Mankiw is not alone in advancing this point. The idea that governments are reaching the limits of fiscal policy is a common theme these days among economists and financial commentators. This view has also taken hold in Canada where, for instance, a recent TD Bank report suggests that Canadian federal policymakers have less "wiggle room" on the fiscal front now that the outstanding (consolidated) government debt in Canada has surpassed 60 percent of GDP.
The notion that large deficits are detrimental to the economy is central to the mainstream view of fiscal policymaking. This view of fiscal policy holds that governments should stay clear of large deficits because, it is claimed, they increase interest rates, crowd out private investment, heighten macroeconomic instability and lead to larger trade deficits, higher taxes, lower profits and higher inflation.
This is a most pessimistic view of deficit spending. Fortunately, the reality is quite different. In this post, I wish to make the case that, for nations that are sovereign issuers of currency such as the US and Canada, fears of large increases in interest rates caused by additional fiscal stimulus are overblown. The other negative consequences listed above will be examined in later posts.
First off, with respect to interest rates, it should be mentioned that the effect produced by deficits is nothing like what the mainstream analysis suggests. In fact, if it were not for the active involvement of the monetary authorities, government deficits would actually have the effect of lowering the benchmark rate (e.g., overnight rate in Canada; Fed funds rate in the US). The reason for this is explained in the following excerpt from a paper examining the interaction between fiscal policy and monetary policy published by the independent research staff of Canada's Library of Parliament:
...a fiscal deficit results in an influx of cash into the private economy since the government injects more money through its spending than it collects in taxes. This added liquidity – in the absence of any intervention by the Bank of Canada or the Government of Canada – would create an imbalance in the form of surplus liquidity in the private economy that would drive the overnight rate lower. It is the Bank’s role to neutralize, on a daily basis, this injection of liquidity with a corresponding withdrawal of cash from the private economy. [...]
It is worth mentioning that the principle of balancing liquidity in the private economy in order to achieve a target interest rate would be similar for any country with its own floating currency that is non-convertible to commodities. (original emphasis) (2010:5-6)And, it should be pointed out, central bankers are aware of this fact. For instance, the former Governor of the Reserve Bank of Australia, Ian Macfarlane, provided a similar explanation in an insightful speech in 2001:
Any government deficit not financed by an exactly coincident issue of debt to the public, for example, would mean a rise in cash and a fall in interest rates. Similarly, a surplus not exactly matched by debt retirement would lead to a shrinkage of the amount of cash and an escalation of interest rates. (emphasis added) (2001:15)
Now, one could argue that, despite the above, the impact of budget deficits on existing economic conditions could lead to monetary tightening and increased interest rates. While this is possible, however, there is very little evidence to support the view that budget deficits play a significant role in increasing interest rates. As economist Stephen Slivinski of the Federal Reserve Bank of Richmond recently concluded when examining the case of the US, the link between government debt and interest rates is tenuous:Canada (Library of Parliament), "Fiscal Surplus and Fiscal Deficit: Everything is quiet on the monetary front", Background paper, June 2010
During the past 25 years, many studies have arrived at the conclusion that there doesn't seem to be much connection between interest rate movement and debt in the long-term. (2010:14)Finally, it should be emphasized that the American and Canadian economies now face, from a historical standpoint, extremely slack economic conditions. Therefore, both economies could easily absorb the increased demand created by additional fiscal stimulus. And, more importantly, it is doubtful that the level of activity spurred by additional fiscal policy measures would be significant enough to propel the monetary authority in either country to increase interest rates significantly as a result.
Macfarlane, I., "The movement of interest rates", Reserve Bank of Australia, RBA Bulletin, October 2001
Slivinski, S., "Do deficits matter? And, if so, how?", Federal Reserve Bank of Richmond, Region Focus, Second quarter, 2010
TD Economics, "Canada's economy - A fortress or a sand castle?", August 22, 2011