Federal debt in the United States has skyrocketed in the past two decades, especially in the wake of the 2007-2008 financial crisis bailouts and the more recent COVID-19-related emergency spending. When interest rates were at historic lows, some economists argued that such levels of borrowing were sustainable. But since the beginning of 2022, interest rates, and thus the costs of servicing the national debt, have increased sharply. In 2020, interest payments on the national debt totaled about $518 billion. In 2023, they exceeded $1 trillion, surpassing 2024 defense spending to become the biggest part of the national budget.
Along with his co-researchers, Stijn Van Nieuwerburgh, the Earle W. Kazis and Benjamin Schore Professor of Real Estate in the Finance Division at Columbia Business School, undertook an analysis to compare national debt, measured by the market value of outstanding Treasury bonds, with the government’s ability to service that debt, measured by the present value of future fiscal surpluses.
Key Takeaways:
- Governments should borrow only what they can justify based on the present value of their future surpluses –– their fiscal backing.
- When calculating the present value of future surpluses in public finance, analysts and investors should discount for risk, as is done in finance. For government debt, the risk is that future recessions will make it harder to service the national debt.
- The current market value of the Treasury bond portfolio exceeds the risk-adjusted present value of future fiscal surpluses, a gap the researchers call the government debt valuation puzzle.
- Since World War II, and especially since 2007, the United States has issued much more debt than warranted by its fiscal backing.
How the research was done: To determine the present value of future surpluses, the team of researchers took a novel approach, borrowing a concept from the field of finance.
“One of the methodological improvements that we made,” explains Van Nieuwerburgh, “is in exactly how you calculate the present value of future surpluses. In finance, there’s a principle: If the cash flows are risky, discount at a higher rate to recognize their uncertain futures. They need to be worth less today because they’re uncertain in the future. We’re saying that these future surpluses are uncertain and people hadn’t fully understood that.”
Given that cash flows — surpluses — are lower in recessions, there is inherent risk in the Treasury portfolio. To capture this risk, the team used data from 1947 to 2021 and ran a vector autoregressive model to study how surpluses change depending on risk from macroeconomic forces like GDP growth, inflation, and interest rates. The team then compared the measurement of the present value of future surpluses, using both their own risk-adjusted projections and those of the Congressional Budget Office (CBO), to the current market value of government debt.
What the researchers found: The present value of future national surpluses was significantly lower than the current market value for US Treasury debt. The team observed the same discrepancy when it discounted the future surpluses projected by the CBO. This gap, which the researchers termed the government debt valuation puzzle, means that US Treasury debt is substantially overvalued based on realistic projections of the future of the US economy and the country’s ability to pay back and service its debt.
Why it matters: As paying the national debt becomes so much more expensive, the status of the US dollar as a global safe haven is increasingly under threat. Last August, Fitch Ratings downgraded the US Treasury from a AAA to an AA+ rating. In November, Moody’s decided to keep the rating at AAA but changed its outlook from “stable” to “negative.” A loss of foreign investment could cause the dollar to collapse.
The country imperils its own economy by continuing to take on debt disproportionate to its real fiscal backing, explains Van Nieuwerburgh. “If we keep racking up our debt the way we have the last 15 years, at some point, we won’t be able to service the debt anymore. We’ll just be paying the interest. At some point, it will become such a burden, something dramatic will need to happen,” he says. “Policymakers would be wise to heed the lessons of the past.”
Adapted from “The U.S. Public Debt Valuation Puzzle,” by Zhengyang Jiang from the Kellogg School of Management at Northwestern University, Hanno Lustig from the Stanford Graduate School of Business, Stijn Van Nieuwerburgh from Columbia Business School, and Mindy Z. Xiaolan from the University of Texas at Austin.
