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FRBSF

WEEKLY LETTER

April 19, 1985

Views on Deficits and Interest Rates
One of the most confusing issues in the present
debate over econom ic pol icy is the argument over
the effect of federal government deficits, both current and projected, on interest rates. Widespread
confusion is understandable, in view of the conflicting views on the subject expressed by professional economists. Indeed, during the same set of
hearings before the Joint Economic Committee of
the U.S. Congress in the fall of 1983, a representative of the
Treasury concluded that the relationship between the federal deficit and interest
rates remained an open case; a representative of
the National Association of Realtors argued that
the current deficit was raising interest rates; and
the then-chairman of the Council of Economic
Advisers argued that justthe prospect of large
deficits through the rest of the decade was sufficient to raise real long-term interest rates and thus
crowd out current activity in interest-sensitive
sectors of the economy.

u.s.

Frameworks for understanding
The purpose of this Letter is to outline four different
frameworks that can be applied to the analysis of
the relationship between deficits and interest
rates. It is important to understand that each of
these frameworks predicts a different effect on
interest rates for deficits. The controversy is not a
new one in economics. The same issues have
been disputed in one context or another for fifty
years. Unfortunately, research efforts to date have
not been able to discriminate unambiguously
among the various frameworks.
It is also important to understand that the controversy over the impact of deficits on interest rates
usually focuses on a very limited issue. Frequently,
the exact question addressed is whether financing
a given amount of government expenditures by
borrowing has a different effect on economic
activity and interest rates than financing by taxation. Questions of the impact of changes in the
size of the government sector or whether the new
debt issued is purchased by the public or monetized by the Federal Reserve have not been major
concerns of the recent controversy.

Loanable funds theories
Loanable funds theories of interest rate determination view real, or inflation-adjusted, interest rates

as the "price" that adjusts to equate the supply of
and demand for loanable funds. Thus, proponents
of this theoretical approach focus on the size of
current government deficits-which are one of
the sources of demand for funds-in relation to
total private savings generated in the economy.
They believe an increase in the current government deficit relative to the flow of new private
savings causes real interest rates to rise to restore
equilibrium between the demand for and supply
of loanable funds. Generally, these analysts also
view the supply of private savings as quite unresponsive to changes in real interest rates, at least in
the short-run. They conclude that the rise in real
interest rates must reduce the demand for loanable
funds from other sources, notably for financing
business plant and equipment and housing, by
approxi mately the same amou nt as the increase in
demand presented by government borrowing.
Careful adherents to this approach acknowledge
that the reduction in the quantity of loanable fu nds
demanded also could come at the expense of
investment abroad by affecti ng the net capital flow
from the U.S. to foreign countries.

Portfolio balance theories
Portfolio balance theories of interest rate determination emphasize that, at every point in time,
the outstanding stocks of all assets in an economy,
real and financial, must be held in the portfolios of
some private wealthholders (households and/or
firms). In this framework, changes in interest rates
affect the decisions of wealth holders to hold the
outstanding stocks of all available assets, including government debt.
This framework explicitly recognizes that a temporary increase in the deficit has a different effect
from an increase that persists for several years.
Compared to the enormous size of outstanding
stocks of government bonds and other assets, the
flow of new government debt coming on to the
market in a single year is small. Thus, itshould not
take much of a change in interest rates to persuade
wealthholders to absorb a relatively small addition to their holdings of government bonds.
In contrast, deficits that are sustained over a long
period of time accumulate into a large percentage

FRBSF
change in the stock of government debt. This ultimately will require a relatively large increase in
real interest rates to induce wealthholders to
absorb the cumu lative deficits into thei r portfoIios.
Thus, while loanable funds theorists predict that
substantial changes in real interest rates will result
from deficits that are large in comparison with
current savings flows in an economy, portfolio
balance theorists predict such effects only after
government deficits cause significant changes in
the size of the outstanding government debt relative to the total wealth of the economy.

Forward looking expectations
A variant of the portfolio balance theory advocated by some analysts in the current discussion
over the impact of government deficits on interest
rates argues that expectations of on-going deficits
in the future will affect long-term interest rates in
the present. This argument relies in parton the
proposition that market participants understand
that a continuing large deficit means that interest
rates in the future will have to rise significantly to
persuade investors to purchase the growing stock
of government bonds outstanding.
The other part of the argument involves the term
structure theory of interest rates, which argues that
current long-term interest rates are a weighted
average of today's short-term interest rates and
expectations about future short-term yields. Thus,
the prospect of large deficits over a long period
into the future, which means higher short-term
yields in the future even though current short-term
rates are largely unchanged, is translated by the
market into a higher current long-term yield.

Neo-Richardian theories
The starting point for the neo-Richardian view of
the impact of deficit finance is the observation that
the current sale of government debt requires
additional taxation in the future to pay the interest
costs and/or the principal when the newly issued
debt matures. In this view, a decision by the
government to finance current government
expenditures by borrowing rather than by taxing is
in reality a decision to increase taxes in the future,
or, to postpone them for the present. The value

discounted to the present of the future taxes
needed to service and repay the new debt
Iiabil ities equals the market value ofthe new debt.
This is true even if the government never plans to
repay its debt but plans instead to roll the debt over
in perpetuity.
The argument that investors consider future tax
liabilities in valuing assets is widely accepted in
individual cases of certain types of securities. For
example, it is generally accepted that municipal
bonds, which are exempt from federal income
taxation, sell at lower market yields than Treasury
securities of similar maturity because of the difference in the future taxes that will have to be paid on
the two types of secu rities.
Neo-Richardians generalize this principle from
individual examples to apply to the economy as a
whole. In particular, they use it to answer the
question of whether wealth holders regard their
holdings of government securities as contributing
anything, on balance, to their wealth, or net worth
position. The neo-Richardian view is that investors assume that the value of the government
securities in their portfolios is offset by an implicit
tax liability equal to the discounted value of the
future taxes the government will have to levy to
service and repay the securities.
The basic neo-Richardian position is that the offset
is complete, meaning that on balance the private
sector regards its holdings of government debt as
contributing nothing to the sector's wealtb position. A less extreme variant is that the offset is
incomplete because the value of government
securities derives from their unique feature as a
default-free instrument as well as from the income
they yield. According to this variant, the excess of
the market value of government securities over the
discounted value of the corresponding tax liabilities reflects the premium the market places on this
feature.
If taxpayers behave according to the basic neoRichardian view, they regard their aggregate net
wealth position as unchanged when the government borrows to finance a deficit. If, in addition,
the fundamental determinant of their consump-

tion plans is their net wealth position, a switch
from financing government expenditures by
taxation to financing by borrowing brings forth an
increase in private savings equal to the market
value of the new government debt. This occurs
because the reduction in taxes increases current
disposable income by the same amount, yet there
is no change in private consumption expenditures
because private wealth has not changed. Thus, the
increase in disposable income is entirely saved.
The increase in the demand for loanable funds
from the extra government borrowing is therefore
exactly matched by additional savings, leaving the
rate of interest unchanged.

Conclusion
Much of the confusion about the impact of
government deficits on interest rates and economic activity in general is the result of a failure to
identify properly the theories applied in different

analyses. At least four distinct theories have been
used to analyze the effect of the current and
prospective federal fiscal situation. They produce
predictions ranging from no effect on real interest
rates from debt-financed government expenditures (versus tax-financing) to significant effects on
current real interest rates from any deficit that is
large relative to current private savings.
At this time, economic research is still trying to
discriminate among the competing frameworks,
but because the elements of the various theories
are not mutually exclusive, the task is a difficult
one. Until a better understanding is reached on the
importance of these elements in actual market
behavior, predictions of the impact of government
deficits on real interest rates will remain impre(fise.

Robert H. Rasche

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.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author ...• Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments' 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding
04/03/85
190,223
172,242
52,873
62,588
33,281
5,325
11,109
6,872
197,937
47,454
30,898
14,116
136,367

-

-

44,027
38,940
20,110
Period ended
03/25/85

Change from
04/04/84
Dollar
Percent?

Change
from
03/27/85
1,039
609
4
70
148
3
461
31
4,524
3,253
1,450
1,025
246

-

12,398
14,115
5,020
2,688
5,986
314
1,129
589
8,126
970
923
1,083
6,072

138

-

3,299

8.1

124
806

1,005
2,681

2.6
15.3

Period ended
03/11/85

Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( -)

67
36
31

63
32
30

1 Includes loss reserves, unearned income, excludes interbank loans

Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
? Annualized percent change
2

3
4

-

-

6.9
8.9
10.4
4.4
21.9
6.2
9.2
7.8
4.2
2.0
3.0
8.3
4.6