- The Washington Times - Wednesday, December 13, 2000

President Clinton and Vice President Gore have asserted that reducing the federal budget deficit and then moving to a surplus had the effect of cutting interest rates. Unfortunately, economic reality fails to back up this seemingly tidy thesis.

In particular, Mr. Gore, during the presidential campaign, highlighted his Senate tie-breaking vote in 1993 for the Clinton economic plan, which in reality amounted to nothing more than a massive tax hike, including a large increase in the income tax rates. Mr. Gore argued that the tax increase reduced and then eliminated the budget deficit, which in turn caused a fall in interest rates. This decline in interest rates created our recent economic prosperity.

Well, several problems exist with this analysis. First, the decline in the federal budget deficit came about due to economic growth and some brief, relative restraint in federal spending growth. For example, economic growth generated an annual increase in federal revenues of 8 percent from 1993 to 2000, while federal spending climbed by an average annual rate of 3.4 percent over the same period. It simply strains economic credibility to say that a hefty tax increase, particularly an increase in income tax rates which impact decisions regarding investing and risk-taking, caused the economy to grow faster. Instead, the best case one can make is that this tax increase fortunately did not derail an economy that already was recovering.

Second, interest rates have been on the rise recently, even while budget surpluses are mounting. For example, the prime rate has been creeping up steadily for more than a year. In fact, interest rates are higher today than they were in 1993.

Third, the accompanying chart reveals no causal relationship whereby U.S. federal budget deficits or surpluses impact interest rates. This holds for market rates like the prime rate or the yield on Moody's Corporate AAA bonds, and whether one prefers to look at nominal or real (inflation-adjusted) interest rates. While there are brief periods when deficits and interest rates move in the same direction, more often deficits and interest rates seem to move in opposite directions. Just look at the 1990s, which is what Messrs. Clinton and Gore highlight. In 1993, for example, the nominal prime rate averaged 6 percent versus 8 percent in 1999. The real prime rate averaged 3.6 percent in 1993, while it registered 6.5 percent in 1999. The Moody's AAA bond yield actually was down slightly from 7.22 percent in 1993 to 7.04 percent in 1999, but the real rate was up from 4.82 percent in 1993 to 5.54 percent in 1999. All of these rates have gone higher in 2000, with the nominal Moody's AAA yield now above its 1993 level as well, while the budget surplus has grown even bigger.

If anything, interest rates may lead to budget deficits or surpluses, which makes some economic sense. A rise in interest rates traditionally has a dampening effect on the economy, so government revenue growth slows. In addition, higher interest rates push up the costs of borrowing, and thereby increase government debt service. This combination boosts prospects for larger budget deficits or smaller surpluses.

In contrast, a drop in interest rates tends to boost the economy, and therefore increase government revenues. At the same time, lower interest rates reduce borrowing costs, which helps to restrain government spending growth. This combination then tends to work in favor of smaller deficits or larger surpluses. Looking ahead, the Federal Reserve's hikes in interest rates over the past year or so could spell real trouble for the economy and for the federal budget, especially since forward-looking market indicators like the price of gold had been signaling no threat of inflation. At the very least, a slowdown engineered by the Fed would mean smaller than anticipated budget surpluses in the future.

In the end, inflation expectations, economic growth, money demand and money supply determine interest rates. U.S. federal budget deficits or surpluses do not influence interest rates.

Raymond J. Keating is chief economist for the Small Business Survival Committee, and co-author of the new book, "U.S. by the Numbers: Figuring What's Left, Right, and Wrong With America State by State (Capital Books, 2000).

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