Deficits and Interest Rates: Fact vs. Fiction

With all the talk about record deficits – both budget deficits and trade deficits, I think it makes sense to discuss some common misconceptions, especially among Democrats who subscribe to Rubinomics. The basic argument is that a higher long-run budget deficit reduces national savings. The reduction in savings implies a higher interest rate as the government competes with firms for limited investment funds.

The main problem with the argument is that it is not true and historical evidence does not support it. During the 1970s, U.S. budget deficits were well under control yet interest rates were rising dramatically. Conversely, during the 1980s and more recently in the past few years, budget deficits were rising, yet interest rates were falling. If any of these data points were anomalies, they could easily be explained away by other variables that have effects on interest rates. Likewise, Australia and Canada have maintained budget surpluses since 1998, yet their interest rates are higher than in the U.S. By contrast, Japan has had budget deficits averaging nearly 6% of GDP since 1994 – roughly double the rate as the U.S. – yet interest rates have been practically zero in Japan during that time. Unfortunately for Rubin theorists, these are not anomalies but are regular patterns.

Additionally, Rubin theorists claim that budget deficits reduce national savings and that tax increases can add to national savings. Again, as the U.S., Australia and the U.K. moved towards budget increases in the late 1990s, national savings as a % of GDP did not budge.

Alan Reynolds of the Cato Institute has written a great paper on the subject. In it, he summarizes the relationship between deficits, interest rates and taxes:

"In particular, the arguments of a recent study by former Treasury secretary Robert Rubin, Brookings Institution scholar Peter Orszag, and economist Allen Sinai are examined in detail. That study proposed four hypotheses about the effects of sustained budget deficits: First, projected future deficits affect current interest rates. Second, smaller budget deficits produce more domestic private investment. Third, budget deficits cause trade deficits. Fourth, budget deficits cause fiscal disarray and require tax increases to maintain confidence.

Empirical evidence—U.S. time series data and international comparisons—do not support these hypotheses. Also, several of the hypotheses are inconsistent with each other. In reality, neither actual nor projected budget deficits raise real or nominal interest rates, steepen the yield curve, reduce national savings, cause trade deficits, or make the dollar go down or up. The logic behind such speculations is flawed and the evidence is missing."

The next time a Democrat tries to explain to you that today’s budget deficits are going to cause interest rates to rise, simply ask them why the history on the subject since World War II actually shows the opposite effect.