President Bush: deficits and interest rates
Gerard Jackson
The Democrats and their media supporters screamed that deficits would raise interest rates and dampen the economy. Many Bush supporters deny that interest rates are linked to deficits, and draw on Reagan's 1981 tax program for support.
Now a reasonable person might point out that if a government increases its demand for savings to fund a deficit this must surely increase interest rates and so crowd out private investment. Not quite.
It is true that if a government demands more of a nation's savings this will influence the level of interest rates, as a rule. The only exception I can think of would be when companies' price margins have been squeezed out of existence with no apparent prospect of recovery. Under these circumstances deficits would probably have no effect on interest rates. Of course, this is not the situation in the US.
Therefore deficits will inevitably influence interest rates. But readers should note that I did not say they would raise them. This is because interest rates are not determined by demand alone. For example, cutting capital gains taxes and ending the double taxation of dividends might offset the Government's increased demand for public funds by increasing savings. But in the absence of the deficit interest rates would have been lower.
We can therefore see that because interest rates do not necessarily move in tandem with deficits that does not mean that deficits are not influencing them. As this is the case then the answer is to raise taxes, or so the Democrats argue. No so fast.
It is obvious that when governments run deficits they are commanding resources they are not prepared to raise taxes to fund. The damage here is that governments must directly compete against the private sector for funds. Additionally, they must continue to use taxes to pay the interest on those borrowings.
But raising taxes will also affect interest rates. These tax receipts are redirected from private spending to government consumption. This in turn must keep savings lower than otherwise be the case. At the same time, by bidding resources away from the private sector it raises its costs of investing.
Be that as it may, deficit hawks argue that funding deficits is far more damaging because it directly attacks savings. If government spending was a small proportion of GDP this argument would have validity. But this approach has the effect of ratcheting spending and taxes upwards.
Increased government spending creates deficits that in turn bring about a demand for government to behave responsibly by raising taxes to eliminate the deficit it created. The inevitable result is that total government spending, meaning Federal, state and local, rises until it reaches the point where taxes and not deficits become irresponsible. In other words, the problem is not deficits but government spending.
Thus the Democrats' deficit argument for raising taxes becomes a recipe for crushing taxation and economic stagnation. Unfortunately, most Senate and Congressional Democrats, with a sprinkling of Republicans, do not understand this fact. What is even worse, they do not care to understand it.
We can now see that though there is no mechanical relationship between deficits and interest rates deficits definitely do influence them. So is President Bush right? From a free market angle he is. Not because free marketeers favour deficits, they do not, but because Bush, knowingly or otherwise, has drawn the public's attention to the fact that it is they and not politicians who pay for government spending.
And by they I mean even those who think they do not pay any taxes at all. Ultimately, nearly everyone pays. Perhaps this insight is what encouraged Oregon voters to come out in record numbers and reject by a margin of 54 per cent to 46 per cent an income tax hike.
(For reasons of simplicity I omitted the effects of monetary policy on interest rates).
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 26 July 2004