There is little debate among economists that when the government borrows to finance a deficit, interest rates rise and private investment declines.
It ain’t fair. Astronomers don’t get letters arguing that the sun really does revolve around the Earth. Biologists are not told that the West Wind really does impregnate mares. But if an economist states some simple fact, a member of the Flat Earth Society immediately will insist that it ain’t so.
Two weeks ago, in a column on Sen. John Kerry’s and President Bush’s relative economic programs, I noted that budget deficits tend to raise interest rates. This is not controversial among economists; it is a generally accepted fact.
The next morning I got an e-mail arguing, “You are off base when you talk about the relationship of deficits and interest rates. Rates are at historical lows yet the deficit has risen in the last four years. … Your theory does not hold up.”
Perhaps I should be flattered someone thinks a widely held belief among economists is “my” theory. Even so, the reader’s belief that government borrowing does not increase interest rates merits a serious answer.
Interest rates are a price. The price of soybeans is dollars per bushel, the price of hamburger is dollars per pound and the price of money is the percent of interest per year. As for soybeans or other goods, any decrease in supply or increase in demand drives up the price, all other things being equal. This is in week two of any introductory microeconomics course.
There is little debate among economists that this also holds true for money. It is no more an issue of liberal vs. conservative or Republican vs. Democrat than is the question of whether the sun rises in the east or west.
That explains why virtually all college texts for macroeconomics or money and banking courses assert that budget deficits raise interest rates and drive out private investment.
The phrasing in one popular textbook is typical: “When the government spends more than it receives in tax revenues, the resulting budget deficit lowers national saving. The supply of loanable funds decreases and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms who would otherwise borrow to finance investments.”
That particular explanation is taken from N. Gregory Mankiw’s “Principles of Economics,” but I found virtually identical assertions in 11 other similar texts on my shelf.
Informed readers will recognize Mankiw as the chairman of the President’s Council of Economic Advisers. He now supports the Bush administration’s position that deficits are not harmful to the economy, something very different from what he said in his well-accepted textbook. Yet his textbook argument cited above is essentially the same one in virtually every other mainstream text.
Economies are complicated, and economists always qualify their assertions of cause and effect with the “all other things being equal” caveat. Might other factors override economists’ general consensus that budget deficits do increase interest rates?
Mankiw, who was then at Harvard, and Lawrence Ball from Johns Hopkins wrote a thoughtful paper, “What do Budget Deficits Do?” for the Kansas City Fed’s 1995 symposium at Jackson Hole, Wyo. (The paper is available at www.kc.frb.org/PUBLICAT/SYMPOS/1995/pdf/s95manki.pdf.)
They essentially repeated what Mankiw and others say in textbooks, but they examined all effects of deficits — not only on interest rates but also on exchange rates, national savings and private sector investment. In their concluding paragraph, they describe budget deficits’ crowding out other investments as “well-understood and quantifiable.” This is just another way of saying that deficits raise interest rates.
The reader who objected to “my” theory that deficits tend to increase interest rates noted that deficits have risen for four years and rates remain low. Yes, rates are low because the Federal Reserve increased the money supply to push short-term rates to unprecedented low levels. But this monetary expansion cannot be sustained much longer. Indeed, history may well show that the Fed’s 2001-2004 lowering of rates harmed the economy in ways we don’t understand yet.
Rates also are low because Asian central banks are buying up virtually all of the bonds the U.S. Treasury is issuing to finance deficit spending. Again, this is unsustainable in all but the short run. When Japan, Korea and China stop buying U.S. debt, interest rates will rise.
Finally, the writer asserted that the Reagan era demonstrated high deficits don’t raise rates. That dog won’t hunt. Real mortgage interest rates — adjusted for inflation — were higher under Ronald Reagan than during the term of any other U.S. president and were more than two percentage points higher than under Bill Clinton and more than six points higher than during the high-inflation terms of Gerald Ford and Jimmy Carter.
Government deficit spending generally does raise interest rates
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.