New Evidence on Deficits and Interest Rates

IT IS GENERALLY ASSUMED ON THEORETICAL GROUNDS that increases in government borrowing cause interest rates to rise. 1 But empirical support for this proposition has been weak at best. Several recent papers have uncovered no strong relationship between deficits and short-terrn interest rates. However, the research reported here indicates that although the relationship between deficits and short-terrn interest rates may be tenuous, there is strong evidence that larger deficits are associated with higher long-terrn interest rates. Much of the debate about whether there is a strong relationship between federal borrowing and interest rates concerns the crowding-out question. This controversy centers on the direct and indirect eilffects of government fiscal actions on private spending. These effects have been well documented in the theoretical literature (e.g., Buiter 1977; Carlson and Spencer 1975; Blinder and Solow 1973). Many of the crowding-out effects studied in this literature depend on the connection between government borrowing and high interest rates (Friedman 1978; Meyer 1975; Silber 1970). This is called short-run indirect crowding out and may occur when increases in government spending (and borrowing) cause interest rates to rise, which then may cause private spending to be reduced (Buiter 1977, pp. 310-13).