The relationship between budget deficits and interest rates—and an interesting story

On Wednesday, Cato Institute economist Ryan Bourne wrote me the following:

There is a Conservative leadership race going on in the UK right now. Liz Truss promises to abolish the tax by installing her opponent Rishi Sunak as chancellor. If he overturned them all, that would mean canceling tax increases of about 2% of GDP. Sunak claims that this will worsen inflation.

Today in The Times The newspaper had an op-ed in the 1980s quoting David Stockman about how Reagan cut taxes and then couldn’t cut spending. This means that, despite promises to cut Trus spending, he won’t and the UK will have high deficits which will fuel inflation and lead to higher interest rates.

I pointed out to the author of the op-ed that inflation fell under Reagan and, in any case, was a fiscal phenomenon, and he said “Okay, but what happened to interest rates?” I checked and to my surprise nominal interest rates have declined since the early 1980s, though still remain historically high in real terms. Now economic research on the link between larger structural deficits and those higher real rates seems to yield mixed results. Ben Friedman and Krugman state that deficits inflate real rates; Hendershot and pick that it didn’t make much of an impact either way.

I wondered if you had navigated this debate at all and had any thoughts on who was right?

I had, and so I wrote the following:

I had strong priors in the late 1970s and early 1980s about the link between deficits and real rates. But the experience you mention has dashed my previous ones. Not only that, but in discussions since about 1984, plenty of people, both academic economists and fairly smart politicians like Dick Cheney, have argued that there was no connection. Politicians weren’t clear on why there wasn’t much connection.

Some economists—I remember Paul Evans of the University of Houston in the mid-to-late 1980s—gave one reason: Ricardian equilibrium. I recommend that you track down and read this article from the Journal of Political Economy in 1987:

https://www.journals.uchicago.edu/doi/abs/10.1086/261440

And then I added my funny story because it involved Martin Feldstein, my boss at the Council of Economic Advisers. Marty was a deficit hawk who believed there was a strong connection between deficits and real interest rates. Here’s the story:

I was a senior economist on President Reagan’s Council of Economic Advisers from August 1982 to July 1984. I went there a few weeks before Marty Feldstein became chairman the day after Labor Day in 1982. In the first meeting he said, he said. If we ever see him doing something wrong or making a wrong statement, we should call him out. (I tried it the other day on a fairly minor issue and got some pretty negative feedback, which I expected.)

Fast forward to 1983 writing Economic Report of the President. It’s crazy time. It starts at the beginning of November and goes to the end of January. CEA raises the hand of how hard we worked but the truth is, we worked harder than usual. So people are pumped up. It is our exciting time. There was a junior staff economist named David S. Reitman, an undergrad whom Marty had brought with him from Harvard. Over lunch in late December or early January, I think, David said he wasn’t sure he would “let Marty go” that higher deficits imply higher real interest rates. His point, which is well taken, is that the evidence for this relationship is extremely thin.

I laughed silently because I knew that if Marty wanted to say it, he would. He did, p. 86.

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