Budget Deficits and Interest Rates Reply to Spiro

The transition strategy from administratively set interest rates to market rates is discussed. Despite worldwide trends toward financial liberalization, few monetary authorities are prepared to accept as reasonable any interest rate level that is market determined. The paper suggests some helpful indicators to assess the adequacy of interest rates and discusses factors that contribute to a smooth liberalization process. The main conclusion is that interest rate liberalization is not synonymous with laissez-faire policies, but requires the replacement of the administratively set interest rates by indirect monetary management techniques that operate through the market.

Abstract

The transition strategy from administratively set interest rates to market rates is discussed. Despite worldwide trends toward financial liberalization, few monetary authorities are prepared to accept as reasonable any interest rate level that is market determined. The paper suggests some helpful indicators to assess the adequacy of interest rates and discusses factors that contribute to a smooth liberalization process. The main conclusion is that interest rate liberalization is not synonymous with laissez-faire policies, but requires the replacement of the administratively set interest rates by indirect monetary management techniques that operate through the market.

In this issue, Spiro (1990) finds evidence that supports the hypothesis that “higher government debt contributes to higher interest rates.” He also suggests that I concluded (Findlay (1990)) that the effects of deficits on interest rates remain, as Spiro (1987, p. 403) himself noted, as “elusive as ever.” He further suggests that the situation is “not as bleak as my assessment appears [emphasis added] to make it.” Apparently I was not as clear as I should have been. The purpose of this reply is to clarify my earlier conclusions and to offer several additional observations.

I did note (p. 438) that the interest rate effects of current and lagged budget deficits remain elusive. A casual observation of randomly selected articles on this relationship between the interest rate and the deficit reveals a variety of empirical estimates. Budget deficits have been found to have positive effects, no effects, or even negative effects on interest rates. (For a detailed review of this literature, see Barth, Iden, Russek, and Wohar (1989).) It was this diversity of empirical estimates that initially interested me in this area of research. In particular, I have been interested in examining which factors may have led to the different results.

I also indicated (p. 438) that the approach used by Bovenberg (1988) and Kim and Lombra (1989) is “intuitively appealing and clearly motivated.” They argued that it is expected deficits that will influence interest rates. The results obtained in these two studies appear quite promising; increases in expected budget deficits do cause increases in the interest rate variable. The primary objective of my comment was to determine whether Bovenberg’s results would be obtained for alternative specifications of the interest rate equation and for alternative measures of the deficit variable. Barth, Iden, and Russek (1985) and Seater (1985) have argued that government expenditures must also be included in interest rate equations that include a deficit variable. When the government expenditures variable was included, the effects of expected deficits on interest rates were not as significant as those initially reported. It was not my intention then, nor is it now, to argue that deficits have no effects on interest rates. The main point that I wanted to make in the conclusion is that “additional research, like that presented by Bovenberg [and more recently, by Spiro], is needed on the formation of expectations and on the appropriate specification of interest rate equations,” (p. 438).

The comment by Spiro raises an interesting question about the choice of the deficit/debt variable. In the interest rate equation studies, a number of important issues have to be resolved. First, should a deficit variable or a debt variable be included as the right-hand-side variable? If government debt is the appropriate variable, should the market value or par value be included? If the deficit variable is included, should we use real or nominal (cyclically adjusted or unadjusted) deficits? Furthermore, how does the researcher take into account deficits (or debt) created by state and local governments? A second issue focuses on the measurement of the interest rate variable (that is, before-tax or after-tax, nominal or real, or short-term versus long-term interest rates). Third, are results sensitive to the choice and construction of the expected inflation variable? Fourth, what type of theoretical model should be used to obtain the interest rate equations? There are other issues that also need to be addressed. As noted by Barth and others (1989), many of these (and other) issues have already been examined, to varying degrees, in previously published papers.

In any event, we must continue to examine the appropriate specification of the interest rate equations and to test the robustness of empirical results. The points briefly discussed above make this issue one of the more interesting (and controversial!) in macroeconomics, and it will undoubtedly continue to receive the attention of economists who attempt to disentangle the effects of fiscal actions on the macroeconomy.

REFERENCES

  • Barth, James R., George R. Iden, and Frank S. Russek, “Federal Borrowing and Short-Term Interest Rates: Comment,” Southern Economic Journal, Vol. 52 (October 1985), pp. 55459.

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  • Barth, James R., and Mark Wohar, “Effects of Federal Budget Deficits on Interest Rates and the Composition of Domestic Output,” paper presented at the Conference on Fiscal Policy (Washington; The Urban Institute, 1989).

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  • Bovenberg, A. Lans, “Long-Term Interest Rates in the United States: An Empirical Analysis,” Staff Papers, International Monetary Fund, Vol. 35 (October 1988), pp. 38290.

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  • Findlay, David W., “Expectations and Long-Term Interest Rates: Comment on Bovenberg,” Staff Papers, International Monetary Fund, Vol. 37 (October 1990), pp. 43339.

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  • Kim, Sun-Young, and Raymond E. Lombra, “Why the Empirical Relationship Between Deficits and Interest Rates Appears So Fragile,” Journal of Economics and Business, Vol. 41 (October 1989), pp. 24151.

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  • Seater, John J., “Does Government Debt Matter? A Review,” Journal of Monetary Economics, Vol. 16 (October 1985), pp. 12131.

  • Spiro, Peter S., “The Elusive Effect of Fiscal Deficits on Interest Rates: Comment on Tanzi,” Staff Papers, International Monetary Fund, Vol. 34 (October 1987), pp. 400403.

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  • Spiro, Peter S., “The Effect of Government Debt on Short-Term Real Interest Rates: Comment on Findlay,” Staff Papers, International Monetary Fund, Vol. 37 (October 1990), pp. 88188.

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David W. Findlay is an Assistant Professor in the Economics Department at Colby College, Waterville, Maine.