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.

References

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

Bank of Canada: 2013 is the year normal growth returns

The Bank of Canada doesn't see much improvement in the Canadian economy during the next year or so. As such, the Bank has decided to maintain the overnight rate to 1 percent. A wise decision, indeed.

From today's press release:

The outlook for the Canadian economy has weakened since July, with the significantly less favourable external environment affecting Canada through financial, confidence and trade channels.  Although Canadian growth rebounded in the third quarter with the unwinding of temporary factors, underlying economic momentum has slowed and is expected to remain modest through the middle of next year.

Domestic demand is expected to remain the principal driver of growth over the projection horizon, though at a more subdued pace than previously anticipated.  Household expenditures are now projected to grow relatively modestly as lower commodity prices and heightened volatility in financial markets weigh on the incomes, wealth and confidence of Canadian households. Business fixed investment is still expected to grow solidly in response to very stimulative financial conditions and heightened competitive pressures, although it will be dampened by the weaker and more uncertain global economic environment.  Net exports are expected to remain a source of weakness, owing to sluggish foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar.

Overall, the Bank expects that growth in Canada will be slow through mid-2012 before picking up as the global economic environment improves, uncertainty dissipates and confidence increases.  The Bank projects that the economy will expand by 2.1 per cent in 2011, 1.9 per cent in 2012, and 2.9 per cent in 2013.

The weaker economic outlook implies greater and more persistent economic slack than previously anticipated, with the Canadian economy now expected to return to full capacity by the end of 2013. (emphasis original)

For those of you scratching your head and wondering why it'll take so long for full capacity to return, you should know that Canada's current capacity utilization rates are near the lowest non-recessionary levels they've been in two decades.

Also, it's significant that the Bank's statement highlights the fact that fiscal austerity in Europe and elsewhere is contributing to restrain growth across the advanced economies.

The downside of paying down the national debt

Tom Hickey (via Mike Norman Economics) points us to a NPR article in which we learn of a report outlining some of the reservations of Washington officials during the Clinton years about paying down the US federal debt.

The NPR story reminds me of Alan Greenspan's testimony before the Budget Committee of the House of Representatives on March 2, 2001.  During that testimony, the Chairman of the Fed stunned Congress when he explained that the objective of zero debt might come at a cost.  According to Greenspan,

...continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer-term fiscal policy issue of whether the federal government should accumulate large quantities of private (more technically, nonfederal) assets. 

At zero debt, the continuing unified budget surpluses now projected under current law imply a major accumulation of private assets by the federal government. Such an accumulation would make the federal government a significant factor in our nation's capital markets...

In other words, what Greenspan was trying to hint at is that an "accumulated surplus" (i.e., negative debt) would either result in a reduction in the money supply, which would be deflationary, or force the US government to acquire private financial assets, which would be tantamount to the nationalization of US industry.  I remember like it was yesterday the look of disbelief on the faces of Committee members upon hearing Greenspan's testimony.

Of course, there are other problems with paying off public debt.  As I've discussed in a previous column, in the case of Canadian provinces, years of public debt and deficit reduction have led to the increased financial vulnerability of the household sector in those provinces.  Policymakers beware.

Federal Reserve Board, Current Fiscal Issues, "Testimony of Chairman Alan Greenspan Before the Committee on the Budget", US House of Representatives, March 2, 2001

h/t: Tom Hickey

On austerity in the UK

From the Opinion Pages of the NYT:

Drastic public spending cuts were the wrong deficit-reduction strategy for the weakened British economy a year ago. And they are the wrong strategy for the faltering American economy today. Britain’s unhappy experience is further evidence that radical reductions in federal spending will do little but stifle economic recovery.

A few years of robust growth would go far toward making swollen federal deficits more manageable. But slashing government spending in an already stalled economy weakens anemic demand, leading to lost output and lost tax revenues. As revenues fall, deficit reduction requires longer, deeper spending cuts. Cut too far, too fast, and the result is not a balanced budget but a lost decade of no growth. That could now happen in Britain. And if the Republicans have their way, it could also happen here.

Austerity is a political ideology masquerading as an economic policy. It rests on a myth, impervious to facts, that portrays all government spending as wasteful and harmful, and unnecessary to the recovery. The real world is a lot more complicated. America has no need to repeat Mr. Cameron’s failed experiment.

I couldn't agree more. The only thing missing from this article is a discussion on the high level of indebtedness of the household sector in the UK. For such an analysis, see this first-rate piece of research by economists Richard Barwell and Oliver Burrows of the Bank of England (2011:17).

Barwell, R. and O. Burrows, "Growing Fragilities? Balance sheets in the Great Moderation", Bank of England, Financial Stability Working Paper, No. 10, April 2011.

Stephen Harper, David Cameron and the illusive dream of austerity

Last week, Canada's Prime Minister, Stephen Harper, and his British counterpart, David Cameron, joined forces to urge world leaders, especially those of European nations, to embrace austerity as a way to avoid tipping the world economy into recession.

According to Harper and Cameron, cutting government expenditures is the only way to fix the national economies of Europe and the United States, and restore confidence in the market. Excessive debt, they say, are to blame for the current problems now affecting several European countries. And the best way to remedy these problems, they conclude, is for nations to deliver on their promises to impose austerity measures and implement budget cutbacks on government expenditures.

In my view, there are a number of problems associated with this course of action. Firstly, from a historical standpoint, it should be emphasized that austerity has been found to be associated with positive economic performance in only a minority of cases where it has been attempted. For instance, an IMF study authored by C.J. McDermott and Robert Wescott concluded that fiscal retrenchment was accompanied by improved economic conditions in only 19 percent of the relevant episodes occurring between 1970 and 1995 (1996).

Also, more recently, a study by Alberto Alesina and Sylvia Ardagna found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, both studies demonstrate that the odds of successfully reducing public debt levels and achieving increased growth through austerity are not very good.

Secondly, austerity rarely leads to improved economic conditions solely as a result of fiscal retrenchment by government. Most often, successful public sector austerity campaigns are the outcome of the combined effects of monetary policy and exchange rate policy, as well as the positive impacts of external economic conditions.

For instance, Canada's experience with austerity in the mid-1990s could be viewed as positive largely because of the change in US exchange rate policy announced in April 1995. As I explained in a previous column, this change in US exchange rate policy

...resulted in the rise in the value of the US dollar against other currencies. The ensuing depreciation of the Canadian dollar provided a huge boost to Canada's exports, and helped Canada achieve several years of consecutive current account surpluses.

In the case of many European countries today, austerity cannot benefit from changes in monetary and exchange rate policies given that the European Central Bank has no mandate to assist members of the European Monetary Union (EMU) in this regard. Also, given the weak global economic conditions at the moment, European nations cannot look to improvements in trade as a way to achieve growth.

Finally, there is something inherently odd about hearing the Canadian and British Prime Ministers scold Europeans with calls to stem the growth in public debt. As the subprime crisis and the ensuing recession have taught us, it is excessive household debt that ought to be the main preoccupation of governments right now. And when it comes to excessive household debt, Canada and the UK are countries with two of the highest household debt to GDP ratios in the world.

To be sure, it is true that public sector debt is currently a problem in many European countries. However, the problem is primarily the result of structural deficiencies in the EMU, not the result of excessive fiscal spending. These structural deficiencies have been known to many economists since before the EMU was even established. Thus, budgetary austerity in the Eurozone will do nothing to remedy the public sector debt crisis now affecting Europe. If anything, further austerity will likely worsen the existing situation (see Forstater, 1999).

On the issue of excessive household debt, the Bank for International Settlements (BIS) has recently estimated that a household debt to GDP ratio above 85 percent has damaging effects on growth (Cechetti et al., 2011). With ratios now at over 94 percent and 100 percent, respectively, Canada and the UK are well above the "safe" limit set by the BIS. Canadian and British policymakers should take note of this fact. (For more on ratio figures, see Tang and Upper, 2010:27)

Also, it would be appropriate to remind policymakers of the "counterpart principle" in government transactions put forth by economist Kenneth Boulding and others several decades ago (1958:169). According to this principle, all activities of government have opposite counterparts in the private economy. Thus, any decision by government to cut expenditures or increase taxation will have an impact on private sector income and savings.

In other words, for every dollar, pound or euro not spent by government, one less dollar, pound or euro gets added to private sector bank accounts. Similarly, for every additional dollar, pound or euro levied in taxes to reduce public sector deficits and debt, there is one less dollar, pound or euro available for the private sector to spend, add to savings or use to pay down private debt.

In a context of excessive household debt and weak global economic conditions, government austerity will most likely have serious deleterious effects on the balance sheets of households. Under such circumstances, austerity is not to be recommended.

To conclude, I strongly urge Messrs. Harper and Cameron to consider the above before continuing to praise the merits of public sector austerity.

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Boulding, K., Principles of Economic Policy, (Englewood Cliffs: Prentice Hall), 1958

Cecchetti et al., "The real effects of debt", BIS Working Paper No. 352, 2011

Forstater, M., "Introduction", Eastern Economics Journal, Vol. 25, No. 1, 1999

McDermott, C.J and Wescott, S., "Fiscal Reforms that Work", Economic Issues, No. 4, November, IMF, 1996

Tang, G and Upper, C., "Debt reduction after crises", BIS Quarterly Review, September, 2010