Two days ago (11/11/06) I saw several guests on Neil Cavuto’s cable TV show talking about the economy; all but one of them took it as unquestionable gospel that deficits cause higher interest rates. The one who didn’t—Mike Norman—said “...there’s no evidence that deficits cause higher interest rates.” But he was immediately shouted down by others who, wearing smug grins, dismissed it out of hand, as if it’s some kind of wacko cult theory to assert that there’s no connection between deficits and interest rates.
The 'Crowding Out' Theory
Well, I’ve seen smug grins before, and for me that’s an unmistakable signal to go check the data. It’s been years since I checked the theory that deficits cause higher interest rates—which is sometimes called the “Crowding Out” theory, because government borrowing supposedly crowds private investors out of the bond markets—so I decided it was time to check it again.
Step One
The first thing I did was reread a recent paper by one of my favorite authors, titled Deficits, Interest Rates, and Taxes: Myths and Realities, by Alan Reynolds. For some reason I usually get a kick out of seeing a beautiful theory murdered by ugly facts, and this paper is one of my all-time favorites for that, because Reynolds destroys not one, but four plausible-sounding, politically-popular theories about the deficit. Go to the link, download the paper, print it out, then relax in a chair and read the whole thing. Neil Cavuto should do that, too, by the way.
Here’s an excerpt from the paper’s summary:
Some economists have argued that deficits will raise interest rates, reduce economic growth, increase trade deficits, and possibly create a financial crisis ... 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.
As I said, read the whole thing.
Step Two
After rereading Alan's paper, the second thing I did was to spend the remainder of my weekend searching through historical deficit and interest-rate data, looking for some kind of correlation that supports the conventional wisdom that “deficits cause higher interest rates.” By now, I’ve analyzed enough data to draw a tentative conclusion: Instead of searching for a positive correlation between deficits and interest rates, it would have been much more productive for me to have spent my time sitting outside in a patio chair—with a beer in one hand and my binoculars in the other—trying to spot a squadron of flying pigs heading south for the winter.
I retrieved monthly deficit data from the Monthly Treasury Statement, monthly interest rates on the 10-year constant-maturity Treasury note, and monthly interest rates on the Moody Triple-A corporate bonds. I matched the month-to-month changes in interest rates against monthly deficits, and against rolling 3-month, 6-month, and 12-month deficits. I even tested the curious assumption that the bond markets can accurately forecast deficits 12 months into the future (...Alan Reynolds tears that assumption to shreds in his paper, but I thought I’d test it anyway). That’s five ways of looking at the “deficit” and two different measures of “interest rates” for a total of ten correlation analyses.
Here are two charts (scatter plots) from the analysis. If there were a positive relationship, as the talking heads keep saying, the data points would be bunched inside the ovals; but there is no relationship. The size of the deficit apparently doesn’t matter one whit to the bond market.
If you’re interested in the specific results for each of the ten cases, click on this thumbnail:
What to do next
When so-called pundits try to get away with the false mantra that “deficits cause higher interest rates,” what we should do—instead of paying no attention to the man behind the curtain—is call them on it:
“Excuse me; may I see your evidence, please?”
My suspicion: They have no evidence, they're just repeating what somebody else told them; it sounded plausible and persuasive, so they're just parroting the false rumor like a programmed bobble-head doll. Let's call them on it. And if you have any other ideas on how to help kill a false rumor that has captured well over 90% of the market, I'm all ears, by the way.
