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CD)
IT
July2,1 982
Deficits, Interest Rates,Crowding Out
A spectre is haunting the financial community -the spectre of rising Federal budget
deficits. Fears are rampant that coming
deficits, by keeping interest rates high, will
severely retard -'crowd out' -private
investment, particu larly in key sectors such as
housing and autos. Almost certainly, these
worries help explain the present extraordinarily high level of long-term interest rates,
which in turn has dimmed hopes for a
vigorous recovery from the present recession.
Not all observers, though, see such dire consequences. Supply-siders maintain that the
Administration's tax cuts will stimulate
private savings enough to finance higher
government borrowing anda boom in investment. Moreover, one former administration
advisor, John Rutledge (President, Claremont
Economics Institute) argued recently in the
Wall Street
Journalhat private investors
t
would be willing to absorb projected
increases in Federal debt without substantial
interest-rate hikes, in part because of the
increasing attractiveness of financial assetsin
an environment of declining inflation.
Sti II, both sides of the controversy generally
view deficits, interest rates, and crowding out
as inextricably linked, in the sense that any
crowding out would be accomplished
through the mechanism of interest-rate
increases. Pessimists thus tend to see interest
rates as remaining very high for some years to
come, while optimists on the matter of
deficits and interest rates are often more
optimistic about crowding out as well. But in
fact (see below) the government actions
behind the deficits are likely to lead to
changes in many relative prices, and not
simply in interest rates-suggesting that
interest rates and crowding out are not so
rigidly linked.
Two channels
To many, increased deficits must push up
interest rates because of the higher Federal
borrowing they entail. With the government
taking a larger share ofthe supply of loanable
funds, private businesses and individuals
must be persuaded to borrow less (or lend
more)-and how else unless borrowing is
made more expensive? This reasoning is
plausible, but it is also incomplete because
deficits actually force two distinct types of
adjustment on the economy. The first is a
financialadjustmento the higher governt
ment debt the public must be induced to
hold. But since such borrowing is needed to
finance expenditures on business capital,
housing, and other goods and services,
deficits also force a real adjustment the
on
public's spending. Both of these adjustments
can affect interest rates, but the question in
each case is, by how much? And which is the
more important?
The first problem-persuading the public to
alter its existing holdings of securities to make
room for more government debt -may not
cause much of an interest-rate increase. Projected deficits, large as they are, are substantially smaller than the private sector's present
holdings of government debt-and only a
fraction of its total wealth. The composition
of private portfolios (i.e., the shares of alternative assets)thus wou Id not have to change
drastically to accommodate projected
increases in Federal debt. Furthermore, the
public's desired allocation of its wealth,
among short-term assetsat least, apparently is
fairly responsive to changes in their yields.
This suggeststhat the public is apt to digest
the extra government debt without any substantial rise in interest rates-partkularly
as
declining inflation makes financial assets
generally more attractive (relative to tangible
assets).
The real deficit problem concerns what
happens to the spending of those private
borrowers that cannot obtain funds when the
government takes more. But this worry pri-
IP1©i1&
Th
(G)
11
Opinions expressed in. this newsletter do not
necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal
Reserve System.
marily concerns commodity and factor
markets rather than financial markets.
and amortization on the funds borrowed
while still leaving some profit for the firm.
Basically, deficits must compete with private
investment for those real resources not being
used to meet current consumption needs, that
is, the resources provided by the nation's
saving. The deficit and private investment
thus are jointly constrained by the level of
saving; given a certain level of saving, the
more the government takes, the less private
investors must be content with. (Admittedly,
some resources can be borrowed from
abroad through a current-account deficit, but
typically the amount is fairly small in comparison to total
or even to projected
deficits). Higher budget deficits thus must
crowd out some private investment in the
absence of a rise in private saving. True, a
conflict may be avoided temporarily if there
is excess capacity in the economy, and thus
enough resources for all needs. But some
crowding out is virtually inevitable once full
employment is attained-unless the supplyside argument is correct about the effects of
tax cuts in stimulating private saving. The
only remaining question is howthis crowding
out will be accomplished: how will private
investors be persuaded to spend less?
This argument can be demonstrated by a textbook illustration (seechart). For the economy
as a whole, the level of investment demanded
(10) is simply the total value of all projects
with internal returns above the market rate.
What happens, then, when the government
crowds out investment (from 10to 11)by
raising its deficit?
Plainly, with no change in productivity, commodity prices, and production costs-with
no change in the investment-demand schedule-interest rates may rise substantially.
Indeed, they may rise high enough to force
the cancellation of enough previously-worthwh i Ie projects to release the saving-resources
the government requires. This assumption is
implicit in most analyses, and certainly it is
hard to dispute claims that interest rates will
have to rise very high to crowd out private
investment if they are the only mechanism for
doing so.
.
But surely, given enough time, other prices
are nearly certain to change. After all, deficits
arise from government tax and expenditure
decisions that directly affect demands and
supplies (and hence prices) for commodities
and productive factors. Suppose, for example, thatthe deficit rises because of increased
defense spending. To expand production,
defense industries will have to attract
resources away from other sectors by bidding
up their prices. Non-defense sectors, faced
with increased production costs, wi II experience lower internal returns to investment,
and so will reduce their demand for investment at any given interest rate (in the aggre.gate, the investment-demand schedule, 10,
shifts back). Or suppose the deficit results
from a tax cut which raises private demand
for consumption goods. Then consumption,
rather than defense, industries will bid up
factor costs in an effort to attract resources.
Still, as before, production costs will rise in
other industries, particularly capital-goods
industries, and investment will again fall.
Manyways
Higher interest rates need not be the Qnly
mechanism of crowding out, in part because
investment decisions depend on far more
than interest rates alone. Typically, a firm
contemplating an investment projectwill first
estimate its internal rate of return (l RR)-the
rate that equalizes a project's (discounted)
present cost with the present value of the
revenues raised from the project. This return
is, of course, higher the more output is
obtained for each dollar, and the higher the
price that output can be expected to fetch.
And the internal return is clearly lower the
higher are the costs of labor, materials, and
other factors used to produce the output. But
in any case, generally only those projects are
undertaken whose IRR's (allowing for risk)
exceed the market interest rate, since it is
these projects than can payoff the interest
2
Interest Rate
i1
(Just -after
Deficit)
I
1
1
11
(Long-run)
"
1
,I
---
-I"
1
(Before
Deficit)
"
1
iO
---+-
1
:
--
"
....
I
"'I D'
:
<Aftel' Deficit) I
I
ID (Before Deficit)
I
Investment (Real $)
-o-lCrowding Out'11
10
(After Deficit)
(Before Deficit)
I
Two lessons
Ultimately, then, crowding out will involve
changes in commodity and factor prices that
lower investment demand -an d not only
interest-rate increases. Naturally, interest
rates then will rise less (say to if rather than i 1)
when other prices vary than they wou Id i f
they alone bore the burden of adjustment.
(Conceivably, interest rates might have to rise
very little if the adjustments in these other
prices were great enough). Of course, price
changes may take considerable time, so
, interest rates may have to rise very sharply at
first when a deficit begins to crowd out
private expenditures. Subsequently, though,
as these other prices adjust, interest rates are
apt to fa II back -though such decl i nes wou Id
not signal any reduction in 'crowding out',
but only the working of other mechanisms to
accomplish it.
What, then, do future deficits imply for interest rates and crowding out? Much depends
on the course of saving: without a largerthan-expected rise in saving, crowding out
will result. However, crowding out may not
entail interest rates remaining at anywhere
near present levels over the next several
years. Ratesmay now be high because deficit
fears are exaggerated, or because interest
rates now must bear the full burden of deficit,
or because of market uncertainties about the
future course of monetary and fiscal policies,
or for some other reason. But in any case,
rates could well fall substantially in coming
years-even if crowd i ng out tu rns out to be
severe and persistent. Of course, i f interest
rates do fall we would still be premature to
claim that that meant an end to the deficit
problem, since crowding out might simply be
accomplished in other ways. For example,
the housing industry is now depressed
because high interest rates make the cost of
owning a home so expensive. But, the
industry's troubles will not be removed by
falling interest rates if defense-department
demands bid up carpenter wages and lumber
prices -and thus the price of houses -to
prohibitive levels.
Crowding out, then, may be simply an aspect
of a more general problem: how the private
sector adjusts to its 'loss' of the real resources
used up by government expenditures. Government spending for goods and services
always subtracts from resources available for
other purposes-resources which the private
sector must somehow be persuaded to relinquish. True, there may appear to be no
crowding out when expenditures are completely financed by direct taxation. But this is
only because the private sector releases the
required resources mainly by the tax-caused
reduction in disposable income rather than
by adjustments in relative prices. Financing
expenditures by borrowing generally causes
a smaller reduction in current income, so that
more of the adjustment is apt to fall upon
prices, including interest rates. So clearly, the
actual adjustment to a government deficit is
apt to depend much less on the size of the
deficit than upon the exact tax and expenditure measures producing it. For this reason,
there is hardly likely to be any fixed relation
between deficits and interest rates.
Still, the industries apparently hurt the most
by defi cits-the interest-rate sensitive
industries-may not be the worst sufferers in
the long run. I f interest rates fall considerably,
the most seriously affected sectors may
instead be those which use the same (or
similar) resources as those the government is
now demanding in increasing quantities. For
example, the defense build-up might drain
scarce engineering and other technical talent
from those high-technology electronics and
other industries which are now producing for
consumer and business needs-even though
such industries are generally hurt less by high
interest rates than are housing and autos.
Charles Pigott
3
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(G)
BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand Liabilities
Large Commercial Banks
Loans (gross,adjusted)and investments*
Loans(gross,adjusted)- total #
Commercial and industrial
Realestate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities*
Other securities*
Demand deposits - tbtal#
Demand deposits - adjusted
Savingsdeposits - total
Time deposits - total#
Individuals, part. & corp.
(Largenegotiable CD's)
Weekly Averages
of Daily Figures
Member Bank ReservePosition
ExcessReserves + )/Deficiency (- )
(
Borrowings
Net free reserves(+)/Net borrowed{- )
Amount
Outstanding
6/16/82
159,294
138,712
43,494
56,923
23,327
2,158
6,521
14,061
40,016
27,384
30,786
95,035
85,339
-35,124
Weekended
6/16/82
21
8
3.
. Change
from
6/9/82
Changefrom
year ago
Dollar
Percent
-
613
529
525
35
5
28
32
- 116
1,063
- 633
- 232
8
192
- 375
-
-
-
Weekended
6/9/82
114
199
84
9,472
10,763
5,516
4,245
318
, 565
88
1,379
761
519
550
14,920
14,523
4,436
6.3
8.4
14.5
8.1
1.4
35.5
1.4
8.9
- 1.9
1.9
1.8
18.6
20.5
14.5
Comparable
year-agoperiod
111
125
14
* Excludestrading account securities.
# Includes items not shown separately.
Editorial comments may beaddressed the editor (William Burke) or to the author . .. . Freecopiesof this
to
and other FederalReserve
publications can beobtained by calling or writing the PublicInformation Section,
Federal ReserveBankof SanFrancisco,P.O. Box 7702, SanFrancisco94120. Phone(415) 544-2184.
@FedFRASER