WASHINGTON, July 12 (UPI) -- According to economist David Ricardo, if the public sector deficit increases sharply, private saving can be expected to increase commensurately, thus ensuring that the capital is supplied to fund the deficit. Since total U.S. saving in 2003, public, corporate and private, was a mere 2 percent of gross domestic product, this doesn't seem to have happened. Is the U.S. savings dearth about to become a problem?
The question arose at an American Enterprise Institute seminar last Thursday, at which the effect of the deficit on interest rates was discussed. AEI scholar Eric Engen presented a paper written with former head of the Office of Management and Budget Glenn Hubbard, which purported to demonstrate that there was only a small effect of budget deficits on interest rates. In fact, what the paper proved was that there is only a small effect of the level of public debt (as a percentage of gross domestic product) on interest rates -- a 1 percent increase in the debt/GDP ratio raises 10 year Treasury bond interest rates by about 3 basis points (0.03 percent.)
However, this in itself says nothing about the effect of deficits, because it assumes a steady state; interest rates are affected not only by the stock of savings and investment opportunities, but also by the flow of savings and investment opportunities in each year. In a steady state, a United States with public debt equal to about 50 percent of GDP might have long-term interest rates only 0.3 percent above the actual U.S., which has public debt equal to roughly 40 percent of GDP.
However, that doesn't mean that the United States could run a budget deficit of 10 percent of GDP ($1.2 trillion, compared to the deficit in the year to September 2004 expected to be just under $500 billion) with interest rates rising only 0.3 percent.
Not only does the market rightly take this year's deficit to be closely related to next year's, because spending plans and even taxes can be changed only slowly, but a $1.2 trillion deficit would be a huge proportion of the year's savings flows, and hence drive up interest rates through the need to sell such a huge volume of Treasury bonds.
The Engen/Hubbard paper included a regression showing that an increase in debt of 1 percent (i.e. a public sector deficit of 1 percent of GDP) has in the past increased interest rates by 18 to 24 basis points (0.18 to 0.24 percent). In spite of the fact that in Engen's phrase this is "not consistent with an economic model of crowding out," it is consistent with (although somewhat below) estimates produced by other research done by the Brookings Institution's Peter Orszag, who suggested that a 1 percent of GDP budget deficit would increase interest rates by 30 to 60 basis points (0.3 to 0.6 percent.)
Taking a middle position of a 25 basis points (0.25 percent) rise in interest rates for a 1 percent budget deficit, we can therefore regard it as fairly well established that the current budget deficit of about 4 percent of GDP is raising long-term real interest rates by about 1 percent (4 times 25 basis points). Since the 10 year TIPS (Treasury Inflation Proofed Securities) bonds issued Thursday yielded only 2.02 percent, this suggests that the huge wave of liquidity injected by the Federal Reserve since 1995 has indeed produced a very low interest rate environment and very "loose" money -- without the budget deficit, real interest rates would be around 1 percent, far below their long term average of close to 3 percent.
That, therefore, is why the low U.S. savings rate, combined with the substantial budget deficit, hasn't currently produced any adverse side effects. Foreign central banks are buying U.S. Treasuries, the Fed is pumping out money, and real interest rates are quite low, and would be at record lows but for the budget deficit.
John Maynard Keynes, in his 1936 "General Theory of Employment, Interest and Money," called for "the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest today rewards no genuine sacrifice." In today's United States, his wish would seem to have been granted; the rentier saves almost nothing and is of very little importance, capital is liberally available, has no scarcity value and gives almost no "cumulative oppressive power" to the capitalist, and real interest rates are at historic lows. An economic Nirvana?
Unfortunately, for the Keynesians but still more for the U.S. public, no. Contrary to Keynes' belief system, all that loose money has a price effect, and produces inflation. Furthermore, the appetite of foreign central banks for U.S. Treasuries is finite, not under the control of the U.S. authorities, and likely to be severely diminished by the price declines in long-term Treasury bonds that rising inflation and rising nominal interest rates will bring.
If the federal budget deficit were at the same time to decline rapidly, this wouldn't matter in the short term. Declining demand from foreign central banks would match declining supply of Treasury securities, so that until inflation rose enough to be painful, the loose money/low savings environment could continue as before.
However, the Federal budget deficit shows no sign of declining rapidly. Accordingly, if interest rates are not to rise precipitately, causing a sharp recession and further worsening the budget deficit, the rentiers are going to have to step up to the plate. Only by an increase in the U.S. savings rate, validating, albeit with some delay, Ricardo's theory that a budget deficit should produce an increase in saving, can the economy be brought back into balance and a market crisis averted.
There are a number of things a new administration elected in November 2004 can do to encourage saving:
-- It can shift 2003's dividend tax concession, whereby stock dividends are taxed at only 15 percent, to the corporate level, "leveling the playing field" between stocks and bonds as far as investors are concerned, since both will pay the same tax, but making dividends partially (or, ideally fully) tax deductible for corporations, thus at a stroke wiping out many corporate tax dodges (including stock options) and forcing companies to distribute most of their earnings to investors.
-- It can remove the home mortgage interest tax deduction for interest payments above $10,000, thus removing the incentive for potential savers to sink resources into housing, an unproductive asset, and greatly reducing the volume of housing finance, alleviating the supply situation in the long term bond market.
-- It can impose a stiff withholding tax on gambling winnings, thus reducing the appeal of unproductive speculation to the U.S. public, and correspondingly decreasing spending and increasing saving. Social costs from the various pathologies that gambling addiction produces would also be reduced.
-- It can back the Financial Accounting Standards Board on expensing of stock option costs, and the Securities and Exchange Commission on greater accountability of corporate boards to shareholders, thus reducing the ability of top executives to pay themselves like princes and spend the money on Pharaonic lifestyles.
-- At the same time, it can jawbone the judiciary to reduce drastically the jail sentences on corporate criminals that have been imposed or will be imposed in connection with the various 90s scandals (such as the outrageous 24 years for former Dynegy tax manager James Olis.) The truth is, the top management incentive system in the middle and late 1990s was broken; it rewarded crookery to an unprecedented extent, and so more crookery is what we got -- there is little if any ethical or legal difference between Kenneth Lay, the indicted former Enron chairman and dozens of executives still enjoying their ill-gotten gains. Reducing both the rewards and the risks of top corporate life will produce more sober, morally upright top corporate management -- just what the system needs. Long term saving, not short term speculation, will thereby be encouraged.
If these reforms are instituted, then gradually, over the next few years, the rentier will emerge from the burrow where he has been hiding, the U.S. savings rate will increase to a sustainable level, and the Federal deficit will become financeable on a sound basis, subject to any huge increases in Medicare costs.
At that time, we might suggest some euthanasia for Keynesian economists, whose lunatic theories stated that rentiers were unnecessary and budget deficits didn't matter.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) --details can be found on the Web site greatconservatives.com.
