...against fictions and other tall tales

Wednesday, 26 October 2011

Deficit myths (Part 1): The effect of budget deficits on interest rates

Economist Greg Mankiw is suggesting that the US government is nearing an endpoint when it comes to the effectiveness of deficit spending. According to his latest article in the New York Times, any further fiscal expansion will likely lead to rising interest rates and have other negative consequences.

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:
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.


Canada (Library of Parliament), "Fiscal Surplus and Fiscal Deficit: Everything is quiet on the monetary front", Background paper, June 2010

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


  1. Super, super! C'est un expose excellent, et votre argumentation magnifique.

  2. very good synthesis: substance and form.

  3. Well explained...Eager to read the second part!

  4. V. Carter Sydney, Au.27 October 2011 at 04:17

    Fine expose, circuit. I enjoy the manner you bring in institutionals' empirical research to solidify the premises. Good material and great narrative.

  5. Thanks to all. VC, the empirical findings are key. Helps to counter the misinformation.

  6. i won't comment on greg mankiw's keynesianism; better minds, including his own will contend the label. however your summary of the anti-deficit ideology is the most succint statement i know. it is worth repeating because it so eloquent:

    "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."

    masterful Circuit, masterful!!!

  7. Goldscheider London UK28 October 2011 at 05:24

    I would presume JH that you are opposed to the view that deficits are detrimental. Looks like the coda was truncated for some intentional reason. lol

    Circuit I like your idea of analyzing the fallacy by section. It is not only easier to follow in a column like yours, but it solidifies itself more effectively in the reader's mnemonic structure.

    The Slivinski reference is deserving. FRBR has always published excellent work.

  8. JH and Goldscheider, my preference for the "to the point/one issue at a time" approach is inspired by JK Galbraith "Letters to Kennedy" (1998). Though, I don't believe he discusses the deficit issue in that work. That said, if it's good enough for a President, it's good for everyone.

  9. I agree with JH Craw's commendation of your write-up. It was very good and as most of your readers have noted-to the point. However, I was perplexed by JH Craw's own cryptic note on Greg Mankiw's philosophy "i won't comment on greg mankiw's keynesianism; better minds, including his own will contend the label." Is there a doubt on Mankiw's keynesian leanings?

  10. Greg Mankiw is a solid thinker; though, he really misses the point here. He appears to overstate the case in arguing that larger deficits in the US would be detrimental. I gather this is what JH is alluding to. Also, he seems unaware of the most recent empirical work in this area, as well as the manner in which deficits impact the open market ops of central banks. As far as mainstream treatment of deficits goes, the paper he co-authored with Laurence Ball in 1996 entitled "What do budget deficits do?" provides a reasonable treatment of the effects of deficits. Though I disagree with the central premises of the paper, I find the article stays clear of some of the more annoying, unfounded rhetoric that is often associated with deficits. One day, I hope to write a critique of that paper.

  11. it is common knowledge that gm is considered a keynesian. but then the qualifier is fairly generic and, these days, as a better mind once said, everyone is keynesian. however i contend that a necessary condition for the attribute is to prioritize viable solutions to unemployment as main policy objectives. i leave it to the readership to evaluate if gm satisfies that test. of course, some may argue that the above test is not the sole criteria. i would agree it's not the sole, but it identifies the keynesian bloodline.

    @CIRCUIT. greg mankiw is an excellent macroeconomist and i will go so far as to suggest that he is by far the best of a younger generation of economists that also focus on fiscal policy and public finance.

  12. I agree with JH that Mankiw is a very good economist. The label issue is political and I assume that is JH's irk. However, the NYT article which you, circuit, cite(nod!!)showed a lack of sophistication on gm's part concerning the modus operandi of the debt market and the relationship between deficits and monetary policy that is, unfortunately surprising. I can only presume that his political incumbency within the Romney campaign represses his better technical insights. His deliberations actually remind me of Krugman a few months ago deliberating against the obvious on deficits. I bookmarked your columns on Krugman from this site, as one of the more comprehensive instances of a good critique. Paul Krugman has since had the courage to modify his former position on the matter accordingly. Greg Mankiw will do the same, and may actually advise Mr. Romney to alter his position ever so slightly on deficits, as to make the latter politically acceptable to the undecided center, if political gain is the measure of good counsel.

  13. JH, I think we agree on Mankiw. Also, I share your view when it comes to unemployment - it's the key variable. And, as such, it should be the focus of policymakers.

    @Swells: I hadn't thought of Mankiw's involvement in the Romney campaign. It's a good point.

  14. swells(nod!!)on the romney link. you and circuit know how to say these things better lol.

  15. Beginning with the deserved nod!!! to Circuit for daring to challenge Mankiw, and not with partisan analytics. One still wonders what happened to the media's econo-stars on the Mankiw file.

    Secondly, swells' clue that there is more to Mankiw's position than just economics may be correct. There is an undermining school of thought which suggests that debt consolidation and deficit management is the current road to political success, and that maybe Mankiw is cleverly endorsing electoral success rather than the common goal of employment. That is a much more difficult challenge to undertake.

  16. Excellent initiative Circuit!! Stay the course.

    However, the recent nuanced comments by jh, swells and gc are actually very important and they address a fundamental consideration in policy. To what extent do pragmatics affect policy orientations, where pragmatics is defined by electoral success. Suffice to refer to earlier discussions in FRB on the importance of logistics and pragmatics in implementing MMT by government.

    In this column, the question raised is 'Why does a true keynesian mitigate his position?' I presume that the above-mentioned are most probably referring to a set of conclusions dating back to the late 1990's by the excellent scholars Alesina and Ardagna. The implication these days of those results is predominant in the minds of campaign strategists and economic advisors, regardless of the latter's ideological leanings. The '98 paper by Alesina & Ardagna: "Tales..." followed by the more recent 2009 article "Large Changes..." and Alesina, Carloni & Lecce's 2010 "The Electoral Consequences..." pose a significant hurdle to keynesian political economists and strategists. The work must be addressed and the considerations they pose taken seriously. It is not enough to suggest that the contexts of the empirical data are very different than the circumstances defining the existing economies...level of unemployment, global contagion and malaise, the banking sector's structural weaknesses,...

    Keynesian policy can only succeed if sympathetic ears steer the ship, an old friend would say. The A & A hypothesis, which I refer to as the Italian Job on Keynesian Economics, must be considered.

  17. Are we suggesting that Greg Mankiw may have stored some of his keynesian luggage in a depot in order to win an election, because keynesian credentials don't sell well during a recessionary period?
    C'est interessant!!!

  18. anyone listening mr. cameron or is everyone running for a shelter. does anyone hear the tremors? the worst part of the snippet is that the economists were so far off forecasts. and Canada is supposed to be imitating?


    here's another snippet:

  19. The markets will tell the story not the Government: http://www.guardian.co.uk/business/2011/nov/01/uk-gdp-growth-stronger-than-expected

    coupled with this one:


    makes for Bad News Bears.

  20. Very nice post. My only reservation, more form than substance is that we should not fall into the opposite mistake of thinking that deficit is good for all seasons. More or less in bad faith, neoclassical economists typically accuse me of this all the time. The intrinsic message of Keynes was in my opinion that there is no "one policy fits all". In fact, I think this is also true for monetization. It is not harmful, actually necessary, as long as when growth resumes the CB reabsorb the excess of money.
    Let's tay in touch!

  21. MI, your old friend is very wise. Indeed, Keynesian policy needs sympathetic ears. I would also add that it requires leaders who are capable of articulating when its application is justified. I always say a balanced economy, not a balanced budget should be the goal (nod to Vickrey). The point you and GC discuss does indeed present a challenge to Keynesianism. I'm familiar with the the work of Alesina et al., but find that it is sometimes lacking. The paper on "Electoral consequences..." has become a staple of the more informed political advisor. While I find some faults with that paper (I tend to support the reverse causality argument; Canada being an important example), one cannot deny its impact on policy. Surely, more than a few superbureaucrats in Whitehall have a copy of that paper somewhere in their offices. Countering its conclusions should be the aim of smart Keynesians and sympathizers. I think MMTers are doing a fine job changing views on this. Guys like B. Gross would never have come out like they did recently without the critical mass of voices from the MMT camp calling out for more government involvement.

    @Coleen: the point you and others raise is probably the most disappointing thing about modern economics. When politics taints economic ideas, everybody loses. That said, I happen to be a huge fan of Galbraith père, who was known for being sometimes partisan, so I guess I shouldn't talk! But seriously, Mankiw should watch out: he shouldn't compromise too much for the win.

    @Francesco, welcome and thanks for your comment. The above also applies to your comment. I fully support the view that large government deficits are not always the answer. In a previous post, I discussed when austerity might be effective. As in the case of Canada in the 1990s, exchange rate and monetary policies play an important role in determining its success. BTW, I visited your site last week and enjoyed reading your views on Europe. Keep up the good work.

    @Swells: Thanks for the support and for linking my work on Krugman's site. Paul needs to be made aware of this stuff. I sometimes drop by his site to give my two cents. I recently read a column of his that sounded surprisingly familiar to me. He's the right track, if you ask me. Perhaps Mankiw will board the same train and follow him there.

    @Gold and JH, the UK won't stand a chance with austerity. And they know it too. At least those folks at Treasury do. Some there are still wondering what went wrong, but most are realizing the conclusions of the Alesina et al. papers weren't applicable to the UK. Such are the odds of choosing austerity in the face of a massive demand shortfall.

  22. is anyone watching global manufacturing slowly falling apart with more and more industries joining the dustbins. europe is sinking the rest of the world. even brazil is in trouble. is there a lesson? somewhere? where?

  23. Nod to JH and Goldscheider on their alerts to the decline of UK manufacturing, However, the ISM figures suggest that the UK is not the only partaker in this pattern. The fact that you are focusing on manufacturing suggests that unless that sector picks up, the recession may become more serious than the seriousness being experienced. Are you warning a squall or a tsunami; I borrow the metaphors from your own narratives.

  24. Very much so, JH. EU Manufacturing and Services PMIs are not showing good signs. Household consumption has pretty much stalled and retail sales are slowing in many EU countries.

    KP, the interesting thing about manufacturing in the UK is that the government was putting much hope in that industry. I never believed the UK would get anywhere. A while back I checked through the figures and, while the UK's central government increased spending during the recession in '08-'09, the local governments were cutting back. Even the IMF warned at the time that this wasn't a good idea. Canada didn't go down that road. The provinces accompanied the central government in countercyclical fiscal policy. In retrospect, this was a good collective decision on the parts of governments in Canada.

  25. Looks like I'm not the only one these days who has something to say about Mankiw: http://hpronline.org/campus/an-open-letter-to-greg-mankiw/

  26. Taxiing by the BoE building on a beautiful cloudy/sunny London day, I was reminded of an interview given by Rick Parker on JKGalbraith that might Greg Mankiw's students a tab more light than they're exposed to these days:


    I think that the IMF is on the wrong track on how to approach the Euro-zone crisis.

  27. Great link GC. Parker's bio of JKG is brilliant. IMO, the best economic history of XXth century US. Footnotes are gems. Bibliography true gold. London is a fine place. IMF back to its old tricks. Consolidation, reform, action plan. Interesting acronym.