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27.01.2003, 16:59

Deficits and Interest Rates: The Causal Connection / mises.org-Artikel

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Deficits and Interest Rates: The Causal Connection
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By Christopher Mayer

[Posted January 27, 2003]

[img][/img] Economic
debates seem to have their own growing seasons. For stretches of time they may
disappear, only to reappear in later years covering the same old ground again.
The debate about the effects of deficits on interest rates, though temporarily
stunted by the frosty winters of the Clinton years with its visions of budget
surpluses, is back with all of its heartiness intact.

It's back because times have changed, as they always do -
the economy has weakened, the stock market bubble has burst. Government
revenues are falling off while government spending grows apace. There is war
talk in the air; proposals of economic stimulus packages and tax cut chatter.
The cheery optimism that produced those rosy budget surplus forecasts of
yesteryear is long gone. What was once passÃ©, the debate regarding government
deficits and their effects on the economy has again attained significance.

As with many economic questions, this one can degenerate
into a de facto political debate where economics is sought after only as
vestments by which political opinions are given the aura of authority. In a
fashion akin to religious wars, each side likes to claim that the science of
economics is on its side. Those in favor of the Bush administration's fiscal
policy are prone to dismiss or downplay the risk of deficits and there is not
shortage of court economists willing to take up the charge. 

Witness the salvo written by the editorial staff of The
Wall Street Journal titled"Flacking for Rubinomics" where
the view that deficits push up interest rates (inaccurately dubbed"Rubinomics")
was sarcastically dismissed."Robert Rubin's theorem is all politics…"
the Journal sneered, adding that its point is"to argue
against the Bush tax cuts and especially against making them permanent. The
economics are incidental."  By implication, The Journal
believes that economics will back its position that deficits do not push up
interest rates.

A couple of weeks later, as if answering to the call,
economist Rik Hafer produced a piece entitled"The Deficit Debate"
in which he says the conventional wisdom - that deficits do push up interest
rates - does not fit the facts. 

The facts, as he sees them, involves historical and
statistical comparisons. This is the basic blocking and tackling practiced by
many typical modern economists. He compares the Congressional Budget Office's
surplus projections with the ten-year Treasury Inflation-Indexed Securities
yield. Citing figures produced by Fed Reserve economist Kevin Kliesen, Hafer
notes how interest rates rose steadily in the late 1990s as the projected
budget surplus increased steadily. Since early 2001, the projected surplus
numbers have been coming down and, instead of increasing, the yields on the
TIIS have actually declined. Hafer concludes,"the evidence clearly
rejects the conventional deficits-beget-higher rates view."  

Skewering conventional wisdom in a public forum is great
sport. Unfortunately for Hafer, the conventional wisdom is closer to the truth
on this matter.

"The noise of a waterfall"

Before addressing the matter of deficits directly, something
must be said about the method by which conventional modern day economists ply
their trade. For Hafer, and others like him, economic questions are to be
answered by an appeal to the facts, i.e. to the historical record.

The problem with that approach is rooted in the nature of
history and the intricacy of its causal chains. History is a complex
phenomenon where one can never isolate any one cause or factor. Ludwig von
Mises tirelessly hammered home this point as he placed economics firmly on a
foundation of deductive logical analysis. Writing of the social sciences in
general and of economics in particular, Mises observed that these disciplines
"are in the same position as acoustics would be if the only material of
the scientist were the hearing of a concerto or the noise of a waterfall." 

Statistics are factual but they do not explain. Mises wrote
"the material which statistics provides is historical, that means the
outcome of a complexity of forces. The social sciences never enjoy the
advantage of observing the consequences of a change in one dimension only,
other conditions being equal."

Statistics are open to various interpretations and the
historical record can be made to fit many theories. The mere effort involved
in selecting what data to use and what to discard is colored by the human
data-miner - his tastes, his ideas, and his biases and is also limited by
the data available. For Mises, economics begins with sound deductive reasoning
and theory:  "Economic history can neither prove nor disprove
the teachings of economic theory. It is on the contrary economic theory which
makes it possible for us to conceive the economic factors of the past."

Economics, then, is not an empirical science. Its questions
cannot be answered by simply looking for patterns in historical data. There
are numerous factors that influence interest rates - savings, currency
factors, legal and political factors, etc. 

The list goes on and on. For example, Hafer writes,"Apparently
the government's growing appetite for funds is not evident in the falling real
interest rate."  But this could be explained by many other
factors such as a drop-off in demand for such funds so that even though the
government's appetite for funds was expanding, rates still fell. It seems rash
and awful simplistic to simply conclude as Hafer does. The obvious absurdity
would be to take his argument to the extreme and say that increased government
borrowing lowers interest rates.

So the charge that the conventional wisdom does not fit the
facts is easily repelled by noting that many factors influence interest rates
and that no statistical comparison, no matter how advanced or comprehensive
can isolate these facts. There is no way to go back in time and replay two
scenarios, one with deficits and one without, and observe what happens. It
cannot be done. 

No matter how closely two factors may track each other
historically it is nothing if not backed by a sound theory. Using statistics
in this manner is inappropriate in attempting to understand the realm of human
action. Hafer's writing is a perfect example of the fallacy of trying to
refute logic with statistics. To Mises everlasting credit, he understood the
limitations of statistics and refused to compromise on that truth.

What logic tells us

The relationship between deficits and interest rates has to
be understood logically.

First we have to understand that there are two ways such a
monster is fed. The government may borrow by financing its deficits through
bonds bought and held by the public. This has the effect of redirecting
savings from serving the wants of consumers to serving the wants of government
officials. 

As Murray Rothbard noted,"…logic tells us that if
savings go into government bonds, there will necessarily be less savings
available for productive investment than there would have been, and
interest rates will be higher than they would have been without the deficits [italics
added]."  And there we find the answer and the key qualifier,
which is highlighted in italics. 

The simplicity and brevity of this argument stands in sharp
contrast to the muddled empirical inferences wrought by many economists today.
It is irrefutably true. Savings are finite and a siphoning of these funds by
government can only mean less is available for private use. Whether the actual
interest rate is higher or lower during times of deficits is irrelevant; what
really matters is what might have been without the deficits. 

The second way the government can finance its excesses is
through bank inflation. Borrowing through the banking system is a form of
inflation with the newly"printed" money going first to the
government and then spreading throughout the economy as it is spent. As such
it is an indirect"tax" on everyone who uses its money. Bank
inflation does not tap savings directly, as does public borrowing, but taps
savings and consumption. 

Still, the crowding-out effect is operative as the new money
"printed" by the government is competing for resources with old
money saved by the public. The inflation benefits some of the population at
the expense of others and also sets the"boom-bust" phenomenon in
motion. In addition, as Rothbard adds"…the greater the deficits the
greater the permanent income tax burden on the American people to pay for
mounting interest rate payments, a problem aggravated by the high interest
rates brought about by inflationary deficits."  

In summary, deficits, no matter how they are financed,
divert valuable capital from the serving the wants of the public. Hence, the
accumulation of savings, a key component of increasing the general standard of
living, is frittered away. Interest rates are higher as a result. 

The chief role of economics is to discover these indirect,
somewhat concealed consequences of the various forms of human action. As
Rothbard neatly summarized,"The hidden order, harmony and efficiency of
the voluntary free market, the hidden disorder, conflict and gross
inefficiency of coercion and intervention - these are the great truths that
economic science, through deductive analysis of self-evident axioms, reveals
to us." 


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Christopher Mayer is a commercial lender for Provident Bank in the suburbs
of Washington, D.C.  Send him MAIL and
see his Mises.org Articles
Archive.