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The power of compound interest

Albert Einstein remarked, “Compound interest is the eighth wonder of the world. He who understands it earns it. He who does not pays it.” With one brief shining moment about two decades ago, the United States seemed to understand compound interest. The government ran four consecutive annual budget surpluses, with which it paid down debt. With lower than estimated debt, the interest costs fell, cutting that debt and so forth. We knew compound interest and made it our friend. We earned it.

But the nation then decided that it had other more important priorities. Taxes were cut and spending rose. The debt increased so interest costs increased. Year after year, compounded, we paid it. One financial crisis and one pandemic later, the nation is in a very different place from two decades ago. The government has published its outlook for the federal budget. It assumes no new tax cuts nor new spending hikes.

The budget numbers in these projections run where current forces of economic activity, population aging, and so on push them. With these projections, even though interest rates are assumed to rise slowly and only back to historical average levels, the interest costs for the public debt is by far the fastest growing slice of the federal budget.

This year, the interest costs on the public debt is less than half the costs of Medicare, which is the second fastest growing part of the budget. But after 2050, so swift is the interest bill rising that it will be nearly the other way around, so the interest costs will be more than a third as large as the costs of Medicare. The interest on the spending will increase to become greater than the spending itself. This should not be allowed.

Driven by such rising interest costs, which add to the deficit that must be borrowed, the public debt will reach its previous historical record relative to the size of the economy in less than 10 years. However, by the forecast horizon of 30 years, the debt burden will almost double that peak. So the budget will skyrocket because of higher interest costs, which themselves will rise not because of higher interest rates, but because we simply have piled up so much debt on which we have to pay that interest.

Since the main cause of the growing debt is the interest costs, we cannot just cut spending to solve the problem. The other major spending items in the federal budget are Social Security, Medicare, and defense, some or all of which many who run for office pledge not to cut. The longer we wait to address this, the worse it will be. A weak economy with a pandemic is not the best time to take on this budget deficit, but the best time to deal with this problem is soon. We must prepare for this coming crisis.

If our generation does not pay its bills, it will leave the massive tax raises on our children and their children. It will leave a nation to face any future crisis, whether it is from a pandemic, climate change, or military attacks burdened by debt. It will force both government and business to battle it out in financial markets to raise capital. When the government inevitably wins, firms will be unable to borrow money. It will crowd out government funding of research, education, and infrastructure, further slowing down the economy. It will threaten a financial crisis once treasury bondholders start to wonder whether the investments will remain secure.

You do not have to be Albert Einstein to understand these projections for the budget. Debt piled on top of debt, building compound interest costs, is a clear formula for disaster. This nation and its elected leaders have to summon the integrity and the strength to deal with this significant fiscal danger before it is too late and our bright future is crushed.

Joseph Minarik is the senior vice president and director of research at the Committee for Economic Development of the Conference Board. He was chief economist at the Office of Management and Budget for Bill Clinton.

Tags Business Economics Finance Government Market Policy President Treasury

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