Another Unconvincing Argument for Fiscal Responsibility

In an earlier post, I pointed out that, with the government’s interest rate below the expected US growth rate, running a deficit is cheaper than not running a deficit. The usual counterargument is that interest rates are going to rise soon, and then running a deficit will no longer be cheap.

If this is really true, it’s mostly an argument for the Treasury to finance at longer maturities. If interest rates are going to rise, the Treasury has the opportunity to lock in today’s low interest rates, and then running a deficit would once again be cheaper than not running a deficit. (It’s possible that a shift to long-term financing would push up long-term rates to the point where running a deficit becomes expensive, but we’ll never know until we try.)

But I have a couple of reasons for questioning the premise. First of all, if interest rates are going to rise, then what kind of idiots are out there holding the long-term bonds? You might say they are being held by central banks that don’t care about profits and losses. I’ll certainly acknowledge that central banks care a lot more about macroeconomic conditions than they do about profits and losses, but I won’t concede that they ignore profits and losses completely even when macroeconomic conditions are not an issue. If anything, investing short-term would give them more flexibility to deal with future changes in the macroeconomic environment. Why would they take the risk of investing long-term when they are getting no reward (indeed, being punished) for taking that risk? I expect that the People’s Bank of China has a pretty smart research staff, and if the PBoC is choosing to invest long-term, it is because they have good reason to expect interest rates to stay low.

When I look at macroeconomic conditions in the world, I’m inclined to agree with whoever is telling the PBoC not to worry so much about rising interest rates. With so much new labor being integrated rapidly into the world economy, potential output is rising quickly, but businesses are still cautious about investing (or, as in China, they are not so cautious, but they are facing adjustment costs), so central banks have to keep interest rates low to help actual output catch up with potential. Some (e.g. Japan and Europe) may be entering a tightening cycle, but others (e.g. the US) are nearing the end of their tightening cycle. In general in the world today, the risk that overheating will require interest rates to rise seems less than the risk that fragile sources of demand (e.g. overextended US consumers, emerging market investors) will collapse and require interest rates to fall.

Actually, I have come up with some reasons for me to oppose deficit spending, but rising interest rates isn’t one of them. (And, I’m afraid, neither are the reasons I will discuss in the next two posts on this subject.)