Brian Motley

English

Research Papers in Economics

November4, 1983
Deficits and interest rates
The fundamental observation leading to this
conclusion is simply that, whatever its
source, an increased actual deficit mustbe
financed. The public must be induced to
invest a larger proportion of its wealth in
government securities. That is, the Treasury
must "crowd out" the competing private
sector claims on the available supply of
In the case ofa policy-induced increase in
the deficit, the high-employmentdeficit
rises along with the actual deficit. By con-
trast, in the case ofan endogenous increase,
only the actual deficit rises and the high-
employment deficit is unchanged. Thus, the
argument that only policy-induced changes
in the deficitaffect interest rates implies that
rates are influenced by changes in the high-
employment deficit rather than the actual
deficit. I will, however, argue the contrary:
that interest rates are only indirectly related
to the high-employment deficit but are
directly affected by the actual deficit.
One widely used summary indicator offis-
cal policy is the high-employment deficit,
which measures howlarge thedeficitwould
beiftheeconomywereat full employement.
The high-employment deficit is thought to
be a better indicatoroffiscal policy than
the actual deficitbecause itvaries only in
response to changes in policy, whereas the
actual deficit responds to the state ofthe
economy as well as to policy changes. Pol-
icy changes that add to the high-employ-
mentdeficit are thoughtto be expansionary
whiIe those that reduce itare contractionary.
either reduces tax revenues or adds to ex-
penditures (such as unemployment com-
pensation payments) with no change in
policy. Marketcommentators often fail to
distinguish these two sources ofdeficits,
while many economists argue that only
policy-induced increases in the deficit have
any significant influence on interest rates.
It is widely argued that these high levels of
real interest rates are connected in some
way with the emergence oflarge federal
government deficits and, hence, that these
deficits pose athreattothe growthofthe real
economy in either the short or the long run.
This Letter seeks to clarify these issues by
examininghow, in principle, federal deficits
might be expected first, to raise real interest
rates on securities, and second, to slow the
growth ofreal GNP.
Sources of deficits
A deficit in the federal budgetoccurs when
federal outlays over any period exceed
revenues from taxation. Ifthis happens, the
difference must be made up by Treasury
borrowing, that is, by selling Treasury
securitieseitherto the non-bankpublicorto
the banking system including the Federal
Reserve. To limitthe range ofissues to be
discussed, I will assume throughout this
Letter that monetary policy-in the sense
ofthe rate ofgrowth ofthe stock ofmoney-
is constant. This implies that all Treasury
borrowing to finance adeficitcomes from
the non-bank public, and none from the
central bank.
The deficit may increase as the result either
ofan exogenous change in fiscal policy-a
loweringoftax rates or an expansion of
expenditure programs, or ofan endogenous
deterioration in business conditions, which
It is by now a commonplace that interest
rates in the UnitedStates haverisen in recent
years to levelsthat are very high by historical
standards. Nominal interest rates consist of
both a real rate of return and an inflation
premium, and most economists believe that
it is the real rate that is above its historical
norm. At least atthe shortend ofthe maturity
spectrum, the fact that nominal market
yields remain high despite the recent
decline in inflation is supportingevidence
fortheir belief.
Deficits, Interest Rates and the Economy
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savings. This crowding out requires that
interest rates be higherthan they would be
ifthe level ofGNP were the same but there
were no deficit. Only at higher interest rates
can private borrowers be induced to reduce
theirclaims on the supplyofsavings in order
that the claims ofthe Treasury can be satis-
fied. In this sense, a larger government
deficit implies a higher real interest rate.
In arecent Weekly Letter, Kevin Hooverand
Joseph Bisignano pointed out that this argu-
mentthatdeficits raise interest rates will not
hold ifmembers ofthe public fully recog-
nize that the issue ofgovernment securities
today implies higher taxes to pay interest
and principal in the future. In such a case,
a switch from tax to deficitfinancing should
lead households to save and lend an exactly
offsetting amount and so should have no
effect on interest rates. But most economists
-including David Ricardo, the first expo-
nent ofthis theoretical argument-believe
thatitassumes agreater degreeofrationality
and farsightedness than most households
possess.
Ifan increased deficitresults from the
adoption ofa more expansionary fiscal
policy-so that both the actual and the high
employmentdeficits rise-its financing
effect on interest rates will be supplemented
by an income effect. Except in the Ricardian
case ofperfectly rational and farsighted
individuals, apolicy-induced increase in the
deficit tends to stimulate more rapid growth
of nominal GNP. Faster income growth
tends to increase the quantity ofmoney the
public needs to hold to carryon transac-
tions. With a given money growth rate, this
tends to push upinterest rates. Faster growth
may also raise interest rates by causing
businesses to become more optimistic and,
therefore, more willing to borrow to finance
such projects. In somewhat differentterms,
faster income growth raises the demand for
both short- and long-term credit and so
tends to raise interest rates.
In contrast, ifa larger deficit reflects a busi-
ness downturn, the accompanying income
2
effect on interest rates will be downward.
A lower level ofnorninal GNPwill both
decrease the demand for money and reduce
the expected rate ofreturn on capital proj-
ects. The private demand for credit will fall
and, as a result, the Treasury's demand for
funds will face less competition from the
private sector. Although interestrates will be
higher than they would be ifthere were no
deficit, they will rise less because less
"crowding out" ofprivate borrowers will
be required. This argument is, presumably,
the basis for the view that non-policy
changes in the federal deficithave little
effect on interest rates.
However, it is misleading to conclude from
these arguments thatonly policy-induced
deficits have an effecton high interest rates.
The volume ofgovernment borrowing is not
the sale determinantofinterest rates: the
level ofGNP isalso relevant because it
affects the credit demands ofthe private
sector. Ifan actual deficitcoincides with a
rise in nominal income, interest rates will
rise more than ifthe deficit accompanies a
decline in income. But at any given level of
nominal income, a larger actualdeficitwill
be associated with higher interest rates. It
is notthe high-employment deficit but the
actual deficit which must be financed! The
highemploymentdeficitonlyaffects interest
rates via its influenceon the level ofincome.
It is because an increase in thehigh employ-
mentdeficittends to raise GNPthat it is
associated with rising interest rates, not
because there is adirectcausal linkbetween
fiscal policychanges and interest rates.
Deficits and the real economy
Over the next few years, the Treasury deficit
is expected to decline as nominal GNP rises
and the U.S. economy approaches full
employment. But even at full capacity
output, asubstantial deficit is expected
to remain (see accompanying chart). As a
result, real interest rates will be higher than
they would be ifthe level ofincomewerethe
same butthe deficit were smaller. These
high rates represent the inducement whichPm'"' 01 GNP
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Brian Motley
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Conclusion
These arguments suggest that as long as
there is substantial excess capacity ofplant
and equipment and widespread unemploy-
mentoflabor, the effectofhigh interest rates
on the pace ofthe recovery will be less than
the impactof the fiscal changes required to
eliminatethe deficit. However, this does not
mean that the deficit has no ill-effects.
Financinggovernmentoutlays byborrowing
rather than by taxes has both short- and
long-run repercussions. The long-run effect
is that future generations are impoverished
in the sense that they will inherit asmaller
amountofproductive capital. The short-run
effect is that as we approach full employ-
ment itwill become more difficultto main-
tain the cyclical expansion because the
economy has undertaken too little job-
creating capital formation.
it is reasonable to suppose that additional
government outlays financed by taxes are
made principally at the expense ofpersonal
consumption. Most economists believe that
the impactofbond-financed outlays falls
more heavilyon capital investment because
it is more sensitive to interest rate changes
than is personal consumption. Thus, a fiscal
policy in which asignificant proportion of
governmentoutlays isfinanced by borrow-
ing-that is, one in which there is a signif-
icant federal deficit-is likely to result in
moreofthe nation'sresources beingapplied
to current consumption and less to private
capital formation. Hence, future generations
-includingourselves when we growolder
-will inherit a smaller stock ofplant and
equipmentand so be able to produce less
output. This is atrue "burdenofdebt"which
the present generation imposes on its heirs
when it chooses to run a budget deficit.
3
Unllied Budgel
Delicit
6% Unemployment .'
Deficit "')/\.
....
Federal Deficits as a Percent of Gross National Product
However, deficitsdonotaffectthe economy
only through the demand for goods and
services. They also influence the capacity of
the economy to supply output. This influ-
ence seems likely to be long-term rather'
than cyclical in nature.
Taxes fall predominantly on households.
In 1982, outoftotal federal government
receipts of$614 billion, no less than $520
billion consisted ofpersonal income taxes
and social insurance contributions. Thus,
Ifthe "businesscycle" argument is meantto
imply that high interest rates will so reduce
aggregate demand thattheeconomywiII fall
back into recession, it is probably wrong.
High rates do, ofcourse, reduce private
demand. But, as pointed outabove, they are
largely asymptom ofthe Treasury's efforts to
divert resources from the private sector to
itself through the financial markets. Thus,
they are an indicatorofthe current strength
oftotal demand ratherthan asignal offuture
weakness. Moreover, a cutting-back ofgov-
ernmentoutlays, or an increase in taxes, in
order to lower the deficitwould surely have
a greater depressing effect on aggregate
demand than an equal amount ofTreasury
borrowing. At least as far as aggregate
demand is concerned, the effects ofcurrent
and prospective Treasury deficits are prob-
ably less contractionary than those ofthe
fiscal policy changes that wouId be needed
to eliminate them.
the Treasury mustofferto lay its hands on the
nation's resources by borrowing rather than
by levying taxes. Rates would be lower if
these government claims (that is, expendi-
tures) on real resources were reduced or if
they were exercised through the tax system
rather than the financial markets.
It is often suggested that high interest rates
will either cause the present cyclical recov-
ery to end prematurely or to lowerthe long-
term growthofthe economy. Thisreasoning
leads to the policy prescription that fiscal
action be taken to narrow the deficit.
-1
-2 .
1960 1962 19641 1966 1968 1970 1972 1914 1976 1978 1980 1982 1984 1986
Source: Congressional Budget Office
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
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Selected Assets and Liabilities
largeCommercial Banks
Amount
Outstanding
10/19/83
Change
from
10/12/83
Change from
year ago
Dollar Percent
loans-{gross, adjusted) and lnvestments* 162.025 - 194 1,242 0.8
loans (gross, adjusted) - total# 141,998 - 219 701 - 05
Commercial and industrial 42,970 - 90 - 2,848 - 6.2
Real estate 57,317 151 - 82 - 0.1
Loans to individuals 24,830 - 63 1,419 6.1
Securities loans 2,489 - 431 - 76 - 2.9
U.S. Treasury securities* 7,485 21 884 13.4
Other securities* 12,541 4 - 1,425 - 10.2
Demand deposits - total# 41,556 -2,498 1,936 4.9
Demand deposits - adjusted 29.546 -1,618 1,624 5.8
Savings deposits - totaH 66,186 - 382 34,203 106.9
Time deposits - total# 67,949 582 - 33,303 - 32.9
Individuals, part. & corp. 62,297 447 - 28,761 - 31.6
(Large negotiableCD's) 16,981 - 43 - 21,329 - 55.7
Weekly Averages
of Daily Figures
Member Bank Reserve Position
Excess Reserves (+l/Defjciency (-)
Borrowings
Net free reserves (+l/Net borrowed(- 1
Weekended
10/19/83
24
o
24
Weekended
10/12/83
73
24
48
Comparable
year-ago period
90
1
89
* Excludes tradmg account secuntJes.
# Includes items not shown separately.
t Includes MoneyMarket Deposit Accounts; SuperMNOW accounts, and NOWaccounts.
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Phone(415) 974-2246.

Deficits, interest rates and the economy

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Deficits, interest rates and the economy

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