How Rising Interest on the National Debt Impacts YOUR Family

The Rising National Debt

You may be saying to yourself, the national debt has been growing for years. What's the big deal now? Big picture - federal spending has always grown, the federal government has nearly always spent more than they bring in, and therefore, the national debt balance has climbed steadily higher year after year.

The big difference now? It's growing faster and costing a lot more. From 2000 to 2019, federal spending grew at 4.9% annually. From 2019 to 2028E, based on the budgetary estimates from the White House Office of Management and Budget, it is projected to grow 1.4x faster, at nearly 7% annually. How will we pay for that?

How the Federal Budget Works

To understand how the growing debt balance and the interest on the national debt impacts your family finances, you first have to understand how the federal budget works: 1) what does our federal government spend its money on, 2) where do they get the money from and 3) what happens when they spend more than they bring in?

First, what does the federal government spend money on? The major buckets include:

• Defense
• Education
• Health provisions under the Affordable Care Act
• Entitlement spending, including Medicare (health care for the elderly, Income Security (unemployment insurance), Social Security (income for the elderly and disabled), and Veteran Benefits
• Physical Resources including Energy, Housing and Transportation
• Net Interest Expense on the National Debt
• Other including International Affairs, Agriculture, General Science, Space and Technology, Justice Department, and General Government

Second, where does the federal government get the money that it spends? The bulk of the funding for the federal government comes directly from your paycheck and your employer in the form of income taxes and social insurance (or FICA taxes).

Finally, what happens when the government spends more than it brings in? When federal spending, or outlays, exceed federal revenue, or receipts, it creates a deficit. Except for the tech boom during the late 1990s and early 2000s, the federal government has operated at a deficit every year for over half a century.

The federal government issues debt to raise cash to cover the deficit, adding to the national debt balance. Every year we run a deficit, adds to the national debt balance, pushing the balance higher and higher.

Pandemic Spending Step Up

In recent years, a couple federal spending issues have become a far starker reality. One, when faced with an emergency, we justify exorbitant spending we might otherwise be more thoughtful about.

From 2019 to 2020, federal spending increased by 47%! While we justified emergency spending measures to support businesses and families during the pandemic, that emergency increase in spending, has never really subsided since.

The step up just became the new baseline for federal spending and drove up annual deficits significantly with it. You can see this clearly comparing the White House OMB deficit forecasts from 2019 vs. 2023. Federal deficits for 2022 and 2023 nearly tripled, and are projected to remain much higher than previously projected going forward.

Mandated Entitlement Spending Now Drives 2/3s of Federal Spending

What actually drives the bulk of Federal spending? Take a look at the percentage-based breakdown of each category relative to total federal spending below. What jumps out at you?

There's a couple categories that now drive 67% of all federal spending, often referred to as entitlements: healthcare, Medicare, Income Security and Social Security.

These are federally legislated benefits that provide economic safety nets to the poor, the elderly, the disabled, and jobless benefits for the unemployed. But they now dominate the federal budget and cannot be cut (or at least cannot be cut without significant legislative challenges).

Meanwhile, Defense spending, relative to total federal spending, and other discretionary spending - items that legislators can choose to change from year to year - continue to shrink, giving Congress very little they can actually do to reduce federal spending.

Interest On National Debt Rising

That brings us to the next big non-discretionary spending category that is now rising dramatically: interest on the national debt. For years, we lived in a falling and low interest rate environment. Increases in the debt balance had little impact on the actual spending every year because interest rates were so low.

But, after the post-pandemic inflation drove the Fed to hike rates, that is changing. Below is a breakdown of the current national debt outstanding by security type. Note the significant step-up in 2020 of shorter-term Treasury Bills and Notes.

Shorter-term debt instruments tend to have lower interest rates, but they also have more variability in rates and need to be refinanced - paid off and replaced with new debt - more frequently. And now, they will be replaced with debt charging higher, current market interest rates.

From 2022 to October 2023, the average interest rate on the national debt has already nearly doubled, from 1.6% to 3.1%. That means, even with no increase in the balance, the net interest expense we would have to pay would double too. And we know, the balance is also rising.

Net interest expense was projected to more than double over the next 5 years in the latest White House OMB projections. And without any other spending concessions, every increase in interest expense drives a direct increase in the deficit. This adds to the debt balance, further increasing future interest expense, which increases the deficit, and so on. It becomes a vicious, never-ending cycle.

Interest Rates Likely to Remain Higher for Longer

Now, some may say, well rates will fall as inflation cools. And while they may, we are also starting to see weaker demand for US Treasuries - the debt securities the federal government issues. How can we tell?

Let's take a look at who holds the national debt. Intergovernmental holdings, or other federal government accounts, like federal pension funds and Social Security, account for roughly 20% on the total debt... that's down from 40% just 20 years ago, which means we rely on independent investors to buy the rest.

Who are those independent investors? Another nearly 20% is now our own Federal Reserve, who we know by their own policy announcements are reducing Treasury holdings.

The largest group holding 30%? Foreign and international governments. The top 3 foreign holders, Japan, China and the UK, account for nearly 1/3 of all foreign holdings.

We also see foreign holders reducing their holdings of US treasuries in recent years. Since 2021, holdings by foreign holders are flat to down, at the same time our national debt is rising rapidly.

In particular, China has significantly reduced its holdings of US treasuries. From pre-pandemic to now, China has cut its holdings of US Treasuries by nearly 30%.

If the Federal Reserve and major foreign holders are reducing their treasury holdings, who will buy our national debt going forward? Remember: existing debt is constantly maturing and must be paid off and replaced with new debt, as well as new debt being issued to fund continual deficit spending.

Recent rating agency downgrades to the US debt outlook and the need to entice independent investors to buy ever-increasing levels of US Treasuries likely requires higher interest rates going forward. I believe we are unlikely to return to the historic all-time low rates we experienced in 2020, and will likely see sustained higher rates going forward.

What Does It Mean for Your Family Finances?

Rising interest on the national debt and non-discretionary entitlement spending that there is little political willpower to change driven the vast majority of federal spending. This leaves little room to cut spending. Therefore, the federal government will likely be forced to raise federal revenues. In other words, raise your taxes.

And there aren't enough millionaires and billionaires to just raise taxes on them and generate sufficient revenues to substantially impact the deficit. It will necessitate raising taxes on everyone. Or having elevated enough growth to naturally increase tax revenues, without the pain of inflation. Some hope developments in AI will provide a 1990s-like productivity boom to help spur growth.

The alternative? Forced cuts to benefits and other sources of government funding, like Education, your family may also rely on now or in the future.

Be prepared. As you think through investing and saving for retirement, plan for higher tax rates in the future. Take advantage of options, like Roth IRAs that tax you today and avoid taxation in the future.