Many years ago, when I was a high school math teacher, I would ask my students to provide constructive criticism on how to improve the class for future students. Invariably I would get one or two students who responded confidentially along the following lines: “This class really sucks.” A similar comparison can be drawn about the president’s proposed fiscal-stimulus package and the constellation of viable alternatives.
On a recent television news program, Sen. Kent Conrad condemned the president’s program and went on to say it was bad, misguided, costly, etc., etc. I don’t remember all the derogatory terms he used in this assault, but I could envision the possibility that Sen. Conrad was one of those students who critiqued my class. In other words — selected politicians have attacked the validity of the president’s program by calling it names rather than by offering up viable fiscal options.
The opponents of investment-oriented fiscal stimulus have honed in on the supposed negative impact of big-government deficits on the economy because deficits raise interest rates. As forecasts for the budget deficit rise, opponents of the president’s proposals keep dredging up that old linkage between bigger budget deficits and higher interest rates. Their purpose in this exercise is to sidetrack the president’s proposal on the grounds that a large budget deficit would force interest rates higher.
Rep. Barney Frank of Massachusetts cited a study demonstrating that for an X percent increase in deficit spending relative to GDP there is a Y percent increase in the long-term interest rate. Alan Greenspan, in questioning by Frank of his testimony before Congress, agreed with this relationship. Hmph!
Well, there are a couple of key points that have not been made in the disagreement between the camp that believes there is little, if any, relationship between budget deficits and interest rates, and some of the other guys who write economic papers.
Here’s one period in American economic history that shoots a large hole through the big-deficit/big-interest-rate argument. From 1983, when President Reagan pushed through his major tax cuts, through 1986, when his second tax-cut program passed, the budget deficit rose substantially. But during this same time (view chart), interest rates actually fell!
If my memory serves me correctly, the “fathers” of today’s economists predicted that the Reagan deficits would cause soaring interest rates. They didn’t get it right then, and they won’t get it right now.
This country recently witnessed a swing from a $200 billion surplus to an estimated deficit of $370 billion this fiscal year. Even such a huge swing from surplus to deficit has had no impact on interest rates.
The U.S. experience is not unique. In Japan, annual deficits are running at 7 percent of GDP and there’s a 150 percent debt-to-GDP ratio. (That ratio is only 3 percent in the U.S.). Meanwhile 10-year government bonds are being issued at 0.6 percent. So why aren’t big-time increases in government deficits causing interest rates to spike? The answer is relatively simple: Deficit financing does not occur in a vacuum.
Here is what is actually happening: The federal government is best thought of as spending first and borrowing later (by selling additional bonds) to “finance” that spending. At the time the government spends, it writes a check to somebody who either spends the money or saves it in a bank account. Theoretically, at the macro level, all the deficit spending winds up in a bank account belonging to either the original recipient or a subsequent recipient as it is spent. These same balances wind up buying the newly issued government securities. The whole process is circular except for a small part that the Fed takes care of as it fine-tunes the federal funds market.
If everybody used the money they received from a tax cut to buy government Treasury bonds, there would be no impact on the economy. But since we know that all of the money from a tax cut is not saved, we can assume that spending on other goods and services will work through the economy and produce economic growth, rising income, and increased hiring to increase output. Maybe President Reagan’s economic program that triggered strong economic growth was a policy that ultimately produced lower — not higher — interest rates.
At the least, this is what the data suggest. Sadly, this common-sense analysis is not part of the budget-deficit debate.
The president’s economic program will stimulate economic growth and the subsequent creation of wealth. It is the only solution to the long-term economic problems facing this country. If the party of wealth redistribution has its way, we will be worse off. But if the party of growth can educate a couple of its wayward members, the long-awaited meaningful recovery will at last arrive.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.