The power of compound interest


Albert Einstein remarked: “Compound interest is the eighth wonder of the world. Whoever understands it deserves it. The one who doesn’t pay it. With a brief shining moment about two decades ago, the United States seemed to understand compound interest. The government has recorded four consecutive annual budget surpluses, with which it has repaid its debt. With less than estimated debt, interest charges have gone down, reducing that debt and so on. We knew about compound interest and made it our friend. We have earned it.

But the nation then decided it had other, more important priorities. Taxes have been cut and spending has gone up. Debt has increased so interest costs have increased. Year after year, composed, we paid for it. A financial crisis and a pandemic later, the nation is in a very different place from two decades ago. The government has released its outlook for the federal budget. It does not assume any further tax cuts or any further increases in spending.

The budget numbers in these projections go where current forces in economic activity, aging populations, etc. push them. With these projections, even though interest rates are assumed to rise slowly and return only to historical average levels, interest charges on public debt are by far the fastest growing portion of the federal budget.

This year, interest charges on the public debt are less than half of the costs of Medicare, which is the second fastest growing part of the budget. But after 2050, the interest bill will rise so rapidly that it will almost be the other way around, so interest charges will be more than a third higher than Medicare costs. The interest on the expenses will increase to become greater than the expenses themselves. It should not be allowed.

Driven by such a rise in interest charges, which adds to the deficit that must be borrowed, public debt will reach its previous all-time high relative to the size of the economy in less than 10 years. However, over the 30-year forecast horizon, the debt burden will almost double that peak. So the budget will skyrocket because of the higher interest charges, which in turn will increase not because of the higher interest rates, but simply because we have accumulated so much debt that we have to pay these debts on. interests.

Since the main cause of growing debt is the cost of interest, we can’t just cut spending to fix the problem. The other main spending items in the federal budget are social security, health insurance and defense, some or all of those who run for office pledge not to cut. The longer we wait to fix this problem, the worse it will be. A weak economy with a pandemic is not the best time to tackle 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 massive tax hikes on our children and their children. This will leave a nation to deal with any future crises, whether it is due to a pandemic, climate change, or debt-ridden military attacks. This will force both government and business to fight in the financial markets to raise capital. When the government inevitably wins, businesses will be unable to borrow money. This will crowd out government funding for research, education and infrastructure, further slowing the economy. This will threaten a financial crisis once Treasury bond holders start to question whether investments will remain safe.

You don’t have to be Albert Einstein to understand these projections for the budget. Debt stacked on top of debt, creating compound interest costs, is a clear formula for disaster. This nation and its elected leaders must show integrity and strength to face this significant fiscal danger before it is too late and our bright future is shattered.

Joseph Minarik is Senior Vice President and Director of Research on the Conference Board’s Economic Development Committee. He was chief economist in Bill Clinton’s Office of Management and Budget.


Comments are closed.