What Happens to the National Debt When Interest Rates Surge?

The country has racked up a lot of debt (maybe you've heard). But, thankfully, interest rates are at all-time lows. That's saved you, the taxpayer, a bundle. Even though the national debt has tripled in the last 18 years, the amount the government spends annually on interest payments has declined from $232 billion in 1995 to $222 billion today.

But what happens when interest rates rise?

What if they rise a lot?

What will that do to budget deficits?

The common answer is, with a $16 trillion national debt, rising interest rates will blow a hole in the budget deficit. This seems unshakably, arithmetically, true. And it probably is. I've written a warning about it several times.

But there's another side to the story I've been thinking about, and it quiets the doom-and-gloom narrative down quickly.

The nation's finances have been here before. Worse, even. In 1946, just after World War II, public debt stood at 109% of GDP, compared with 77% today. And short-term interest rates hovered around 0%, just as they do today.

But from 1945 to 1980, interest rates surged from 0% to more than 11%. This is exactly what we fear happening today.

What did this rate spike do to the country's interest-payment bill? From start to finish, basically nothing:

Source: Office of Management And Budget, Federal Reserve, Bureau of Economic Analysis.

Put this all together, because it's important:

  • National debt was much higher in 1945 than it is now (in relation to the size of the economy).

  • From 1945 to 1980, interest rates rose from 0% to 11%.

  • This did virtually nothing to the real cost of paying interest on the national debt.

How can this be?

It's simple: We grew the economy faster than interest rates rose.

The government ran a deficit in 28 of the 35 years between 1945 and 1980, and national debt rose from $235 billion to $711 billion. But during that period, GDP (the size of the economy) increased from $227 billion to $2.9 trillion. So while the national debt a little more than doubled, the size of the economy increased more than tenfold.

Just as Bill Gates can afford a larger mortgage than I can, the richer a country becomes, the more debt it can handle. And the country became so rich from 1945 to 1980 that it could easily afford to more than double the national debt -- even with interest rates rising from 0% to 11%.

That's not a forecast of what might happen over the next 35 years. A lot of stars aligned to make the post-WWII period an economic miracle: We had a baby boom, a manufacturing advantage as Japan and Europe were left in rubble, and the banking system kept its act together. Plus uncomfortably high inflation to boot, which pushed up GDP.

But the important point is that rising interest aren't necessarily disastrous, even for a country with a massive debt. What matters most is that a country can grow its economy as fast, or hopefully a little faster, than its debt is piling up. With recent budget improvements, we're quite close to doing that already.

Einstein once talked about making things as simple as possible, but no simpler. When we assume rising interest rates will devastate budget deficits, we're thinking about things in terms that are too simple. Rising interest rates are often a signal of stronger economic growth, which is the best medicine a country with a lot of debt can receive.

For more on the national debt, check out my report, "Everything You Need to Know About the National Debt." It walks you through with step-by-step explanations about how the government spends your money, where it gets tax revenue from, the future of spending, and what a $16 trillion debt means for our future. Click here to read it.

The article What Happens to the National Debt When Interest Rates Surge? originally appeared on Fool.com.

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