Inflation (Finance) ; Crowding out (Economics) ; Budget deficits ; Labor productivity

Adrian W. Throop

English

Research Papers in Economics

March 14, 1980 
Inflation  remiums, Budget  eficits 
Productivity growth in the United States has 
been on a declining trend for some time. 
During the first twenty years after World War 
II, output per man-hour in the private non-
farm business sector rose at an average 
annual rate of just under 2%  percent. But 
from 1965 to 1973 the increase was only 
1  V2  percent, and from 1973 to 1979 it was 
less than 1 percent a year. (Indeed, in 1979 
productivity actually turned negative.) 
Weakened productivity performance has 
stunted growth in real income and con-
tributed to inflation by reducing the supply of 
goods relative to the stock of money. 
According to one popular explanation, 
governmental borrowing has helped create 
this poor productivity performance by 
"crowding out" private capital formation. 
The Federal government has run relatively 
large budgetary deficits over the last decade. 
These deficits must be financed by 
borrowing, which absorbs saving that could 
otherwise have financed the accumulation of 
capital and contributed to productivity 
growth in the private sector. Thus, the 
argument goes, excessively large deficits of 
the Federal government have "crowded out" 
private capital formation by bidding away 
loanable funds from business borrowers. 
There is nothing wrong with the argument in 
theory. The only question is whether it is 
consistent with the actual facts. Superficially 
it appears to be. In the 1950's and early 
1960's, Federal budget deficits in some years 
tended to be offset by surpluses in others, 
providing an overall balance. But in 1965-73 
the Government averaged a deficit equal to 
0.7 percent of  the gross national product; and 
in 1973-79 the average deficit jumped to 
1.7 percent of GNP. The facts appear 
obvious, butthere is a problem in interpreting 
them because inflation distorts our measure-
ment of  the deficit's net absorption of saving. 
. Cause of distortion 
The distortion arises from the existence of 
inflation premiums in interest rates. It is well 
known that nominal interest rates reflect 
1) a real component that is independent of 
the rate of inflation, and 2)  an inflation 
component that incorporates both bor-
rowers' and lenders' expectations of inflation. 
The higher the expected rate of inflation, the 
higher the rate of interest that borrowers are 
willing to pay and that lenders require to 
protect the purchasing power of their 
sacrifice in current consumption. Inflation 
premiums can distort the deficit, because 
a substantial portion of  Government expend i-
tures represents payments of interest on the 
national debt, and also because the largest 
part of these payments currently consists of 
inflation premiums. 
The usual measurement of the deficit over-
states the Government's net absorption of 
savi ng, because borrowi  ng for the payment of 
inflation premiums is self-financing. Inflation 
premiums constitute income to the holders of 
Government debt, all of  which must be saved -
if they are to maintain the real value of their 
wealth. Since this added saving is returned to 
the capital markets, Government borrowing 
to pay for inflation premiums is self-financing 
and therefore does not bid away loanable 
funds from private borrowers. Consequently, 
to the extent that deficits are generated by 
borrowing to pay inflation premiums to the 
holders of Government debt, there is no 
crowding out. 
An example will illustrate this point. When 
there is no expectation of inflation and the 
Government budget is balanced, all private 
saving flows into private capital investment; 
and there is no crowding out. Compare that 
with a situation in which all behavior is the 
same in real terms-except that a 10-percent 
rate of inflation is expected, and nominal 
interest rates are therefore 10 percent higher. 
Households now receive larger money 
incomes because of the payment of inflation 
premiums to them by the Government, and by business borrowers as well. Most 
importantly, as rational individuals they must 
save all of the increment to their incomes 
from the inflation premiums in order to 
maintain the same level of  real wealth as they 
would have done in a non-inflationary 
environment. Thus, on the supply side of the 
capital market, household incomes and the 
resultant savings made available to the 
market are increased by the size of  the 
inflation premiums paid by Government. 
On the demand side, if real taxes and 
expend itu res are to be the same as before, the 
Government must borrow in order to pay the 
inflation premiums on its debt. But this does 
not put any net pressure on the capital market 
because households are making available to 
the market an exactly equal increment of 
saving out of  their higher incomes. So on 
balance, the borrowing of  the Government 
does not bid away loanable funds from 
private borrowers or cause any actual 
crowding out of private capital formation. 
Moreover, even though the Government 
budget is still balanced in real terms, as 
traditionally measured it shows a deficit 
equal to the inflation premiums paid. 
How large a distortion? 
The distortion in budget figures caused by 
inflation premiums can be quantified in the 
following way. Since the average maturity of 
the Federal debt is only two to three years, 
inflation premiums are reflected in nominal 
interest rates within a year or so. If we use the 
previous year's increase in consumer prices 
as a measure of expected inflation, and 
multiply that measure by the size of the debt, 
we can arrive at the total amount of inflation 
premiums paid on Federal debt in anyone 
year. To obtain a consistent measure of the 
degree to which the Federal budget absorbs 
. private savings-or the extent of crowding 
out-we then deduct total inflation 
premiums from budget deficits (or add them 
to surpluses). 
In the early 1960's when inflation was low, 
inflation premiums were trivial; and the 
2 
Federal budget was roughly balanced, with 
or without adjustment for such premiums. 
However, by the late 1960's and 1970's the 
adjustment made a significant difference (see 
chart). The Federal budget, as traditionally 
rneasured, moved into an average deficit 
equal to 0.7 percent of GNP in 1965-73 and 
1.7 percent in 1973-79. But with the 
subtraction of inflation premiums from the 
deficit, the Federal budget actually averaged 
surpluses equal to 0.5 percent of GNP in 
1965-73 and 0.3 percent in 1973-79-about 
the same as the average surplus in the early 
1960'  s.  Rather than bei ng a net absorber of 
funds, the Federal government has continued 
to be a modest net su ppl ier, when adjustment 
for the effect of the payment of inflation 
premiums on private savings is made. 
Borrowi ng by state and local governments 
can also cause crowding out, and their 
budgets should similarly be adjusted for the 
amount of inflation premiums paid to 
lenders. Combined state and local budgets, 
which tended to be nearly in balance in the 
1960's, moved strol!gly it}to surplus during 
the 1970's. With rising inflation, larger infla-
tion premiums were paid to holders of state 
and local debt. The payment of  such inflation 
premiums reduced their measured surpluses. 
Butthe reduction in the amount offunds they 
supplied to capital markets was offset by the 
added income received by holders of their 
debt, and hence, by the extra saving under-
taken by debt holders. Consequently, 
traditional measures of state-local surpluses 
understated the extent to which this sector 
became a net supplier of funds to capital 
markets. 
Crowding out-no explanation 
Overall, the crowding-outargumentdoes not 
appear to be a satisfactory explanation of the 
recent weakening in productivity growth. 
Neither has the drop in the aggregate saving 
rate been large enough to limit private capital 
formation. To be sure, the rate of personal 
saving (which is overstated due to inflation 
premiums) has lately been trending down, 
reaching a record low of 3.3  percent in the final quarter of 1979. Still, the growing 
surpluses of  state and local governments have 
served as an effective offset. With the 
aggregate saving rate relatively stable, the 
ratio of total investment in plant and 
equipmentto GNP, not surprisingly, has held 
fairly steady at the historical figure of about 
10 percent. 
Rather than a lack of private capital accumu-
lation, some other factor or factors must 
be responsible for our weakened productivity 
performance. Leading possibilities include 
a slowdown in the incorporation of new 
Percent 
knowledge into production techniques and 
the diversion of a growing share of labor and 
capital resources to meet mandated 
requirements for pollution abatement and 
safety. Experts differ as to the precise 
importance of such factors. But at least one 
thing seems clear. Because borrowing to pay 
for inflation premiums on Government debt 
is self-financing, traditional accounting 
procedures give a misleading impression of 
the extent of crowding out caused by Federal 
budget deficits. 
Adrian W. Throop 
3~------~----------------------------------~ 
2 
1 
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O~~~-r~~~~~-7~r-+-~  __  -+'  ____ T-____  ~~/_S_u~rp~l_u~s_1 
I  /  Deficit 
-1 
-2 
-3 
-4 
Federal  Budget 
As  Percent  of 
Deficit 
GNP 
Unadjusted 
1972 
3 
1976  1980 'j!leJ 'O:lSPUI!'J:I ues 
ZSL 'ON l1WH3d 
(]IVd 
19V  IS0d 's'n 
llVW SSV1J 15211:1 
SSV1:> l.Sl:Il:J 
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
large Commercial Banlcs 
Amount 
Outstanding 
2/27/80 
Change 
from 
2/20/80 
uOl:3U!4SPM.  4Pln • uo:3aJO  •  ppPAaN  •  OLjPPI 
!!PMPH  •  P!UJoJ!IP)  puozpV·  P>lsPIV 
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~  @  21[\ill~C@I 
~&JJ~<§~CQI IT~JJ~lP~d[ 
{l  \ill~W{lJr~d[~@ ~~JJWJ~<§~(Q[ 
Change from 
year ago 
Dollar  Percent 
Loans (gross, adjusted) and investments*  138,334  - 241  +  16,584  +  13.6 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total # 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total # 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weekly Averages 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (+ )/Deficiency (  - ) 
Borrowings 
Net free reserves (+  )/Net borrowed (  -) 
Federal Funds - Seven large Banks 
Net interbank transactions 
[Purchases (+ )/Sales (-)] 
Net, U.s. Securities dealer transactions 
[Loans (+)/Borrowings (-)] 
* Excludes trading account securities. 
#  Includes items not shown separately. 
115,974 
33,736 
44,715 
24A57 
1,384 
6,927 
15A33 
42,172 
30A98 
27,854 
59,775 
51,067 
21A57 
Weekended 
2/27/80 
16 
125 
- 141 
+2,880 
+  136 
- 176  +  16A76  +  16.6 
+  102  +  4)35  +  14.7 
+  158  +  8,834  +  24.6 
+  38  +  3,672  +  17.7 
- 185  - 213  - 13.3 
+  5  - 761  - 9.9 
- 70  +  869  +  6.0 
-2,916  +  1,521  +  3.7 
- 308  +  1,512  +  5.2 
- 277  - 1,823  - 6.1 
+  779  +  8,722  +  17.1 
+  727  +  9,613  +  23.2 
+  551  +  2,713  +  14.5 
Weekended  Comparable 
2/20/80  year-ago period 
78  +  20 
291  112 
- 212  92 
+2,911  +1,995 
+  23  +  364 
Editorial comments may be addressed to the editor (William Burke) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Information Section, 
federal Reserve Bank of San francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 
I 

Inflation premiums, budget deficits

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Inflation premiums, budget deficits

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