Incidentally, Jmac asked me about whether defecits rose interest rates. I said I thought they did, but had recently read that the effect was ambiguous, but I couldn't explain it. I've found out the skinny on defecits since then. The standard story is that budget defecits reduce national saving, and in turn raise interest rates. This is part of the IS-LM model created by John Hicks in the mid-40s. Hicks created the IS-LM model to explain graphically the ideas about macroeconomic behavior as described by John Maynard Keynes' book A General Theory.... This effect of budget defecits on interest rates is called the "crowding out effect." This is also, from what I can gather, more or less the standard view in macroeconomic theory.
A competing view, offered by Robert Barro, is what is known as "Ricardian Equivalence." It was given this name by James Buchanan who argued that Barro's position was essentially that of 19th century British economist, David Ricardo. The idea is that defecits do not result in the crowding out effect, because agents seeing the drop in taxes will save an amount equal to that drop, because they know that in the future government will be forced to raise taxes again, and so they will then use that saved amount to pay back the government the amount equal to the new taxes. In other words, they anticipate that the taxe cuts will be temporary, and so will offset the defecit by an amount equal to the defecit itself, and interest rates will not be affected.
Empirically, there seems to be little support for the standard view, ironically, despite its widespread acceptance. If defecits raise interest rates, then historically, we should see this happen. But according to Barro, we do not. In fact, we sometimes see the opposite. For instance, interest rates did not rise after the "Reagan experiment" at all, but in fact, dropped. Theoretically, economists have been able to generate some conditions in which non-Ricardian equivalence can arise, but the sense I get is that while not widely accepted, Ricardian Equivalence is nonetheless growing in acceptance so much so that most intermediate textbooks in macroeconomics are forced to mention Ricardian Equivalence when talking about the effects of defecits on savings and in turn on interest rates.
So, depending on what you believe about the crowding out effect of defecits on private investment, you'll view Bush's tax cuts as good, bad or somewhere in between. I will note, too, that the impression I get from preparing for this macro prelim is that this is one of the many areas in which the neoclassical macroeconomists and the Keynesian macroeconomists are of a different opinion. There's several such divides in macroeconomics, too. Another area is whether or not money can affect real variables, such as output and employment, or whether it too is neutral. Keynesian economists say that it can; classical ones say that it cannot. This too ends up affecting one's recommendations for dealing with recessions. If fiscal policy is essentially impotent (Ricardian Equivalence), as well as monetary policy (Ratonal Expectations), then there's very little that the government can do. Theoretically, robust models and long tradition support both views, and so it becomes an empirical question mostly.
So to Kevin, that doesn't really answer your question, but I figured it'd be somewhat deceitful if I claimed any kind of definite effect. I get the sense that there's both scientific and ideological reasons for adopting the different stories. But one interesting thing is what Barro does note and that's that empirically, we don't see interest rates rising in response to budget defecits, despite the prediction from the IS-LM model that it should.
Posted by scott at December 28, 2003 05:50 PM | TrackBackBarro's theory implies a testable hypothesis: there should be a positive relationship between changes in the deficit and changes in the savings rate.
Is the evidence any better for this relationship than for the hypothesized relationship between deficit size and the interest rate?
You might also note that the Real Business Cycle hypothesis would imply that even IF deficits affect interest rates, fiscal policy would STILL be ineffective in stimulating the real economy: it simply substitutes government spending for private spending. (Fiscal policy does affect the real economy, but only through incentive affects i.e., because taxes are rarely lump sum.)
Posted by: Jim at December 29, 2003 03:43 PMMind you I'm a journalist, and not a student of economics, so speak to me more ... shall we say plainly, but...
To my understanding, long-term rates did rise under Reagan's economic policies. Not so much during the initial passing of the tax cuts (1981) but later on, during the end of his term and Bush I coming to office.
That was one of the key things Alan Greenspan tried to impress, successfully I might add, on Clinton when he became president. That you had to give the impression that you were going to fight the deficit and that would help lower the long-term rates.
Am I off on that?
Posted by: Jmac at December 30, 2003 09:02 PMI don't know. I'm studying this right now, and the impression I get is that empirically, there's little to no support to everything I just wrote. But, in one paper I did read, the economist I mentioned Robert Barro says that under the Reagan administration, interest rates dropped in response to the defecits, not the reverse. So I really don't know is what I'm saying. Sorry that my post was so jargon-y. You probably know more about this than I do. The traditional view is that interest rates will rise in response to the defecits (called the "crowding out" effect).
Posted by: scott cunningham at December 30, 2003 09:10 PMI definitely will say that I do not know more than you on this. :)
I had read a book by Bob Woodward on Clinton's efforts to successfully pass his 1993 Economic Recovery Act and it went into some background detail on Reagan's tax cuts and Greenspan's lobbying of Clinton to fight the deficit.
It was a good read. Of course, I'm a political progressive so I may be biased a tad....
Posted by: Jmac at January 1, 2004 08:39 PMWell, what I meant was, you may know more about the actual trends in the defecits and interest rates than I do. I've never followed those statistics very well. But then also, I'm just not quite 100% on how to piece together all of the different theories about what drives those statistics in the first place. There are so many different models that will predict certain changes in interest rates in response to defecits, but then the empirical tests, from what I've seen (which is limited to just a few comments made in lit. review articles), the results are ambiguous. The Ricardian Equivalence theory is mainly just saying that people anticipate that the current defecit will have to be paid back to the government in the future through increased taxes. So, the government, financing the defecit through the issuing of bonds, will have no effect on aggregate demand, but will have an effect on changing the savings rate. Jim noted that in his post, and I looked some more into it, and from what I can find, because of how taxes are collected, as well as some other things, there doesn't seem to be much empirical support for it either.
All that to say, I almost get the sense that to answer your question, a person can point to a number of different models in which interest rates do or do not increase because of the defecit. So it becomes an empirical question - and that's what I know even little about.
Posted by: scott cunningham at January 2, 2004 09:42 AMSo the question is do deficits makes interest rates rise?
There is very little to no evidence to support that and i will explain.
First of all, remember that economic history has already answered this question. From 1973 till now, deficits and interest rates have moved in the opposite direction roughly 70% of the time. Lets start with Jimmy Carter. During his term, Interest rates grew and inflation grew rapidly. Why? Deficits were 2% of GDP and less. Reason: no economic growth and high taxes. Unemployment grew to above 10%. He did an awful job. Lets move to Reagan. When Reagan came into office, he CUT TAXES for everybody. Remember, when you first cut taxes, the deficit will swell the first few years because the money has to filter back to peoples pockets and it takes one to three years before they take full effect. The same holds true when you raise taxes. When taxes are raised, the government gets that money immedietly so they can play with it quicker. The problem is uncle Sam shouldn't decide what to do with it. YOU AND I SHOULD.. As Reagan cut taxes, the deficits during his eight year term averaged 4.5 of GDP, and even hit above 6% in 1984. So why did interest rates and inflation during his term down trend with a deficit twice as high as Carters. Simple: economic growth. Lets move to Clinton. Clinton cleared the deficits into surpluses even though he raised taxes (from 31% to 40%). Interest rates fell and inflation fell during his eight year term. why? Well, lets be honest, the internet that was invented in 1994 to the public has been the BEST innovation for humans ever. This has brought info to our fingertips and Bill was fortunate to be president during these times. But he can't get all the credit. Replublicans controlled congress, and in 1997, they cut the capital gains tax from 28% to 20% which fueled the stock market the last two years of the century. The computer brought billions for Clinton and he did the right thing by getting rid of the deficits while we were in a bull market. But what led to goodness? Economic growth. Now to Bush jr. At this point, the deficits are at around 4.5% of GDP again. Remember though, Bush jr. inherited the bad economy, he didn't create it as all democrats want to think. The market turned tail the last seven months of the Clinton administration. The Bull cycle was over and overheated. Any economists will tell you that. The market partied literally till 2000. The excesses were to much, and Bush got the hangover of that. So what did Bush jr. do? He cut taxes. Notice as the deficit grew, interest dropped and deflaion was in our hands from 2001 to 2004(not so much deflaion these past 6 months). Inflation has continued to fall as of this writing. So why haven't interest rates risen with our 500 billion dollar (4.5% of
GDP)???? ECONOMIC GROWTH. you get it. Remember deficits in terms of dollars is irrelvant because your talking about just the debt side and not the credit side. Remember this is the U.S.A. and we have the best economy for a reason. Were not idiots. Bush has followed Reagan and thank Goodness for that.
Cutting taxes has and will always bring economic growth and growth brings well being to everybody, not just the rich.
If deficits don't move interest rates, then what does?? Answer: Inflation, deflationary expectations, and anticipated real returns on investments (economic growth) affect interests rates....