brief is, by necessity, a bit more technical than found in most PWBM briefs. We provide a small “primer” for policymakers and other readers to understand how PWBM analyzes the impact of debt on the U.S. economy. These insights generally apply to the workings of other dynamic models used by government scoring agencies.

As we have discussed elsewhere, government debt reduces economic activity by crowding out private capital formation and by requiring future tax increases or spending cuts to accommodate future interest payments. The dynamic “overlapping-generations (OLG) model”, originally based on the seminal work by Diamond (1965) and Auerbach and Kotlikoff (1987), is the workhorse framework for analyzing the impact of government debt on the economy through both, tax and spending channels. The Penn Wharton Budget Model (PWBM) and the Congressional Budget Office use versions of the OLG model largely based on the papers by Nishiyama and Smetters (2005, 2007, 2014), subsequently modified in various ways over time. The Joint Committee on Taxation also has access to its own OLG model for assessing dynamics.

It is generally not well understood outside tight academic and DC modeling circles that these models effectively crash when trying to project future macroeconomic variables under current fiscal policy. The reason is that current fiscal policy is not sustainable and forward-looking financial markets know it, leading to the economy “unraveling” through “backward induction”.

Dealing with this problem has sometimes led scoring agencies to also use additional models where financial markets follow simple, adaptive (backward-looking) rules-of-thumb. In some cases, these alternative models—in particular, the standard neoclassical growth model—do not include a role for government debt under the strong assumption of “Ricardian” consumers. To be sure, obtaining insights from alternative models can often provide meaningful information. However, for understanding novel debt dynamics with no historical precedent, such alternative “reduced form” models are unsuitable and generally provide projections that are optimistically biased.

Instead, in practice, the workhorse OLG model is generally “fixed” by augmenting it with an additional assumption—namely, a future fiscal policy action that is not actually contained in current law. This modelling fix (also called “closure rule”) springs into action at a future date to stabilize the amount of debt held by the public relative to GDP. It often takes one of several alternative forms: a broad-based value-added tax (VAT); a proportional wage tax (not subject to any payroll tax ceiling); a proportional income tax; a broad-based reduction in spending; or, some combination of each. Broad-based closure rules introduce very small economic distortions relative to other alternatives, such as a narrow-based, progressive tax on capital income. Importantly, broad-based closure rules allow model sustainability with the maximum amount of debt relative to GDP before needing to be activated.

Both PWBM and CBO typically have this rule kick in the year 2050 or later, potentially with some gradual introduction. As it turns out, the exact form of the broad-based closure rule—for example, whether it is a VAT or some other tax—is not that important in terms of economic effects. What is important is that a large broad-based future corrective change in fiscal policy happens in any form to stabilize the debt-GDP ratio, and that such a correction action is anticipated by financial markets. Otherwise, forward-looking financial markets would unravel much sooner—a process known as “backward induction”—to cause a sovereign debt crisis.

Existing dynamic OLG models also face a second encumbrance: For reasons that go beyond this brief, OLG models used in policymaking typically do not properly distinguish between risk-free assets (government bonds) and risky assets (e.g., stocks). That lack of distinction usually creates only a minor loss in model fidelity when analyzing the economic impact of many fiscal policies such as pre-K education or infrastructure. The lack of distinction is more problematic at higher levels of government debt that materially change financial market prices. Now, we want to estimate the amount of government debt that the economy can handle while being consistent with household investment risk-taking preferences and the effects of distortionary taxes and changes to productive spending.

Over the past several years, PWBM has built a second OLG model—the PWBM “moonshot” OLG model—that solves a “state space” 20,000 times larger than the PWBM standard OLG model referenced above. While simpler in some dimensions to our standard model, the moonshot model combines mathematical advances with large-scale computing to solve the “curse of dimensionality” commonly found in quantum computing problems. The moonshot model allows us to compute interactions of debt with financial markets with much greater confidence to ensure consistency with investor risk preference in more extreme, boundary settings.

Even with a closure rule discussed above added to the moonshot model, there is only so much federal debt that financial markets can handle, that is, at any government borrowing rate. We will explore this issue in more detail in a future brief. Succinctly, for now, the increase in debt “crowds out” private capital formation, which lowers GDP growth and the size of tax bases. This crowding out is especially pronounced in the moonshot OLG when reaching limits of the economy’s debt carrying capacity. At the same time, more tax revenue is needed to implement the closure rule that stabilizes debt relative to GDP. Even when using an efficient VAT, the tax distortions shrink the economy even more so that interest payments can no longer be made. In effect, the economy collapses under the sheer weight of government debt.

As of September 30, 2023, the federal “debt held by the public” (herein, “debt”) stood at $26.3 trillion, or about 98 percent of projected GDP. The “public debt outstanding” of $33.2 trillion often cited in media is largely misleading and not relevant for assessing economic impact; about $6.8 trillion of that amount is from the federal government holding its own debt for accounting purposes. The economics profession has long focused on “debt held by the public.”

Still, even with the most favorable of assumptions for the United States, PWBM estimates that a maximum debt-GDP ratio of 200 percent can be sustained even if investors believe (maybe myopically) that a closure rule will then prevent that ratio from increasing into the future. Countries like Japan with an even larger debt-GDP ratio more-than offset their government debt with a household saving rate that is much larger than that found in the United States. This 200 percent value is computed as an outer bound using various favorable assumptions: a more plausible value is closer to 175 percent, and, even then, it assumes that financial markets believe that the government will eventually implement an efficient closure rule. Once financial markets believe otherwise, financial markets can unravel at smaller debt-GDP ratios.

Government Debt Projections Have Risen Sharply Over Time

Federal debt has increased consistently since the late-2000s. Figure 1 shows the Congressional Budget Office’s 10-year projections (labeled by the month and year of publication) of federal debt held by the public as a share of the Gross Domestic Product (GDP) in percent since 2007. Each line in Figure 1 represents a time series of 12 numbers: In each, the first value shows actual debt-GDP ratio at the end of the year before the year of publication. The second value shows debt held by the public expected as of the end of the current calendar year, and the following 10 values are CBO’s projection of debt-GDP ratio at the end of each year during the next decade.

Figure 1: CBO 10-year Projections of Debt Held by the Public as a Share of GDP 2007-2023 (fiscal years, percent)

Some of the increase in debt is well understood and driven by policy changes, including in response to 2007 – 2010 Great Recession, the Tax Cuts and Jobs Act of 2017, and more recent Covid-19 stimulus. Some of the projected debt increase was due to underestimates in entitlement program spending arising from faster-than-expected growth in the population of retirees and their Social Security and Medicare benefits. A decomposition of the exact causes goes beyond this brief. What Figure 1 clearly documents, however, is the secular rise in the debt-GDP ratio relative to past projections rather than an up-and-down relationship consistent with counter-cyclical policy. Put differently, U.S. debt is on secular upward path and past projections have, if anything, underestimated that increase, regardless of the reason.

How Long Does the United States Have?

Financial markets demand a higher interest rate to purchase government debt as the supply of that debt increases, controlling for other macroeconomic shocks that might simultaneously increase the demand for debt. Forward-looking financial markets should demand an even higher return if they see debt increasing well into the future. Those higher borrowing rates, in turn, make debt grow even faster (“snowball”), potentially producing a downward spiral in the price that the government can sell debt in exchange for a promise of a fixed set of future payments. Modeling this behavior can often become circular, with key drivers such as closure rules lacking transparency.

In this brief, we take a more cautious and transparent approach, leaving presentation of our more sophisticated analyses to future briefs. Toward this end, Table 1 uses the PWBM microsimulation model to project future debt-GDP ratios at different levels of interest rates without explicit debt feedback effects on interest rates.

For the PWBM Baseline rate, we use future interest rates that are currently used by the Social Security Administration (their “medium” cost projection) for estimating future trust fund balances. These real interest rates start at around -1.0 percent today and gradually increase to 2.3 percent by the 10th year where they remain steady thereafter. The rate at the 10th year is currently smaller than the 30-year real interest rate as of October 4, 2023. In contrast, CBO assumes CBO real rate that increases from -0.9 percent today to 1.53 in 10 years and then keeps rising to 2.21 percent by 2053. We present values based on their numbers in the Appendix.

Importantly, in theory, the SSA interest rate projections are not intended to include the impact from historically unprecedented, mounting future government debt itself. Candidly, however, at this point, some arguments about debt and future rates become circular in modeling discussions. However, both authors are experts in SSA estimation methods—with one of the authors currently serving on the Social Security Advisory Board and the other author serving on its most recent technical panel. The larger SSA rate is mostly guided by historical averages rather than forward-looking estimates that incorporate future debt. Indeed, SSA generally does not attempt to incorporate federal debt into its own forecasts even though this debt can erode the size of the payroll tax base that supports benefits. We will return to this topic in another brief.

Table 1 then shows the impact on the debt-GDP ratio if financial markets start to demand a larger return before unraveling, equal to an additional 50 basis points (b.p.), 100 b.p, 150 b.p. and 200 b.p. Even the highest return at 200 b.p. is not far-fetched. However, additional rates closer to 50 to 100 b.p. are more reasonable in the short run, as some borrowing rates are already locked in at a weighted average duration of about 6 years.

Table 1: Projected Federal Debt Held by the Public as a Share of GDP

Table 1 shows that between 2040 and 2045—or in about 20 years—the U.S. debt-GDP ratio will hit between 175 and 200 percent under current fiscal policy, depending on the assumed interest rates.