Deficits and Interest Rates: The Causal Connection
Economic debates seem to have their own growing seasons. For stretches of time they may disappear, only to reappear in later years covering the same old ground again. The debate about the effects of deficits on interest rates, though temporarily stunted by the frosty winters of the Clinton years with its visions of budget surpluses, is back with all of its heartiness intact.
It's back because times have changed, as they always do – the economy has weakened, the stock market bubble has burst. Government revenues are falling off while government spending grows apace. There is war talk in the air; proposals of economic stimulus packages and tax cut chatter. The cheery optimism that produced those rosy budget surplus forecasts of yesteryear is long gone. What was once passé, the debate regarding government deficits and their effects on the economy has again attained significance.
As with many economic questions, this one can degenerate into a de facto political debate where economics is sought after only as vestments by which political opinions are given the aura of authority. In a fashion akin to religious wars, each side likes to claim that the science of economics is on its side. Those in favor of the Bush administration's fiscal policy are prone to dismiss or downplay the risk of deficits and there is not shortage of court economists willing to take up the charge.
Witness the salvo written by the editorial staff of The Wall Street Journal titled "Flacking for Rubinomics" where the view that deficits push up interest rates (inaccurately dubbed "Rubinomics") was sarcastically dismissed. "Robert Rubin's theorem is all politics…" the Journal sneered, adding that its point is "to argue against the Bush tax cuts and especially against making them permanent. The economics are incidental." By implication, The Journal believes that economics will back its position that deficits do not push up interest rates.
A couple of weeks later, as if answering to the call, economist Rik Hafer produced a piece entitled "The Deficit Debate" in which he says the conventional wisdom – that deficits do push up interest rates – does not fit the facts.
The facts, as he sees them, involves historical and statistical comparisons. This is the basic blocking and tackling practiced by many typical modern economists. He compares the Congressional Budget Office's surplus projections with the ten-year Treasury Inflation-Indexed Securities yield. Citing figures produced by Fed Reserve economist Kevin Kliesen, Hafer notes how interest rates rose steadily in the late 1990s as the projected budget surplus increased steadily. Since early 2001, the projected surplus numbers have been coming down and, instead of increasing, the yields on the TIIS have actually declined. Hafer concludes, "the evidence clearly rejects the conventional deficits-beget-higher rates view."
Skewering conventional wisdom in a public forum is great sport. Unfortunately for Hafer, the conventional wisdom is closer to the truth on this matter.
"The noise of a waterfall"
Before addressing the matter of deficits directly, something must be said about the method by which conventional modern day economists ply their trade. For Hafer, and others like him, economic questions are to be answered by an appeal to the facts, i.e. to the historical record.
The problem with that approach is rooted in the nature of history and the intricacy of its causal chains. History is a complex phenomenon where one can never isolate any one cause or factor. Ludwig von Mises tirelessly hammered home this point as he placed economics firmly on a foundation of deductive logical analysis. Writing of the social sciences in general and of economics in particular, Mises observed that these disciplines "are in the same position as acoustics would be if the only material of the scientist were the hearing of a concerto or the noise of a waterfall."
Statistics are factual but they do not explain. Mises wrote "the material which statistics provides is historical, that means the outcome of a complexity of forces. The social sciences never enjoy the advantage of observing the consequences of a change in one dimension only, other conditions being equal."
Statistics are open to various interpretations and the historical record can be made to fit many theories. The mere effort involved in selecting what data to use and what to discard is colored by the human data-miner – his tastes, his ideas, and his biases and is also limited by the data available. For Mises, economics begins with sound deductive reasoning and theory: "Economic history can neither prove nor disprove the teachings of economic theory. It is on the contrary economic theory which makes it possible for us to conceive the economic factors of the past."
Economics, then, is not an empirical science. Its questions cannot be answered by simply looking for patterns in historical data. There are numerous factors that influence interest rates – savings, currency factors, legal and political factors, etc.
The list goes on and on. For example, Hafer writes, "Apparently the government's growing appetite for funds is not evident in the falling real interest rate." But this could be explained by many other factors such as a drop-off in demand for such funds so that even though the government's appetite for funds was expanding, rates still fell. It seems rash and awful simplistic to simply conclude as Hafer does. The obvious absurdity would be to take his argument to the extreme and say that increased government borrowing lowers interest rates.
So the charge that the conventional wisdom does not fit the facts is easily repelled by noting that many factors influence interest rates and that no statistical comparison, no matter how advanced or comprehensive can isolate these facts. There is no way to go back in time and replay two scenarios, one with deficits and one without, and observe what happens. It cannot be done.
No matter how closely two factors may track each other historically it is nothing if not backed by a sound theory. Using statistics in this manner is inappropriate in attempting to understand the realm of human action. Hafer's writing is a perfect example of the fallacy of trying to refute logic with statistics. To Mises everlasting credit, he understood the limitations of statistics and refused to compromise on that truth.
What logic tells us
The relationship between deficits and interest rates has to be understood logically.
First we have to understand that there are two ways such a monster is fed. The government may borrow by financing its deficits through bonds bought and held by the public. This has the effect of redirecting savings from serving the wants of consumers to serving the wants of government officials.
As Murray Rothbard noted, "…logic tells us that if savings go into government bonds, there will necessarily be less savings available for productive investment than there would have been, and interest rates will be higher than they would have been without the deficits [italics added]." And there we find the answer and the key qualifier, which is highlighted in italics.
The simplicity and brevity of this argument stands in sharp contrast to the muddled empirical inferences wrought by many economists today. It is irrefutably true. Savings are finite and a siphoning of these funds by government can only mean less is available for private use. Whether the actual interest rate is higher or lower during times of deficits is irrelevant; what really matters is what might have been without the deficits.
The second way the government can finance its excesses is through bank inflation. Borrowing through the banking system is a form of inflation with the newly "printed" money going first to the government and then spreading throughout the economy as it is spent. As such it is an indirect "tax" on everyone who uses its money. Bank inflation does not tap savings directly, as does public borrowing, but taps savings and consumption.
Still, the crowding-out effect is operative as the new money "printed" by the government is competing for resources with old money saved by the public. The inflation benefits some of the population at the expense of others and also sets the "boom-bust" phenomenon in motion. In addition, as Rothbard adds "…the greater the deficits the greater the permanent income tax burden on the American people to pay for mounting interest rate payments, a problem aggravated by the high interest rates brought about by inflationary deficits."
In summary, deficits, no matter how they are financed, divert valuable capital from the serving the wants of the public. Hence, the accumulation of savings, a key component of increasing the general standard of living, is frittered away. Interest rates are higher as a result.
The chief role of economics is to discover these indirect, somewhat concealed consequences of the various forms of human action. As Rothbard neatly summarized, "The hidden order, harmony and efficiency of the voluntary free market, the hidden disorder, conflict and gross inefficiency of coercion and intervention – these are the great truths that economic science, through deductive analysis of self-evident axioms, reveals to us."