Federal deficits not the interest-rate culprit
Federal budget deficits have been hit with a false charge. Wall Street blames the prospect of a bulging deficit for today's high interest rates. But Citibank of New York finds this explanation "just not very plausible." Says chief economist Leif Olsen: "Wall Street is wrong, in theory."
In other words, there is no historical economic evidence that interest rates move up or down with the size of federal deficits. Indeed, during the 1950s, ' 60s, and '70s, interest rates tended to move inversely to movements in the federal deficit. As deficits got bigger, interest rates fell. That was largely because a weakening economy would trim federal revenues and thus enlarge the deficits; but at the same time it would reduce the demand for private credit.
Rates, Citibank recalls in its Economic Week, plummeted in 1975 when federal bortowing accounted for twice the share of total funds raised in the credit markets that it does in 1981.
If federal deficits are financed through the creation of new money by the government, that could be a different story. The extra money would permit higher prices.
But econometric tests (combining mathematics and economics) indicate that bigger deficits don't do much to crowd the money markets and thus push up interest rates. That, says Citibank, is because the supply and demand for credit are both highly elastic.
"Small increases in real estates due to increased borrowing by the government might readily discourage an equivalent volume of consumer and business borrowing , because these private borrowers are highly sensitive to even small rate changes."
Another reason that enlarged deficits should theoretically have little effect on interest rates is their magnitude. An extra $20 billion to $40 billion may be a huge amount. But in comparison with the annual net volume of funds raised in the credit markets of around $500 billion in recent years, it is not large. It is just 4 to 8 percent of the market.
People active in the credit markets have never believed government forecasts of the deficits for 1981-82. So, although they may now be expecting larger deficits because of the tax cuts, higher interest charges, and so on, they are probably thinking of only an extra $15 billion at most, Citibank figures.
Moreover, during the first quarter of this year, the Treasury managed to borrow a massive $36 billion. That was much more than the market initially expected. Yet interest rates dropped. This left only around $40 billion to $45 billion to be raised in the last three quarters of this year. Supposedly this would ease markets pressures. Yet rates have climbed.
Oddly, one reason could be Wall Street's unsupported belief in the effect of deficits on interest rates. Olsen explains: "The bond market is not functioning today. Traditional bond buyers are sitting on portfolios which are deeply depressed. The advocates of buying bonds thus have no credibility in these institutions. As long as there is any argument around which sounds plausible, it will be believe. The Market will act accordingly."
The economy is softening, a trend that should supposedly mean a reduced demand for credit and lower interest rates. Inflation is coming down, another tendency that should help trim interest rates.
Nonetheless, interest rates remain in the stratosphere and only now show a down-to-earth movement. Two major banks, Chase Manhattan and First National of Chicago, lowered their prime rate to 20 percent from 20 1/2 percent Monday. It could be that economic mythology -- the belief that higher federal deficits would force up interest rates -- could have helped prop up those rates for a while. If many investors believe that interest rates are going to up further, they will refrain from buying depreciating bonds. But such a thin prop will eventually collapse and interest rates will tumble as the economy slows and credit demands slacken.
When precisely? Citibank isn't saying. Merril Lynch, Pierce, Fenner & Smith suggests buying bonds now, figuring that the turnaround is here or nearly here. Others expect new interest rate peaks.
So take your choice.