budget deficits and interest rates

8/9/2019 Budget Deficits and Interest Rates

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Economic Policy institutE 1333 H strEEt, nW suitE 300, East toWEr WasHington, Dc 20005 202.775.8810 WWW.EPi.org

E P I B R I E F I N G PA P E RE c o N o m I c P o l I c y I N s t I t u t E A P R I l 2 6 , 2 0 1 0 B R I E F I N G P A P E R # 2 6 2

Despite the act that the unemployment rate is currently 9.7% and projected to rise throughout much o 2010,

many policy makers remain reluctant to take urther strong action aimed at job creation in the short-term.

Further, many commentators have applauded this reluctance.

Policy makers most commonly cite a concern over the ederal budget decit to justiy their inaction on the jobs

crisis. A previous primer explored the economics and arithmetic o budget decits (Bivens 2010) and addressed a broad

range o arguments made about them. One o the most widespread (and most pedigreed) arguments used to malign

budget decits is the claim that rising decits will lead to rising interest rates that will choke o any incipient recovery.

Decit hawks invoke this specter every time these rates nudge upwards and routinely issue warnings about how todayslow rates can turn on a dime. Tis paper shows how these ears are misplaced. It argues that economic undamentals

are placing great downward, not upward, pressure on interest rates, and consequently, todays low rates will persist right

up until the economy has begun a robust recovery that sharply reduces the current slack in labor and capital markets.

It examines the historical relationships between decits,

savings, and interest rates and reviews the economic theories

behind these relationships. Its key ndings are:

Tere is no evidence that large increases in the ederal

budget decits during recessions or even periods o

slower-than-trend growth are associated with risinginterest rates.

Te mechanisms behind this non-relationship are

clearrising public borrowing during recessions

generally just makes up or allingprivateborrowing,

leaving pressure on interest rates in the markets or

savings and investment roughly unchanged. Further,

private savings rates tend to rise during recessions as

T a b l e o C o n T e n T s

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budget deicits andinterest rates

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EPi BriEfing PaPEr # 2 6 2 aPril 2 6 , 2 0 1 0 PagE 2

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newiue,

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households cut back consumption and businesses cut

back on new investments. Tis, all else equal, increases

the pool o unds available or borrowing and actually

puts downwardpressure on interest rates.

Te correspondence in the current recession between

large increases in the ederal budget decit and his-

torically low interest rates is nota uke or a puzzle.

Indeed, there is no serious reason to expect interest

rates to rise until a robust recovery is underway and

pre-recession unemployment rates are approached.

t m o f , llFigure Aprovides the empirical base or ignoring interest

rate ear-mongering in the current economic environment.

he bars in this igure show new borrowing by the

ederal government since the end o 2006, while the

lines show interest rates on long-term reasuries. As

the gure shows, large recent increases in ederal govern-

ment borrowing have clearly not translated into spiking

interest rates.

Te most important thing to note about this lack o

correspondence is that it is not a puzzle. Tis paper will

explain why.

Te very short version as to why decits are notleading to rising interest rates right now is as ollows:

decits only put upward pressure on interest rates when

there are no idle resources in the economy. Resources

are idled as households and businesses pull back on new

spending and throw the economy into recession. Further,

part o this spending pullback is reduced demand or new

investments, and this translates directly into lowerinterest

0%

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2%

3%

4%

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6%

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$0

$100

$200

$300

$400

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rates as less new borrowing is needed to und investments.

In short, the upward pressure put on interest rates by

increasedpublicborrowing is ully oset (and then some)

by downward pressure on interest rates coming rom

reducedprivateborrowing.

Te very short version o the case against ederalbudget decits that is based on interest rate ears relies on

the assumption that private-sector savings and investment

demands are xed, and consequently as the government

begins borrowing more (i.e., it begins to run budget

decits) it is competing against (xed) private-sector

borrowers or (xed) scarce private savings. Tis competi-

tion bids up the cost o borrowing (i.e., interest rates) and

this rise in borrowing costs leads to less private invest-

ment. Future living standards depend in part on the

size o the capital stock, so less investment today that

leads to a smaller capital stock tomorrow can hamstring

uture growth.

Tis latter story is not implausible, and indeed there

are economic times and places where policy makers should

worry about just these circumstances. However, the United

States in 2010 (as in 2009 and almost surely 2011) is not

such a time and place. odays increased public borrowing

is not happening while private-sector borrowing is xed,

it is instead occurring in the midst o a record reduction in

private-sector borrowing and spending

Te rest o this brieng paper provides more back-

ground on the link between decits and interest rates. Te

irst section is an overview o how interest rates are

determined in the U.S. economy, discussing issues related

to the Federal Reserve and market or debt (or loanable

unds). Te second section examines trends in private

savings and spending in the current recession and outlines

their implications or interest rates. Te third section

examines trends in public borrowing and spending and

outlines how public and private savings have interacted in

the current recession to aect interest rates. It concludes

by arguing that increases in the ederal budget decit

will not push up interest rates or years to come and

certainly not beore a robust recovery is underway and

pre-recession levels o unemployment are approached. As

a robust recovery is achieved, then (and only then) the

budget decit should start being reduced.

t l rv mk o lol Te Federal Reserve (or, the Fed) controls a couple o

crucial interest rates in the economyessentially the rates

that set the price or very short-term (overnight) loans o

reserves rom the Fed to banks. Te common descriptionthat the Fed sets interest rates may give the impression

that the Fed controls all interest rates in the economy. It

does not.

Te interest rates that matter most or the decisions

o businesses and consumers to borrow and spend are

interest rates on debt that is longer-term than overnight

loans rom the Fed, riskier than reserves at the Fed, and

which can be aected greatly by movements in ination.

ake interest rates in the market or corporate debt,

or example. Firms that wish to expand plant and equip-ment purchases may decide to borrow (issue bonds) to

nance this investment. Tese bonds are typically long-

termthey oten have maturity dates quite a bit longer

than overnightthree, ve, or 10 years or even longer.

Further, these bonds are riskymost private corpora-

tions, even the largest, are less insulated rom the risk o

deaulting on debt than the ederal government. Lastly,

holding private debt or a long time leaves the lenders

exposed to the risk that a burst o ination will degrade

the value o these bonds.

Because o this, real (ination-adjusted) interest rates

in the market or long-term and risky debt will be quite a

bit higher than the very short-term rates controlled by the

Fed. Te Feds movement o short-term rates can inuence

these longer-term rates; as the Fed cuts short-term rates

this should create some downward pressure on longer-

term rates, mostly by providing the possibility o nancial

arbitrage on the part o potential lenders. But the real

interest rate or risky, longer-term debt is also largely

determined in active markets, not just through conven-

tional Fed policy.1

How the market or risky, longer-term debt(or, the loanable unds market) worksIn a well-unctioning economy, interest rate adjustments

theoretically allow any given households extra savings to be

seamlessly translated into greater investment spending. Te


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market where savings and investment meet is the market

or loanable unds. Savings (whether provided by domestic

or oreign lenders) constitutes the supply o loanable unds

in the economy while investment spending constitutes

the demand. When savings (supply) exceed investment

(demand), then interest rates (the price o loanable unds)should all.2 Lower interest rates should then spur demand

or new investments. I all o this happens seamlessly, any

pullback in household spending on consumption goods

that makes extra savings possible should not harm the

economy, as the market or loanable unds ensures that

investment spending (responding to lower interest rates)

rises one-or-one to oset the decline in consumer spending.3

Unortunately, theres a hitch in this argument that

makes large pullbacks in consumer spending almost never

seamless or the overall economy: both overall savings

and the demand or new investments (that is, the two

sides o the loanable unds market) depend on national

income. As national income rises, even i the savings rate

remains constant, overall savings rise and provide extra

supply in the loanable unds market. Further, as national

income rises, irms tend to respond by stepping up

investment demand.

o put it more succinctly, many things besides interest

rates determine the level o national savings and invest-mentand these other determinants have been moving

wildly since the recession began. Te next two sections

describe these developments in the demand and supply

side o the loanable unds market in some depth.

Pv v, p, oTe most important thing to note about developments in the

private sector since the recession began is that allo the

determinants o interest rates stemming rom it are actually

pushing them down, not up. Private supply or loanable

unds has increased, while private demandhas collapsed.

i g u r e b

ud r rrwig: Dmd dw, uppy up

souRcE: Bureau of Economic Analysis.

Grop

rivateivetmet,idex2005=100

savigrate,a%o

dipoaleperoalicome

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5%

6%

502005Q

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2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

2008Q3

2009Q1

2008Q3

60

70

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90

100

110

Gr privt ivtmt

Pr vig rt


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SupplyOn the supply side, the bursting o the housing bubble

made tens o millions o households realize that they were

less wealthy than they had previously thought. Tis has

made them begin saving more to both meet long-run wealth

goals (or retirement income or paying or kids college edu-cation, or example) and to take precautions in the ace o a

higher probability that they will become unemployed.

DemandOn the demand side, this rise in savings by both house-

holds and businesses has not translated into a rise in

investment demand.4 Instead, the pullback in consumer

spending led to a large decline in total national incomes

not surprising, as consumer spending is roughly 70% o

the overall U.S. economy. And because the overall state

o the economy is a prime driver o the demand or

new investment, this urther led to a very sharp reduction

in demand or investments and the loanable unds oten

used to nance them.

Figure B illustrates this, charting the rise in the personal

savings rate against the pronounced all in total private

investment. Tis quick examination o the private sector

shows that leaping to the conclusion that interest ratesmust rise when public debt rises is to be guilty o ignoring

what is happening in the private sector, both on the

demand and the supply side o the loanable unds market.

Federal Reserve policyAt the same time and in response to this same all-o

in private demand, the Fed has slashed the short-term

rates it controls to eectively zero over the past three

years (see Figure C).

Yet, even this aggressive action by the Fed has not

been enough to spur investment spending and counter-

balance the pullback in consumer spending caused by

i g u r e c

ectiv dr ud rt

NotE: Shaded areas indicate recessions.

souRcE: Federal Reserve data.

0%

5%

10%

15%

20%

25%

1954 1958 1962 1967 1971 1975 1979 1983 1987 1992 1996 2000 2004 2008


6/13


the bursting housing bubble. And with the interest rate

controlled by the Fed now near zero, they are essentially

out o their conventional ammunition. I, somehow, the

Fed could engineer negative interest rates, this could con-

ceivably spur enough new investment demand to pull the

economy back out o recession. Indeed, researchers at theSan Francisco Federal Reserve had argued that interest rates

o negative 5% to 6% would be needed or interest rate cuts

alone to push the economy back to ull employment.

However, negative nominal interest rates are impossible

people can (and will) always choose to hold their wealth in

the orm o cash (or checking accounts) rather than bonds i

interest rates actually became negative. While zero nominal

interest rates can be associated with negative real interest rates

when there is ination, the last year has seen the longest sus-

tained period o deation in the past 50 years, and driving real

rates down through rapid ination in a recessionary economy

is unlikely unless the Federal Reserve undertakes a radically

dierent course than it has ever pursued beore. It very likely

should undertake this course, but let alone, real interest rates

will not go steeply negative because o expected ination any-

time soon.

Pl v p( f), rovya, Te initial pullback in private spending has now cascaded

into lost jobs and decelerating wage growth, leading to

even urther downward pressure on spending. And even

worse than that, the Feds interest rate cuts traditionally

spur economic activity in part through increased home

sales and home building. Te housing bubble led to

massive over-building in the residential (and to a slightly

lesser extent, the commercial) real estate market, so

ar ewer new housing units or commercial buildings

will be needed anytime soon, making this important

mechanism ineective.o stop this downward cascade o private spending

rom pulling the economy into a depression, the American

Recovery and Reinvestment Act (ARRA) was passed to

ramp up public spending on relie and investments.

It is important to note that the inuence o ARRA on

the decit is actually quite small relative to the purely

mechanical inuence o a slowing economy on the ederal

budget. As incomes and asset prices all and as the labor

market weakens, tax collections all and saety net spending

expands, even absent any policy change. Te rise in the

decit that accompanied the extraordinary all in private

spending over the past year (a rise oten reerred to as the

result, in part, o automatic stabilizers) exceeded $800billion in 2009 alone. ARRA, by contrast, increased the

decit by roughly $180 billion in scal year 2009 and just

under $400 billion in scal 2010.

As the economy alls,decits risethankullyGiven the conventional Beltway wisdom that budget

decits are always and everywhere damaging, it is perhaps

surprising to hear that this large automatic rise in the

budget decit was a very good thing. Surprising or not,

however, it certainly was. Without the rise in the govern-

ment spending and reductions in taxes that led to the

budget decit, American households would have had over

$800 billion subtracted rom their purchasing power.

How important was this stabilization provided by

decit-nanced increases in spending and tax reductions?

Macroeconomic orecasters rom Goldman Sachs, or

example, estimate that the pullback in private spending

that began the current recession was larger (scaled against

the overall economy) than that which characterized the

beginning o the Great Depression. In 1930, however, the

government targeted budget balance as a goal and the initial

shock to private spending was ampliedby reductions

in public spending. In the current recession, the large

increase in the decit accompanying the initial shock to

private spending was instead mufed by a concomitant

rise in public spending.

However, while these automatic stabilizers cushioned

the initial shock to the economy rom the reduction in

private spending, they did not completely neutralize it.

Further public spending and increases in the decit wereneeded and this is why ARRA was passed. It has, so ar,

largely done its advertised job: in the rst three quarters o

implementation (the second, third, and ourth quarters o

2009), ARRA added between 2 and 3 percentage points

to overall GDP and created or saved between 1.5 to 2

million jobs. Over 2009, 2010, and 2011, ARRA will add

roughly $700 billion to the decit.


7/13


i g u r e d

Privt ctr icm cp,

puic ctr tiiz pdig pwr

souRcE: Bureau of Economic Analysis.

billioo$2009

$10,200

$10,400

$10,600

$10,800

$11,000

$11,200

$11,400

$11,600

$11,800

Privae er perna ine:

Perna ine in ne gvernen

ranfer and gvernen wage

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Figure D provides some evidence on how large decits

and public spending, both those arising rom automatic

stabilizers as well as those associated with ARRA, have

mued the initial shock to the economy. Te gure

compares data on personal income minus transers, which

can be thought o as a rough proxy or spending power

generated by the private sector o the economy, and dis-

posable personal income, which includes the eect o taxes

and transers on households purchasing power. Personalincomes minus transers have allen by almost 7% since

the recession began, while disposable personal incomes

have actuallyrisen slightly. Tis stabilization o disposable

personal income kept consumer spending rom alling

even more than the 1% it has declined since the recession

began. In short, looking at Figure D, one realizes that i

consumer spending had tracked personal incomes minus

transersinstead odisposable personal income, that is, i there

had not been large increase in the decit, the economic

contraction would have been much, much greater.

Will large decits causeinterest rates to rise?We should not worry that large decits (resulting either di-

rectly rom the recessions impact on the ederal budget or

rom temporary interventions aimed at ghting recession)will lead to large interest rate spikes and threaten to choke

o the very recovery they were meant to encourage.

While the previous section provided the reasoning or

this sanguine take (recent increases in public-sector bor-

rowing are just mirroring pullbacks in private-sector bor-

rowing), Figure E provides the evidence, tracking budget

decits and interest rates over time. In act, large increases


8/13


i g u r e e

dr udgt dcit d itrt rt gvrmt dt



Iteretrate

DefcitahareoGDP

in the budget decit since 1954 are associated with large

alls in interest rates. It is important to note again that

this is not a puzzle. Large increases in the budget decit

occur exactly when the economy enters recession, hence

the decit rises just as private demand or loanable unds

plummets. Tis is not a coincidenceit is automatic

stabilizers (and sometimes legislated scal policy responses)

in action. he plummeting private spending is also

associated with a decline in private demand or loanable

unds, as rms shelve plans or new plant and equip-ment. Further, as the economy enters recession, the Fed

invariably begins cutting the interest rates that it controls.

Is public borrowing crowdingout corporate nancing?Figure F provides more direct evidence that growing public

demands in the loanable unds market are not crowding

out desired private investments. Tis gure shows the

corporate nancing gapthe dierence between cash

low and investment in ixed assets and inventories. I

investments exceed cash ow internal unds, then rms

will have to go into the loanable unds market to borrow.

For all o 2009, the corporate sector nancing gap

was actuallynegativemeaning that there was, on net, no

need or the corporate sector to venture into the loanable

unds market, as all investment could have been nanced

with internal unds. Tis negative nancing gap is espe-cially striking given the very large recession-induced

decline in corporate cash low. In this context, with

demand or new investments and new borrowing in the

private sector so small that it could be completely nanced

out o rapidly shrinking internal unds, it seems very hard

to make the case that anybody is being crowded out o

private investment opportunities by public borrowing.

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

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-14%

-10%

-6%

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6%

10%

14%

18%

1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

De

1-e

3-e

5-e

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i g u r e

Ch fw d ivtmt dmd i th crprt ctr


Dollar(illio)

How soon do we need to worry aboutrising interest rates?Given this pronounced weakness in private demand or

new borrowing, interest rates will only begin rising i

the economy begins moving briskly back to ull employ-

ment. In a sense, rising interest rates would actually be

evidence that the economy is recovering, not evidence that

incipient recovery is being choked o by proligate

government spending.

In short, we should worry about the impact o decits

on interest rates only atera robust recovery has put idle

resources (labor and capital) back to work. Tis has not

happened yet and is still years rom happening. Te Con-

gressional Budget Ofce (CBO), or example, projects

that a return to the pre-recession (2007) unemployment

rate will occur only in 2014.6 Further, this recession also

saw the capacity utilization rate (the share o the nations

actory capacity that is in use) reach the lowest level since

data on this began being collected in 1967. In short, absent

extraordinarily ast growth in coming years, there will be

idle resources in the economy or quite some time.

Crowding-in more likely than crowding-outCurrently the economy is nowhere near the point where

private activity is being crowded out. Private demand or

loans has plummeted, and idle resources abound. Further,

most economic studies o private investment decisions

actually nd that current GDP growth has a greater im-

pact on investment than interest rates have.7 So, a stimulus

package that adds to GDP will substantially crowd-in

private investment through this so-called accelerator

eect (rising GDP leading to rising investment spending).

Lastly, a robust economic recovery will actually

provide its own moderating pressure on interest rates.

As national income begins growing again, total national

savings will mechanically risetotal national savings is

generally an increasing unction o national income, so

as income rises savings will rise as well. Tis increase in

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4

icig gp

Ivtmt


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i g u r e g

10-yr Trury rt


souRcE: Treasury Department data.

national savings will increase the supply o loanable unds,

which will put downward pressure on interest rates.

Opponents o stimulus will use any uptick in interest

rates to generate ear that decits are threatening to choke

o growth. In the last two weeks o June 2009 there were

numerous stories about rising long-term interest rates and

the role o decits. Te Figure G shows just how odd

those claims werelong-term rates are wobbling up and

down a little, but they have been very low since the all o

2008 and remained so throughout the passage o ARRA.

The eect o the fight to saetySo, what happened in late spring 2009 to nudge up

reasury interest rates? Interest rates on government debt

have many determinants besides the level o the ederal

decit. Te most important determinant over the past

year has been the perceived level o risk o private alterna-

tives to government debt as stores o wealth: the nancial

crisis and widespread threat o bankruptcy in almost all

major nancial institutions made investors around the

world scared o essentiallyall private debt instruments.

Tey ocked to holding government bonds (this is some-

times labeled a ight to saety), driving up the prices

o these bonds and driving down their interest rates to

historical lows. As ears o widespread nancial institution

bankruptcy abate, it is expected that eventually investors

would be willing to exchange public or private debt

instruments, and this would lead to an uptick in interest

rates on public debt. Again, this would not be a problem,rather it would be an indicator o economic recovery

and stabilization.

Similarly, the last two weeks o March 2010 also saw

a slight uptick in long-term rates. Given that these rates

remained ar below the pre-recession levels, it would have

been obviously strange to make much o this. Instead,

many commentators wrote that the large spread between

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1954 1958 1962 1966 1971 1975 1979 1983 1988 1992 1996 2000 2005 2009


11/13


i g u r e h

n ifti xpctti i ight:

10-yr mi d r Trury yid

souRcE: Treasury Department data.

Iteretrate

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

nmi

R

sprd

short- and long-term interest rates were a worrisome sign,

reecting either ears o a deault on government debt or

higher expected ination ears. However, most market

indicators o expected ination (which would surely be a

precursor to wholesale deault) show no such signs. Te

interest rate spread between nominal and inlation-

protected bonds, or example, has not moved at all in the

past ew months (see Figure H). In short, while worries

break out every time the long-term rate wobbles upward,

there remain no signs at all that decit spending is pushing

up interest rates to a degree that is osetting private-sector

pressures that are pushing these rates down.

Are oreign investors providing areprieve rom higher interest rates?It is clearly not true that we need to rely on oreign nancing

o recent budget deicits to keep interest rates rom

rising, though many oten raise this ear when discussing

the decit. Figure I shows that private-sector savings in

the United States rose more than public-sector borrowing

over the past year, meaning that the additions to public

debt o this time could be ully accommodated by domestic

savings. Foreign nancing can indeed be necessary to keep

interest rates low during economic expansions, but it is

not needed to stem upward pressure on rates during reces-

sions and periods o idle resources.8

coloTe connection between persistent low interest rates and

the expanding ederal decit in 2008 and 2009 is oten

presented as both a puzzle and also a uke that is likely to

quickly reverse and imperil any incipient economic recovery.

Both o these scenarios are wrong. Te correspondence

o low interest rates and growing decits is not a puzzle,


12/13


i g u r e i

brrwig y th dr gvrmt d th privt ctr, prct GDP



PercetoGDP

-10%

-5%

0%

5%

10%

15%

20%

dr gvrmt

rather it is ully predicted by mainstream economics. As

long as private demand or new borrowing and spending

is weak, then increased public borrowing will not cause

sustained upward pressure on interest rates. Strong private

demand or spending and borrowing will mark a robust

recovery that sharply reduces the current slack in labor

and capital markets. Only when unemployment rates and

capacity utilization rates are back near pre-recession levels

should policy makers worry about the impact o decits

on interest rates.


13/13


eoNote that the Fed could intervene directly in the market or long-1.term debt by purchasing longer-term assetseven private assets.o a limited degree, the Fed has done this in the current recession.raditionally, however, the Fed restricts itsel to setting the veryshort-term interest rates mentioned above.

Tis assumes that there is not an innitely elastic supply o2. savings available to the economy at a xed interest rate. For alarge country like the United States, this assumption is almostsurely correct.

It is worth noting that3. investingin this regard has a very specicmeaning: building new plants and equipment or building newresidential housing. Buying a share o stock is not investing toan economistits just transerring ownership. Investing is some-thing that increases the physical capital stock o the economy.O course, spending money to augment human capital is also aproductive investment. In the macroeconomic statistical aggre-gates, however, only investments in physical capital are measuredand tracked.

Tis obviously begs the question o just how oten the economy4.is well-behaved. Many economists (including the author othis report) who would sel-identiy as Keynesian would arguethat the economy is very rarely well-behaved absent govern-ment management, at the very least through a Federal Reservethat took economic growth into account when making monetarypolicy decisions.

For more on this, see Irons, Edwards, and urner (2009).5.

Its worth noting as well that the pre-recession unemployment6.rate o 4.9% is by no means as low as unemployment can go. Inthe late 1990s the unemployment rate dipped below 4% withoutsparking any economic overheating.

See Bernanke, Gertler, and Gilchrist (1999); Carpenter, Fazzari,7.and Peterson (1998); and Binswanger (1999) or evidence on this.

O course, it is ar rom clear that oreign nancing that keeps8.interest rates low during economic expansions is a good long-term economic strategy. A orthcoming brieng paper will examinethis issue in some depth.

rBernanke, Ben S., Mark Gertler, and Simon Gilchrist. 1999.Te Financial Accelerator in a Quantitative Business CycleFramework, in Handbook o Macroeconomics, Volume 1C,Handbooks in Economics, vol. 15. Amsterdam: Elsevier, pp.1341-93.

Binswanger, M. 1999. Stock Markets, Speculative Bubbles, andEconomic Growth. Northampton, Mass.: Edward Elgar.

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