A recent article in Bloomberg discusses the outlook for the federal deficit and potential repercussions with respect to interest rates.

The article reports that the Congressional Budget Office’s release of projections late last month reflected a scenario of “steadily rising deficits,” attributable to the following:

• Growth in government health care spending due to the aging of the population and also because of higher medical costs.
• A rise in interest rates that will force the government to “spend much more on simply paying interest on its debt. The federal government now pays an average of 2.4% to borrow; in three decades, the DBO predicts that this will rise to 4.2%.”

This will lead to an exponential increase in the government’s debt service burden:

The article presents the following scenarios:

1. If the government attempts to reduce the deficit by raising taxes, it could slow the economy.
2. If, on the other hand, the government chooses to allow the deficit to grow, it will be forced to increase its borrowing to cover the higher interest payment demands, and “both borrowing and interest costs will snowball. “

The latter scenario, it says, “could provoke what the CBO calls a fiscal crisis—a private investor panic about the government’s ability to repay its debt, causing a drop in bond prices that render financial institutions insolvent and leading to an economic crisis.” The best way to avoid this, the article says, it for the Fed to slash interest rates to zero and “keep them there. As the government replaces its old, higher-interest debt with new, lower-interest debt, its yearly interest payments would go down, until finally they dwindle to nothing at all.” This, it says, would stabilize the deficit and possibly even allow for new spending initiatives.

The article illustrates how such a strategy, known to economists as fiscal dominance, has been used in Japan for years, but notes that it might not work in the U.S. since investors here “could be more inclined to abandon the country for greener pastures if rates stayed too low for too long.” It also notes that zero interest rates could lead to risky levels of inflation.