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March 14, 1 980
Inflation remiums, Budget eficits
Productivity growth in the United States has
been on a declining trend for some time.
During the first twenty years after World War
II, output per man-hour in the private nonfarm business sector rose at an average
annual rate of just under 2% percent. But
from 1965 to 1973 the increase was only
1V2percent, and from 1973 to 1 979 it was
less than 1 percent a year. (Indeed, in 1979
productivity actually turned negative.)
Weakened productivity performance has
stunted growth in real income and contributed to inflation by reducing the supply of
goods relative to the stock of money.
According to one popular explanation,
governmental borrowing has helped create
this poor productivity performance by
"crowding out" private capital formation.
The Federal government has run relatively
large budgetary deficits over the last decade.
These deficits must be financed by
borrowing, which absorbs saving that could
otherwise have financed the accumulation of
capital and contributed to productivity
growth in the private sector. Thus, the
argument goes, excessively large deficits of
the Federal government have "crowded out"
private capital formation by bidding away
loanable funds from business borrowers.
There is nothing wrong with the argument in
theory. The only question is whether it is
consistent with the actual facts. Superficially
it appears to be. In the 1 950's and early
1 960's, Federal budget deficits in some years
tended to be offset by surpluses in others,
providing an overall balance. But in 1 965-73
the Government averaged a deficit equal to
0.7 percent of the gross national product; and
in 1 973-79 the average deficit jumped to
1 .7 percent of GN P. The facts appear
obvious, butthere is a problem in interpreting
them because inflation distorts our measurement of the deficit's net absorption of saving.
. Cause of distortion
The distortion arises from the existence of
inflation premiums in interest rates. It is well
known that nominal interest rates reflect
1) a real component that is independent of
the rate of inflation, and 2) an inflation
component that incorporates both borrowers' and lenders' expectations of inflation.
The higher the expected rate of inflation, the
higher the rate of interest that borrowers are
willing to pay and that lenders require to
protect the purchasing power of their
sacrifice in current consumption. Inflation
premiums can distort the deficit, because
a substantial portion of Government expend itures represents payments of interest on the
national debt, and also because the largest
part of these payments currently consists of
inflation premiums.
The usual measurement of the deficit overstates the Government's net absorption of
saving, because borrowi ng for the payment of
inflation premiums is self-financing. Inflation
premiums constitute income to the holders of
Government debt, all of which must be saved if they are to maintain the real value of their
wealth. Since this added saving is returned to
the capital markets, Government borrowing
to pay for inflation premiums is self-financing
and therefore does not bid away loanable
funds from private borrowers. Consequently,
to the extent that deficits are generated by
borrowing to pay inflation premiums to the
holders of Government debt, there is no
crowding out.
An example will illustrate this point. When
there is no expectation of inflation and the
Government budget is balanced, all private
saving flows into private capital investment;
and there is no crowding out. Compare that
with a situation in which all behavior is the
same in real terms-except that a 10-percent
rate of inflation is expected, and nominal
interest rates are therefore 10 percent higher.
Households now receive larger money
incomes because of the payment of inflation
premiums to them by the Government, and
Federal budget was roughly balanced, with
or without adjustment for such premiums.
However, by the late 1960's and 1970's the
adjustment made a significant difference (see
chart). The Federal budget, as traditionally
rneasured, moved into an average deficit
equal to 0.7 percent of GN P in 1965-73 and
1 .7 percent in 1 973-79. But with the
subtraction of inflation premiums from the
deficit, the Federal budget actually averaged
surpluses equal to 0.5 percent of GN P in
1 965-73 and 0.3 percent in 1 973-79-about
the same as the average surplus in the early
1 960' s. Rather than bei ng a net absorber of
funds, the Federal government has continued
to be a modest net suppl ier, when adjustment
for the effect of the payment of inflation
premiums on private savings is made.
by business borrowers as well. Most
importantly, as rational individuals they must
save all of the increment to their incomes
from the inflation premiums in order to
maintain the same level of real wealth as they
would have done in a non-inflationary
environment. Thus, on the supply side of the
capital market, household incomes and the
resultant savings made available to the
market are increased by the size of the
inflation premiums paid by Government.
On the demand side, if real taxes and
expend itu res are to be the same as before, the
Government must borrow in order to pay the
inflation premiums on its debt. But this does
not put any net pressure on the capital market
because households are making available to
the market an exactly equal increment of
saving out of their higher incomes. So on
balance, the borrowing of the Government
does not bid away loanable funds from
private borrowers or cause any actual
crowding out of private capital formation.
Moreover, even though the Government
budget is still balanced in real terms, as
traditionally measured it shows a deficit
equal to the inflation premiums paid.
Borrowi ng by state and local governments
can also cause crowding out, and their
budgets should similarly be adjusted for the
amount of inflation premiums paid to
lenders. Combined state and local budgets,
which tended to be nearly in balance in the
1960's, moved strol!gly it}to surplus during
the 1970's. With rising inflation, larger inflation premiums were paid to holders of state
and local debt. The payment of such inflation
premiums reduced their measured surpluses.
Butthe reduction in the amount offunds they
supplied to capital markets was offset by the
added income received by holders of their
debt, and hence, by the extra saving undertaken by debt holders. Consequently,
traditional measures of state-local surpluses
understated the extent to which this sector
became a net supplier of funds to capital
markets.
How large a distortion?
The distortion in budget figures caused by
inflation premiums can be quantified in the
following way. Since the average maturity of
the Federal debt is only two to three years,
inflation premiums are reflected in nominal
interest rates within a year or so. If we use the
previous year's increase in consumer prices
as a measure of expected inflation, and
multiply that measure by the size of the debt,
we can arrive at the total amount of inflation
premiums paid on Federal debt in anyone
year. To obtain a consistent measure of the
degree to which the Federal budget absorbs
. private savings-or the extent of crowding
out-we then deduct total inflation
premiums from budget deficits (or add them
to surpluses).
Crowdingout-no explanation
Overall, the crowding-outargumentdoes not
appear to be a satisfactory explanation of the
recent weakening in productivity growth.
Neither has the drop in the aggregate saving
rate been large enough to limit private capital
formation. To be sure, the rate of personal
saving (which is overstated due to inflation
premiums) has lately been trending down,
reaching a record low of 3.3 percent in the
In the early 1960's when inflation was low,
inflation premiums were trivial; and the
2
final quarter of 1979. Still, the growing
surpluses of state and local governments have
served as an effective offset. With the
aggregate saving rate relatively stable, the
ratio of total investment in plant and
equipmentto GN P, not surprisingly, has held
fairly steady at the historical figure of about
10 percent.
knowledge into production techniques and
the diversion of a growing share of labor and
capital resources to meet mandated
requirements for pollution abatement and
safety. Experts differ as to the precise
importance of such factors. But at least one
thing seems clear. Because borrowing to pay
for inflation premiums on Government debt
is self-financing, traditional accounting
procedures give a misleading impression of
the extent of crowding out caused by Federal
budget deficits.
Rather than a lack of private capital accumulation, some other factor or factors must
be responsible for our weakened productivity
performance. Leading possibilities include
a slowdown in the incorporation of new
Adrian W. Throop
Percent
,/1
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/
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__-+'
____- ____
T
I
/ Deficit
-1
-2
-3
-4
Federal Budget
As Percent
of
Deficit
GNP
Unadjusted
1 972
3
1976
1 980
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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollaramounts millions)
in
Selected
Assets Liabilities
and
large CommercialBanlcs
Amount
Outstanding
2/27/80
Change
from
2/20/80
Change
from
yearago
Dollar
Percent
+ 16,584
+ 13.6
+ 16.6
+ 16A76
241
138,334
Loans
(gross,
adjusted) investments*
and
- 176
Loans
(gross,
adjusted) total#
115,974
33,736
Commercial industrial
and
+ 14.7
+ 102
+ 4)35
Realestate
44,715
+ 24.6
+ 8,834
+ 158
+ 17.7
Loans individuals
to
24A57
+ 38
+ 3,672
- 185
213
- 13.3
1,384
Securities
loans
761
5
9.9
U.s. Treasury
securities*
6,927
+
70
869
Othersecurities*
15A33
+
+ 6.0
-2,916
42,172
Demanddeposits total#
+ 1,521
+ 3.7
- 308
Demanddeposits adjusted
30A98
+ 1,512
+ 5.2
- 277
1,823
6.1
Savings
deposits total
27,854
+ 17.1
59,775
Timedeposits total#
+ 779
+ 8,722
Individuals,
part.& corp.
51,067
+ 23.2
+ 727
+ 9,613
(Large
negotiable
CD's)
+ 14.5
21A57
+ 551
+ 2,713
Comparable
WeeklyAverages
Weekended
Weekended
of Daily Figures
year-ago
period
2/20/80
2/27/80
MemberBankReserve
Position
78
Excess
Reserves )/Deficiency - )
(+
(
16
+ 20
291
112
Borrowings
125
212
Net freereserves+ )/Netborrowed-)
(
(
141
92
Federal
Funds Seven
large Banks
+2,911
+1,995
Net interbank
transactions
+2,880
[Purchases )/Sales )]
(+
(Net, U.s. Securities
dealertransactions
23
+
+ 364
+ 136
[Loans
(+)/Borrowings
(-)]
* Excludes
tradingaccountsecurities.
# Includes
itemsnotshownseparately.
Editorialcomments
maybeaddressed the editor (William Burke) to the author.... Free
to
or
copies this
of
andother Federal
Reserve
publications beobtainedby callingor writing the PublicInformation
can
Section,
federal Reserve
Bankof Sanfrancisco,P.O.Box7702,SanFrancisco
94120.Phone
(415)544-2184.
I
@FedFRASER