Accounting for the federal government’s cost of funds

The press routinely reports extraordinarily large government deficits, mainly consisting of interest costs, for countries experiencing high rates of inflation. For example, the New York Times reported that in 1993 Brazil’s government deficit was 30 percent of the country’s gross domestic product (GDP). Most of this deficit was accounted for by interest costs. In the late 1980s, less dramatic but still large government interest costs (around 12 percent of GDP) were reported for Italy. These large ratios are computed by dividing a government’s nominal interest payments by nominal GDP. Financial specialists know such figures to be substantial overstatements because they fail to account for the real capital losses that government creditors experience during high inflation. Every year, an equally flawed ratio is reported in the federal budget of the United States. Figure 1 reports these official interest expenses as a percent of federal outlays over the period 1960 to 1995. The figure displays the well-known 1980s growth in interest payments as a fraction of outlays, a hallmark of Reaganomics. Figure 2 displays our corrected estimates of federal interest expenses as a fraction of federal outlays. Compared with the official numbers, the true figures are much more variable, and lower on average. It is timely to note that section 7 of the recently proposed balanced budget amendment explicitly includes the official interest payments on the federal debt as expenditures. We are not necessarily suggesting that the framers of the amendment are unaware that this measurement is flawed from an purely economic standpoint. The current measure tends to overstate interest payments more the higher the inflation rate is. By including the official measure of interest costs, the amendment’s framers may intend to add incentives to lower both inflation and expenditures. This article describes and defends our corrections to the official series. After showing how to do the accounting correctly, we calculate how the interest costs of the government would have been affected had it used a different debt-management strategy. We simulate the consequences of particular versions of shorts only and longs only debt-management policies, two classic policies that have been advocated.