This report reviews theoretical and empirical evidence to see what relationship exists between budget deficits and interest rates. Any explanation of the budget deficit-interest rate relationship must first come to grips with an indisputable fact: budget deficits consume real resources. When the government borrows from the public to finance public spending or tax cuts, the resources must come from somewhere. In mainstream theory, the resources come from the nation's pool of saving, which pushes up interest rates for simple supply and demand reasons. This "crowds out" private investment that was competing with government borrowing for the same pool of national saving. But other theories offer different explanations of where the resources come from that do not involve higher interest rates. To determine the effect of budget deficits on interest rates, these other factors must be held constant using statistical methods. The capital mobility view and Barro-Ricardo view both explain how deficits could have no effect on interest rates, and yet the deficits still impose a burden in both views. In the capital mobility view, they crowd out the trade sector of the economy; in the Barro-Ricardo view, they crowd out current private consumption. Because less investment leads to a smaller economy in the future, economists often describe deficits as placing a burden on future generations. In the capital mobility view, foreigners lend the United States the saving it needs to finance a deficit, leaving interest rates unaffected. But foreign capital can only enter the country through a trade deficit, leading to a decline in the output of U.S. exporting and import-competing industries. In the Barro-Ricardo view, forward-looking, rational, infinitely-lived individuals see that a budget deficit would result in higher taxes or lower government spending in the future. Therefore, they reduce their consumption and save more today. This provides the government with the saving needed to finance its deficit, placing no upward pressure on interest rates. Empirical evidence that budget deficits do not affect interest rates is not evidence that government budget deficits do not impose a burden. Simply comparing changes in budget deficits to changes in interest rates is not a valid way to determine whether budget deficits affect interest rates because there are many other factors that simultaneously affect interest rates. Otherwise, the effect of budget deficits on interest rates could be misestimated or even reversed. Gale and Orszag (2002) argue that more recent evidence tends to find a stronger, positive relationship between the two, with all sixteen of the studies they surveyed finding positive or mixed evidence. In addition, 10 major forecasting models all predict that a budget deficit would increase interest rates. According to Gale and Orszag (2002), the models predict that a budget deficit equal to 1% of GDP would increase interest rates, with a range of 0.1 to 1.0 (mean=0.52) percentage points after one year and 0.05 to 2.0 (mean=0.99) percentage points after 10 years.
Persistent budget deficits have directed attention to their economic effect, particularly whether they raise interest rates. Any explanation of the budget deficit-interest rate relationship must first come to grips with an indisputable fact: budget deficits consume real resources, and this is the more relevant public policy concern. When the government borrows from the public to finance public spending or tax cuts, the resources must come from somewhere. In mainstream theory, the resources come from the nation's pool of saving, which pushes up interest rates for simple supply and demand reasons. As a result, the deficit "crowds out" private investment that was competing with government borrowing for the same pool of national saving. Since less investment reduces the future size of the economy, economists often describe deficits as placing a burden on future generations.
But other theories offer different explanations of where the resources come from that do not involve higher interest rates. In the capital mobility view, foreigners lend the United States the savings it needs to finance a deficit, leaving interest rates unaffected. But foreign capital can only enter the country through a trade deficit, leading to a decline in the output of U.S. exporting and import-competing industries. In an alternative theory, popularly known as the Barro-Ricardo view, forward-looking, rational, infinitely-lived individuals see that a budget deficit would result in higher taxes or lower government spending in the future. Therefore, they reduce their consumption and save more today. This provides the government with the saving needed to finance its deficit, placing no upward pressure on interest rates. Empirical evidence that budget deficits do not affect interest rates does not prove that government budget deficits do not impose a burden, as demonstrated by the capital mobility and Barro-Ricardo views. In the capital mobility view, deficits crowd out the trade sector of the economy; in the Barro-Ricardo view, they crowd out current private consumption. And in both of these views, deficits no longer have any stimulative effect on the economy.
Comparing changes in budget deficits to changes in interest rates is not a valid way to determine whether budget deficits affect interest rates. That is because there are many other factors that also affect interest rates, such as the state of the economy. To determine the effect of budget deficits on interest rates, these other factors must be held constant using statistical methods. Otherwise, the effect of budget deficits on interest rates could be misestimated or even reversed.
Empirical evidence on a link between budget deficits and interest rates is mixed. There is not a consensus among economists on how to model the economy and what relevant variables should be included. Therefore, conclusions drawn from empirical evidence vary widely. More recent evidence tends to find a stronger, positive relationship between the two. In addition, 10 major forecasting models all predict that a budget deficit would increase interest rates. According to Gale and Orszag (2002), the models predict that a budget deficit equal to 1% of GDP would increase interest rates, with a range of 0.1-1 (mean=0.52) percentage points after one year and 0.05-2 (mean=0.99) percentage points after 10 years. This report will be updated.