Higher Rates Won't Cause Debt Spiral

For decades, investors have feared the national debt growing to unsustainable levels and destroying the US economy. Back in 1981, the public debt of the federal government was $1 trillion; today it's more than $21 trillion. At some point, their theory goes, additional debt is going to be the fiscal straw that breaks the camel's back.

The problem with this theory is that, in spite of the record high debt, the net interest on the debt – the cost to government to satisfy interest payment obligations – was only 1.4% of GDP last year, hovering near the lowest levels in the past 50 years.

One reason net interest remains so low relative to GDP is that the government itself owns about $6 trillion of the debt, and this doesn't even include the debt owned by the Federal Reserve. So, the "net debt," also known as the "publicly-held debt," is roughly $15 trillion.

The other reason, of course, is that interest rates have been very low.

So now - the pessimistic theory goes - with interest rates rising, it won't be long before interest costs spike upward, meaning the government will have to borrow just to pay the interest on the debt. They envision a debt spiral like Greece faced a few years back, but with no one big enough to bail us out.

But the pessimists are wrong again, here's why:

Today, the average interest rate on the publicly-held debt is roughly 2%. So, let's say at the close of business on Tuesday the entire yield curve moves up to 4%. And let's also assume that the following morning the Treasury Department rolls over the government's entire debt complex at that new higher rate of 4%, even though the average maturity of the outstanding debt is about six years.

Doubling the interest rate to 4% would mean net interest relative to GDP would double as well, going from 1.4% to 2.8%. That certainly wouldn't be pleasant, but it'd be no different than the average net interest on the national debt from 1981 through 1999. Then, as now, the US government was fully capable of issuing new debt and paying its bills without putting the economy at risk.