Do deficits cause higher interest rates? You decide.

We're running huge deficits these days — just in case any of your friends haven't noticed yet. A lot of my friends have noticed, and they don't like those deficits one bit, because they've made up their minds that deficits, especially big ones, cause interest rates to rise.

It's become conventional wisdom, and for good reason. It's based on a common-sense theory: After the government borrows money in the bond markets, there's less money left over for businesses and entrepreneurs to borrow. When borrowable money is scarcer, the interest rates rise.

Who could possibly argue with that logic? Economists call it the "Crowding Out" theory. Alan Reynolds has called it the "fixed supply of bonds" theory. At any given risk level, there's only a fixed amount of bonds that lenders will buy. US Treasuries are as close to risk-free as bonds get, so the government goes to the front of the line, and gets first dibs on the lenders' money. When the supply of near-risk-free bonds runs out, the lenders not only move to higher-risk bonds, but also have fewer dollars to lend; that means interest rates go up.

It's just plain common sense. That's why I was a believer for a long, long time, and that's why it's "conventional wisdom" to this day.

But in 1994, I hit a snag. I decided to research the Crowding Out theory to see if anyone had tested it against our track record of deficits and interest rates. (Why? Because I'd read Dr. Rick Boettger's book, The Deficit Lie, in which he pointed out that the Crowding Out theory was bunk—and I wasn't sure I believed him.)

After a few months of research, I realized that—as plausible as the theory sounds—sure enough, there's a problem: Turns out, it really is a myth. In fact, from the several studies that economists had done, trying their best to find the relationship between deficits and interest rates, the bottom line was this: If there's any correlation at all, it is a weak negative correlation. In other words, whenever deficits got bigger, interest rates got smaller, and vice-versa.

Well, with the huge deficits we're running these days, I thought it would be wise to reopen the question. So I retrieved the monthly deficit and interest rate data from the Fed and the US Treasury, going back to September 1981.

[By the way, there are all sorts of ways to analyze the historical data: nominal interest rates vs nominal deficits, real rates vs nominal deficits, nominal first differences, deficits vs lagged interest rates, and on and on. But I chose to begin by keeping it simple, by just comparing the trailing-12-month deficit to the same month's key interest rates (Prime rate, 10yr Treasuries, and 1yr Treasuries).]

All I was looking for was a correlation indicating a significant positive relationship between deficits and interest rates. But all I could find was more of the same: a weak, negative relationship that merely confirmed what I'd discovered (for myself) fifteen years ago.

Below is a chart of the data. My conclusion is in the caption, but please decide for yourself whether you think bigger deficits cause interest rates to rise, and vice-versa:

I've run every correlation I had time for, and they all indicate a weak negative relationship — including the recent huge deficits we've incurred. I've been hearing for decades that skyrocketing interest rates, driven by deficit spending, are just around the corner. I'm still waiting.

Someone observed once that it's extremely difficult to watch a beautiful theory get murdered by ugly facts. But that's what I've been watching happen to the Crowding Out theory for fifteen years and counting. I guess I'll just have to accept the similar explanations that both Alan Reynolds and Ben Bernanke have given to explain those ugly facts:

The world bond market is a hundred trillion dollars in size—far too large (even now, apparently) for US deficits to have a discernible adverse effect on interest rates.

I'll keep the popular Crowding Out theory in its proper place in the "Plausible-sounding Theories" section of my bookshelf. I like to keep that section in alphabetical order, so I'll put it between the Blue Cheese Moon theory and the Flat Earth theory.

================
ps-
I revisit this analysis every couple years. Here's a link to the last time I took a look:

Pay no attention to the man behind the curtain

================
Also, here are the data sources...

Prime rate.

10yr Treasuries.

1yr Treasuries.

Trailing-12-month deficits: derived from the Monthly Treasury Statement.

Comments

[Don Lloyd]

In the modern world, the Fed would rather eat glass than allow any one to forget, for even a moment, that IT DECIDES what interest rates are and will be. No matter what the connection might be between deficits and the interest rate, it can almost never be deduced from the data, which will be dominated by the Fed.

Regards, Don

[Optimist123]

The Fed would admit that it strongly influences what *short term* rates will be -- until they hit zero, at which point they lose control. (Today's condition, that's why they've switched to quantitative easing; the "Taylor rule", invented by Stanford's John Taylor, said a month ago that the Fed's target rate should be negative six or eight percent in order to prevent deflation.)

The Fed does *not* have control of the long rate. The market has determined that, and always will.

[TDM]

Total world bond and credit markets are growing faster than our National Debt. This is causing interest rates to decline even as deficits increase.

Also, taxes crowd out capital, as taxpayers will both have less capital and less incentive to create capital. And nothing crowds out private capital as much as taxes on private capital. Both the rate and absolute amount matter. When the market went up in the boom, capital tax receipts increased rapidly and interest rates increased. During the crashes, capital tax receipts plummeted with interest rates. Tax cuts, even if they increase the deficit, will decrease interest rates. Taxes matter more than deficits.

[Steve C]

Are those nominal or real rates?

[Optimist123]

Nominal. (It's much easier to compare nominal rates to nominal deficits than to try to convert everything to "real" -- esp. the deficit.)

[Bret]

Could it be that there are so many other variables that it's impossible to see the direct correlation, yet the crowding out theory still be true?

[Mike H]

I did a similar correlation study between deficits and inflation last month and just updated my post with a link to this.

http://tinyurl.com/cuc6ya

Thanks for the help and inspiration Steve.

[Optimist123]

Bret,

Yes, that might be true. Also, it's definitely true that my wristwatch has a gravitational effect on the planet Jupiter. Nobody can deny it, but everyone wisely chooses not to waste time thinking about it. So, if Crowding Out has in fact had an effect, it has been unnoticeable and way too tiny to isolate.

[beancounter]

Well this proof by contradiction leads to the conclusion (that some will dismiss due to their ideology) that the axiom of "there's a fixed amount of bonds the world will buy" is wrong. Either there's a moving target or there is no limit. The latter is the premise that deficits more often than not increases wealth so every dollar increase in deficit is matched by a dollar (or more given the slightly negative relationship) increase in bond purchasing power. The former would be either some unaccounted variable or the "flight to might" syndrome in bad times that buyers scoop more and more of what they perceive as safe, uncaring of even protecting their principal as long as they don't incur a total loss (as in stocks.)

If a tax cut increases the deficit then it's arguing chicken or egg whether tax cuts or deficit spending grows the economy. Might as well do both since if tax goes below some minimum acceptable level (either politically unpalatable or below the level to maintain rule of law and social order) then tax cuts is no longer an option while deficit spending always will be. Like prime tax can only ever hit zero and raises the question why negative tax (a subsidy) wouldn't be effective if lowering taxes was the be all and end all of economic growth.

[Bob]

Steve,

Few questions.

1. In your view what does cause long rates to increase?

2. What is the long rate threshold after which economic activity could contract?

3. At what level of debt are you going to get concerned if the economy only grows at a 2-2.5% real rate? I know you're looking at a 5% or so real rate to service the interest but that looks awfully iffy for the foreseeable future and our DEBT/GDP ratio is moving north darn fast.

[Optimist123]

Bob,

I'm no expert on the causes and effects of long rates, but inflation expectations are obviously built into nominal rates. In recessions, I've heard a good case for rising long rates being good news, because it's easier for banks to get back to profitability.

I'll get concerned if, two years after the economy gets back to positive growth, the interest on the debt keeps taking a bigger portion of tax receipts or spending (take your pick). Obama's budget says we'll reach 4.2% growth (nominal, I think) at five years, which is sufficient to keep things in bounds. Not that I trust those projections, but that number would work (cet par) no matter how we get there.

[dyarchy27]

was wondering if you have any thoughts you can share with us on
dr krauthammer's last column of 4/24/09. Obama:the grand strategy.

the cheese-nationalized health care and federalized education.
the trap medicare/medicaid ,SS reform.
some people think that the brilliance of FDR's social security system
was that he new the American people do not like taxes, by clocking it as SS he was able to fund the growth of our country. if that is true
it looks to me that it worked out well. do you think something similar
could be happening now .
("When asked in his March 24 news conference about the huge debt he's incurring, Obama spoke vaguely of "additional adjustments" that will be unfolding in future budgets. Rarely have two more anodyne words carried such import. "Additional adjustments" equals major cuts in Social Security and Medicare/Medicaid.")
if so maybe it is not a trap but a magic piece of cheese taking our country to new heights.
any thoughts,
nick christie
virginia beach virginia

[clive999]

The worrying factors here are:-
1. we are in uncharted waters, The national debt has never risen so fast, or for so long (predictions of 22 trillion deficit by 2019 (assuming no more wars or catastrophies) indicate throwing the books away on this one
2.The world is playing with far more "money" than the worlds combined GDP,s so someone is playing with "thin air"

3. The worlds resources are finite so the idea of high growth going forwards like after WW2 are remote, especially as half the worlds population works for $2 dollars a day

The above means little if any growth for the forseeable future,

The worst is there is nothing left in the bank for any more disasters for at least the next 10 years
With a shrinking working population i do not see the figures balancing....or am i wrong? i sure hope so

[Bret]

The Skeptical Optimist wrote: "...it's definitely true that my wristwatch has a gravitational effect on the planet Jupiter.

Okay. So let's assume, as you're implying by your comment, that the connection between big deficits and interest rates is negligible. I actually believe that's possible, because the cost of government is really the resources that the government utilizes, not necessarily how it's financed.

However, it leads to some interesting thought experiments. For example, it costs a lot more to collect taxes than to sell treasuries. Typically the federal government gets about 80%-90% of what it spends from taxes and borrows the rest (i.e. sell treasuries). If big deficits have a negligible impact, then it seems like we should maybe just fund 1/2 of what the government spends and then borrow the rest.

Would this work? If not, why not, since you claim big deficits have little impact and won't raise future interest rates?

[Optimist123]

Bret,

You hit exactly on the key point: How much is too much?

"If big deficits have a negligible impact, then it seems like we should maybe just fund 1/2 of what the government spends and then borrow the rest."

That would not be sustainable, but there is a way to infer the combination of growth and permanent deficits that would be sustainable. That's what the following article was getting at:
http://tinyurl.com/b89hc9
The idea: the government (just like healthy private firms that employ a mix of debt and equity to fund their growth, and that roll their debt over as a matter of policy) must pay the interest on the debt, otherwise it is in default. It must also pay for defense, the justice system, etc. To prevent inflation, the budget must be funded by either taxation or borrowing, but NOT by increasing the money supply. That means that the interest vs noninterest portions of the budget are competing for a finite supply of no-inflation dollars.

You and I would vote the politicians out of office if they gradually stopped defending us just so they could afford to pay more and more interest. So the question is, what's the acceptable high-water mark for interest as a percent of the budget in the low-inflation, well-defended country we demand our politicians deliver? Also as important: in a perennial-deficit scenario (to maintain a planned mix of taxation & borrowing to fund growth), just how much growth is required to keep us below whatever high-water mark we set for interest-vs-noninterest spending?

In the article I linked to above, one of the scenarios was 4.2% growth, as Obama's budget projects for the out years. That, combined with its deficit projections, would keep us below the Clinton era interest burden of 15% (net interest as a % of spending) -- presumably a level that is acceptable and survivable, because not only did we accept it and survive it in the 1990s, many ideologues on the left point to those years as the golden era of fiscal responsibility. (Why their counterparts, the ideologues on the right, don't point to the 8-10% level of the subsequent Bush years as an even better example of fiscal responsibility I'll never understand, but that's the level it reached in approx 2005.)

I don't know how high the interest share could go (18%? 25%), but I for one don't want us to test the limit. Again, it was 15% in the Clinton years of "fiscal responsibility" -- and it's about 10-11% now, so we still have some runway.

If you can think of some bumpersticker-size catch phrases to describe all that, it would help get the message out.

In the meantime, we can plan on our politicians and ideologues on the left and right to continue playing on fear-of-big-numbers. It works for them every time; it's a real vote-getter and book-seller.

[Harun]

I wonder how much this theory is hurt by entities who wish to only buy US Treasuries and are not interested in commercial bonds so much. I am thinking about China and the other countries that buy T-bills to sterilize their current account surpluses. I am sure there are other entities who want to buy T-bills only as well for safety reasons.

Also, thanks for the comment about net interest share of spending.

[Barton]

Well one way to look at it is this: in periods such as this, with rising unemployment and huge excess capacity and deflationary tendencies, the demand to net save on the part of the citizenry is huge, and that would normally mean a huge demand for financial assets such as Treasury bonds..and that seems actually to be the case. One could even say that in this economic environment ONLY the governemnt can satisfy that desire for savings instruments by issuing bonds...the private sector can't do it because the private sector isn't going to borrow by issuing bonds if it can avoid it. You have to look at it in aggregate..the government is the only part of the economy that CAN leverage, and it does so by deficit spending and issuing bonds. It HAS to take up the slack or else the economy shrinks more, and more, and more.
And remember, whenever the government spends that initially automatically puts downward pressure on interest rates because it spends by crediting bank accounts at the Fed thereby increasing reserves in the system. If the Fed doesn't immediately counteract that by open market operations (generally by buying govt securities from dealers) then short term rates get immediately driven down. And now with Fed Fund rates pretty close to zero, which is where the Fed can keep them as long as it wants, is it any wonder that long term rates are so low? (View the Fed and the Treasury as one entity) It shouldn't be.
Regards
P,S. I love your site..just discovered it

[jpniner]

anyone have any guesses on how high interest rates will get in coming years?

many on the Glenn Beck, debt doomsday right, are predicting 70's style inflation and interest rates coming soon, is why I ask.

[Bob]

"anyone have any guesses on how high interest rates will get in coming years?"

I don't have any guess but don't buy in that the great inflation of the seventies will repeat. Let me explain:

1. Anyone who worked in that era remembers COLA's. Cost of living wage increases were common. I remember a 7% automatic raise. What is the chance of that repeating? Pretty low, I suggest. For the last 15 years or so most folks are happy with a 3% increase
and that's with a darn good review.

2. Much has been written about the baby boomers. I am one and suggest that the demographic demand from the boomers, specifically as it relates to first time housing, and the supply constraints in effect contributed mightily to the great inflation. This time the reverse may happen. As boomers retrench from spending aggregate demand could recede.

3. The big caveat in all this, IMO, is commodity prices. I'm confident that the labor percentage of manufacturing will continue to decline due to improved productivity but I'd watch raw material prices closely. If it were me taking a look at closer oversight of the financial markets, I'd hone in on commodity speculation.

[Harun]

Steve,

Over at Megan McArdle, she mentioned that emerging markets are worried that massive borrowing by the developed economies will "crowd out" funds for them to borrow.

Any comment or prediction on this variant of the theory?

[Optimist123]

Harun,

I'm no expert on emerging markets' creditworthiness, but I have no doubt that funds will be available for those that have good prospects for sustainable real growth (and unavailable for those that don't). It always comes down to that.

Regarding our situation, by the way: Based on what I'm watching, I see no reason to be concerned yet. I keep a close eye on it, and my favorite near-real-time reporting on the whole issue of inflation, deflation, and bond rates is by Mark Gongloff in the Wall Street Journal (his column is in section C). He knows what to watch, and he knows how to report it.

Here are a few recent excerpts:
"...aggressive government spending and a busy Federal Reserve printing press...are designed to fight the recession, and both are raising inflation anxiety. But the more powerful force is a deflationary one: the wide and growing gap between the economy's output and its potential..." (April 15)

"Many Fed watchers doubt it will let the 10-year yield drift too high, unless the economy is booming at the same time...
They are well below the 2008 average of 3.66%, which was a record low...
The financial system is stabilizing largely as a result of the Fed's policies, and the risks of a relapse are unthinkable." (May 4)