September 22, 2004


Budget Deficits: Old Theories v. New Facts (Alan Reynolds, 9/22/04, Cato Institute)

Budget deficits in France and Germany are just as large as in the U.S., and the budget gap in Japan is twice as large. Yet all three countries have a current account surplus, not "twin deficits." And the interest rate on 10-year government bonds is only 1.6 percent in Japan.

Australia, by contrast, has maintained budget surpluses since 1998. Yet Australia's current account deficit is larger than that of the United States, as it was in all but one of the past six years. Australia's 10-year interest rate is 5.6 percent -- substantially higher than the U.S. rate of 4.2 percent. Canada, with a budget surplus since 1997, also has a higher interest rate than the U.S, 4.7 percent. These are regular patterns, not anomalies.

From 1994 through 2003, annual budget deficits averaged 5.8 percent of GDP in Japan, compared with 1.6 percent in the U.S. If budget deficits really increased interest rates and current account deficits, then Japan should be experiencing high interest rates and a large current account deficit by now. Countries with budget surpluses, like Australia, should be experiencing much lower interest rates and current account surpluses. The facts obviously don't fit the conventional theory.

The same stubborn theory also claims budget deficits reduce national savings and that tax increases can magically add to savings. On the contrary, the U.S., U.K. and Australia moved chronic from budget deficits to surpluses in the late 1990s, but the ratio of savings to GDP did not increase at all. The U.S. savings rate was 18.2 percent from 1983 to 1989, when deficits were relatively large, and 17.5 percent from 1998 to 2001 when the U.S. budget was in surplus. Hong Kong moved secular surpluses to cyclical deficits in recent years, but the national savings rate remained at 31-33 percent of GDP.

A paper of mine on these topics was originally presented at the U.S. Treasury and later published by the Cato Institute. I concluded: "In reality, neither actual nor projected budget deficits raise real or nominal interest rates, steepen the yield curve, reduce national savings, cause `twin deficits,' or make the dollar go up or down. The logic behind such speculations is flawed and contradictory and the evidence is nonexistent".

The budgetary valetudinarians have been impervious to facts for a couple centuries now.

Posted by Orrin Judd at September 22, 2004 11:49 AM
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