Arnold Kling

Deficits and Interest Rates

Arnold Kling, Great Questions of Economics
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According to standard macroeconomic models, cutting taxes should lead to higher interest rates. However, as Bruce Bartlett points out, estimates of the magnitude of this effect are elusive.

Former Clinton economist Brad DeLong recently called for the resignation of Council of Economic Advisers Chairman R. Glenn Hubbard for supposedly saying so, in contrast to what he wrote in his own textbook.

In fact, Hubbard's views are well within the mainstream of economists. In a December 10 speech at the American Enterprise Institute, he pointed out that many older textbook analyses of the impact of deficits on interest rates failed to take into account world capital flows, which are in the trillions of dollars per year. "The bottom line," he said, "is that real interest rates are not dictated by country-specific short-term deficits."

In principle, a cut in tax rates should reduce revenues, increase the deficit, and increase real interest rates. However, in practice, this is difficult to measure. Bear in mind that deficits and interest rates are both endogenous variables. Therefore, there is no stable relationship between deficits and interest rates.

Also, as Hubbard points out, the effect of a tax cut may be to increase capital inflows, causing a lower increase in domestic interest rates and a larger increase in foreign interest rates than in a closed-economy textbook model. However, to the extent that such capital inflows occur, the stimulative effect of the deficit is reduced by lower net exports. Thus, Hubbard's argument in no way justifies denying that some of the stimulative effect of deficits is offset by countervailing effects in financial markets.

Discussion Question. If higher deficits are only slightly stimulative, does this mean that we should aim for a smaller deficit--or for a larger one?

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