Do deficits boost real interest rates?

Traditional economic theory says “yes.” Deficits require governments to borrow more in capital markets. The increased demand pushes up real interest rates; this effect should be especially pronounced when we are at or near full employment.

But for a long time standard empirical work said “no.” Significant real interest rate effects from deficits are hard to find in the data.

A puzzle, no? More generally there are few propositions about real interest rates that I find convincing.

While the debate remains unsettled, some recent research, published by the Federal Reserve Bank of Philadelphia, offers a new spin on the problem. The claim is that expected future deficits have a significant impact on real interest rates, even if current deficits do not. Announcements that future deficits will be high, for instance, appear to raise real interest rates. If correct, this theory would allow us to resurrect a classical view of the macroeconomy. Relative price effects would reign supreme and the case for fiscal responsibility would be cemented.

I would welcome these conclusions but nonetheless I have my doubts. Once you postulate that individuals are so forward-looking, should not Ricardian Equivalence hold? Then it is the level of government spending that should matter, not the level of the deficit. And doesn’t the entire hypothesis rest on the expectations theory of the term structure of interest rates? Yet the expectations theory otherwise appears to be falsified. If you don’t know those technical terms, the bottom line is the following. The basic model relating deficits to other macroeconomic variables is murky, yet this hypothesis assumes a fairly simple set of relationships.

So where are we left? I’ll suggest a macroeconomic law. When in doubt, opt for moderation. This holds for both deficits and future expected deficits. And I suspect Alex assents as well.

Thanks to Bruce Bartlett for the pointer. His blog is an excellent place to follow developments on fiscal policy and supply-side macroeconomics. Supply-side economics has a bad name in this country. In part some of the Reagan advisors oversold the idea that tax cuts would increase total revenue. Let’s not forget that supply-side ideas, when applied in the proper context, have proven successful in many other countries.