January 23, 2003
Do Budget Deficits Raise Interest Rates?

The Economist publishes an Economics Focus column that says that the answer is "Yes," and that favorably cites Peter Orszag and William Gale's recent survey paper. They could also have cited Doug Elmendorf's and Greg Mankiw's survey paper, or Glenn Hubbard's Money and Banking textbook, or Greg Mankiw's Macroeconomics textbook, or a host of other sources.


Economist.com: ...These results are similar to the numbers built into many macroeconomic forecasting models used by official and private-sector organisations (including the Federal Reserve and the IMF). They all assume that there is a connection between changes in budget deficits and long-term interest rates. On average, they suggest that long-term rates would rise by half a percentage point after one year and a full point after ten years if America's budget deficit rose by 1% of GDP. This paper will not settle the debate in Washington, not least because Mr Gale and Mr Orszag are both prominent Democrats. Indeed, their work has already been dismissed as partisan politicking on the Wall Street Journal's editorial page and elsewhere. That is a pity. The paper may have flaws, but it does attempt to re-examine the evidence and so deserves serious discussion. Unfortunately, in Washington today the argument over whether deficits affect interest rates has more to do with ideology than with economics.


Perhaps the most bizarre thing of all about the Wall Street Journal's editorial page's, about the Bush Administration's, and about their partners in sleaze's claims of "partisanship" is that the idea of an important link between deficits, interest rates, investment, and growth has been the core belief underlying the economic policies advocated by the three most prominent Republican policy-oriented macroeconomists: Martin Feldstein, Michael Boskin, and Alan Greenspan.


Economics focus

The price of profligacy
Jan 23rd 2003
From The Economist print edition


Do bigger budget deficits cause higher interest rates?

MITCH DANIELS, the top budget man in the Bush administration, last week acknowledged what private economists have known for months: that America has “returned to an era of deficits in the nation's public finances”. Only two years ago, Mr Daniels was touting a projected ten-year budget surplus of more than $5 trillion as proof that America could easily afford a big tax cut. Now he expects deficits of between $200 billion and $300 billion (2-3% of GDP) over the next couple of years and modest spills of red ink “for the foreseeable future”. What is more, these deficits exclude both the cost of a war in Iraq and President Bush's planned $670 billion tax cut.

No one disputes that the speed of America's fiscal deterioration has been dramatic. But is it a cause for concern? A fierce political debate is raging. Democrats (and many Republican fiscal hawks) worry that rising budget deficits will harm the economy by reducing total national saving and pushing up interest rates. Just as the shift to budget surpluses in the 1990s helped to reduce interest rates and boost corporate investment, they argue, so the return to deficits will do the reverse.

Nonsense, say the administration and its allies. Mr Daniels claims there is no reason to “hyperventilate” about budget deficits. The vice-president, Dick Cheney, argues that there is no evidence that interest rates move “in lockstep” with deficits. Other conservative commentators dismiss the idea that deficits affect interest rates as “Rubinomics” (after Robert Rubin, Bill Clinton's treasury secretary). The evidence, they claim, has never supported this crackpot idea.


The foundations of Rubinomics

In fact, Rubinomics is well grounded in economic theory. Few economists deny that, other things equal, a higher long-run budget deficit—or a smaller surplus—reduces national saving. This could be avoided only if larger deficits were fully offset by higher saving in the private sector, as households, recognising that deficits today meant higher taxes tomorrow, saved more to make up for the government's profligacy. In practice, there are few signs that savers are so far-sighted.

It is probable, then, that total saving will fall. This implies a higher interest rate as the government competes with firms for limited investment funds. This effect is muted when a country has access to foreign capital, because the budget deficit can be financed from abroad. But even in a global capital market, economic theory suggests that a bigger deficit in a large economy, such as America, would push up global interest rates.

At issue, however, is by how much. The political slanging-match in Washington is not about whether deficits could raise interest rates in theory, but whether they do so significantly in fact. Those sceptical of Rubinomics point out that deficits were tame in the 1970s, while interest rates soared. Interest rates fell in the 1980s, while deficits ballooned. And in the past two years long-term interest rates have fallen as the budget outlook has darkened. These commentators also note that the formal econometric evidence is inconclusive: plenty of studies find a statistical link between interest rates and deficits; plenty find none.

Quite right. It is hard to disentangle the effect of changes in today's budget deficit from other factors affecting interest rates. As well as fiscal policy, monetary policy and the economic weather play a role. During the past couple of years, a weaker economy and looser monetary policy have probably pushed long-term interest rates down, outweighing any impact from bigger deficits. On top of this, it is not enough simply to look at the effect of today's budget deficit (as many studies do). Investors' expectations about future deficits are likely to influence long-term interest rates. So they should also be estimated and taken into account.

According to a new paper* by William Gale and Peter Orszag, two economists at the Brookings Institution, the evidence that deficits affect interest rates becomes clearer once a measure of expected future deficits is included. Mr Gale and Mr Orszag sifted through 58 econometric studies. At first sight the sceptics are right: the evidence is inconclusive. Fewer than half of the studies (28) found that higher deficits increased interest rates significantly. Nineteen studies found no significant effect and 11 had mixed results.

However, Mr Gale and Mr Orszag argue that only 17 of these studies included a careful measure of expected future deficits. No fewer than 12 of these found a significant relationship between deficits and interest rates. The authors conclude that a projected rise in the budget deficit of 1% of GDP raises long-term interest rates by 0.4 to 0.6 percentage points.

These results are similar to the numbers built into many macroeconomic forecasting models used by official and private-sector organisations (including the Federal Reserve and the IMF). They all assume that there is a connection between changes in budget deficits and long-term interest rates. On average, they suggest that long-term rates would rise by half a percentage point after one year and a full point after ten years if America's budget deficit rose by 1% of GDP.

This paper will not settle the debate in Washington, not least because Mr Gale and Mr Orszag are both prominent Democrats. Indeed, their work has already been dismissed as partisan politicking on the Wall Street Journal's editorial page and elsewhere. That is a pity. The paper may have flaws, but it does attempt to re-examine the evidence and so deserves serious discussion. Unfortunately, in Washington today the argument over whether deficits affect interest rates has more to do with ideology than with economics.


* “The Economic Effects of Long-Term Fiscal Discipline



Posted by DeLong at January 23, 2003 01:42 PM | Trackback

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There is no point in trying to logically explain the White House argument. They live in a place called Bushworld, where facts are transitory constructs that are valid only when and if they serve to support Bush's policies. When they try to create a negative term called "Rubinomics", you know they are grasping at straws.... (If there is such a thing as Rubinomics, I'd like a little more of it.) It looks though as if Hubbard is too embarassed to continue spinning within the gravitional pull of Bushworld... At the rate they're going, They will have to appoint Phil Gramm, who will always be able to spout nonsense with a straight face.

Posted by: john on January 23, 2003 02:24 PM

The Economist says:

"Those sceptical of Rubinomics point out that deficits were tame in the 1970s, while interest rates soared. Interest rates fell in the 1980s, while deficits ballooned. And in the past two years long-term interest rates have fallen as the budget outlook has darkened."

1. Inflation was high in the 70's and much lower in the 80's. Is it true that _real_ interest rates fell?

2. Real long term interest rates have risen since January, 2001, not fallen.

Posted by: David Margolies on January 23, 2003 02:25 PM

Any sort of intellectual dishonesty is a virtue in the pursuit of the Friedman "force spending cuts through running deficits" plan.

Posted by: Jason McCullough on January 23, 2003 03:02 PM

If budget deficits don't raise interest rates, does fiscal policy have any impact on interest rates at all?

If the benefits of small government are derived from allowing the allocation of resources to be made efficiently by individuals rather than inefficiently by governments, isn't high government spending as much to be decried as high taxation?

Can the Bush administration then spend as much and tax as little as it likes?

Is the secret to this miracle to be found in George Orwell's 1984?

Posted by: Jack on January 23, 2003 03:30 PM

Ah, but Brad you are missing the bigger picture. The economic problem of the day (according to various people) is deflation. Now deflation is signalled, among other things, by interest rates close to zero---vide Japan. So what the cunning Bushites are doing is pre-emptively forcing up interest rates which will (correlation equals causation, doesn't it?) force inflation up and away from zero.
Just like their cunning plans for Middle East stability and North Korea, it may look foolish from the outside, but you have to trust and believe.

Posted by: Maynard Handley on January 23, 2003 04:13 PM

Mankiw... that's a name you remember, even if you can't pronounce it. I think I used a textbook of his when I was an undergrad. Sure enough, I always thought that deficits raised interest rates.

I also used a gread textbook co-written by Alan Blinder. I don't exactly know why, but I was so pleased to learn that he was part of the Clinton Administration. I figure I'm some special kind of dork for forming personal attachments to authors of textbooks whom I've never met.

Posted by: Terminus on January 23, 2003 05:13 PM

Mankiw... that's a name you remember, even if you can't pronounce it. I think I used a textbook of his when I was an undergrad. Sure enough, I always thought that deficits raised interest rates.

I also used a gread textbook co-written by Alan Blinder. I don't exactly know why, but I was so pleased to learn that he was part of the Clinton Administration. I figure I'm some special kind of dork for forming personal attachments to authors of textbooks whom I've never met.

Posted by: Terminus on January 23, 2003 05:13 PM

I've seen a lot written about how the new (post 1980) Republican economics is not so much about shifting the tax burden to working class poor or rigid adherence to supply side theory way past its utility, but is mostly a way to bankrupt the federal government and force fiscally disciplined moderates (ie. Democrats) to take the lumps for cutting popular programs.

But, what I haven't seen is a discussion about whether their program is also about picking winners and losers. Their oldest constituency, the monied class, with excess wealth to rent out, wins when Federal debt is huge and growing. Their rents (interest rates) go up and one big piece of the economy's debt is like the perfect annuity; tax free treasury bonds guaranteed by the USA. Even better, after they've taken as much of that they want, there's state and municipal bonds, corporate bonds, every type of credit costing more, working harder for them and funneling wage-earnings back their way quicker than usual.

Middle Americans and their advertising deliverers in the US Press hate "Us vs. Them" stories (outside of foreign affairs) so all those "theys" up above are a turn-off. Trouble is, just because you're paranoid doesn't mean it isn't true.

Posted by: Dennis Slough on January 24, 2003 06:24 AM

On the linkage between fiscal deficits and interest rates, I came upon this testimony to the Senate Budget Committee in October 2001, by Kevin Hassett of AEI:

"On the contrary, almost every recent study that has been published on this topic has failed to find any link between moderate increases in deficits and rises in interest rates. As Professor Paul Evans of Ohio State University pointed out in his careful studies of links between deficits and interests in several countries, even the large deficits produced by wartime spending had no discernible effect on long-term interest rates. Other studies published since Evans’ papers on this topic have reached similar conclusions. As Elmendorf and Mankiw conclude: 'this literature has typically supported the Ricardian view that budget deficits have no effect on interest rates.'

"To economists, these facts are not very surprising for several reasons. First, as Harvard’s Robert Barro has pointed out for decades (and as the great classical economist, David Ricardo, was first to note), forward-looking taxpayers should (at least partly) offset government deficits with private savings if they anticipate increases in future taxes to repay the new debt. Perhaps more importantly, when open international capital markets allow countries to draw on each other’s savings, small increases in the amount of one country’s debt will be offset by savings pulled into that country from abroad, leaving interest rates little changed." From: http://www.aei.org/ct/cthass102501.pdf

If so, the implications for the rest of the world are significant. A larger fiscal deficit won't necessarily put upward pressure on interest rates because: "open international capital markets allow countries to draw on each other’s savings, small increases in the amount of one country’s debt will be offset by savings pulled into that country from abroad."

The economic implications are stark. By general consensus, the very rich in America will benefit most and hugely so from the tax cuts but that won't necessarily push up interest rates because the ensuing increase in the fiscal deficit can draw on savings from the rest of the world. But by the standard (neo-classical) growth model of economists that means less investment in the rest of the world and therefore lower output per head and in countries that almost universally have lower output per head than America.

If every American agreed to pay me just one dollar a year I could live very comfortably on that but we can't all get rich that way.

Posted by: Bob Briant on January 24, 2003 06:27 AM

Don't we have to differentiate between short-term and long-term interest rates, with the latter more affected by deficits? 30-yr mortgage rates were much higher in the 80s, peaking at 18% in 81, and averaging 12.5% during Reagan's terms. They did decline, to hover around 10% in '86 - '88.

http://www.freddiemac.com/pmms/pmms30.htm

Posted by: Rich Phillips on January 24, 2003 06:57 AM
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