The National Debt Can Crowd Out Investments in the Economy — Here’s How
Last Updated August 22, 2024
The federal government is slated to borrow about $1.9 trillion in 2024, and that annual shortfall is projected to grow to $2.9 trillion by 2034. One consequence of issuing such large amounts of federal debt is that it could “crowd out” investments by the private sector, making the economy less productive and stunting wage growth.
How Does Federal Borrowing Affect Private Investment in the Economy?
To cover its budgetary shortfalls, the federal government raises money by issuing debt in the form of Treasury securities. That debt is commonly purchased by investors such as banks, investment funds, businesses, and individuals because it is generally considered a safe investment. However, the cash used to purchase such debt could alternatively be used for investment by private entities. Therefore, as government borrowing increases, fewer resources are available for other investments, which can hamper economic activity.
Furthermore, increased federal borrowing puts upward pressure on interest rates. A Congressional Budget Office (CBO) study found that each percentage point increase in the debt-to-GDP ratio boosts inflation-adjusted 10-year interest rates by 2 to 3 basis points (.02 to .03 percentage points). The debt-to-GDP ratio is currently at 97 percent, and CBO projects that it will climb to 122 percent in the next decade, so by CBO’s measure, interest rates would be approximately 0.50 to 0.75 percentage points higher than they otherwise would be due to the country’s rising debt.
Higher interest rates raise the price of borrowing, thereby deterring private investment. According to CBO estimation, the net result of this trade-off is that for every dollar the federal deficit increases, private investment would fall by 33 cents.
Why Does More Debt Matter for the Economy?
Increased debt could hold back economic growth and diminish wages. Since 2019, the debt-to-GDP ratio has risen 18 percentage points, from 79 percent to 97 percent. CBO projects that the ratio will continue to grow, rising to 166 percent by 2054 if current laws generally remain the same. Under a scenario where discretionary spending remained around its current level (rather than declining), and revenues revert to their 50-year average (rather than rising), CBO projects that the debt-to-GDP ratio would increase to 249 percent; that trajectory would lower gross national product by 7.2 percent relative to the baseline and reduce income by $8,300 per person (in 2023 dollars).
Conclusion
There is a direct and critically important linkage between the country’s fiscal condition and economic outlook through the effect on private investment and interest rates. The federal government has the ability to tax and spend equitably, promoting growth across the economy and investing in national priorities. But it also must take care to do it effectively and responsibly, making sure not to restrain investment, which would hinder opportunity and prosperity for future generations.
Photo by Jemal Countess/Getty Images
Further Reading
The Fed Reduced Short-Term Rates, but Interest Costs Remain High
Higher short- and long-term Treasury rates mean that the federal government’s borrowing costs will also rise.
What is Inflation and Why Does it Matter?
Here’s an overview of inflation, why it matters, and how it’s managed.
Higher Interest Rates Could Cause the National Debt to Skyrocket
Interest rates on U.S. Treasury securities have a significant influence on federal borrowing costs.