Contradicting Clarida. (Letters To The Editor).

Orszag, Peter R.

To the Editor:

The interview with Assistant U.S. Treasury Secretary Richard Clarida ("The Clarida View," Winter 2003) is an interesting study in contradictions. When discussing the international economy, Clarida is full of insight, subtlety, and nuance, in a wide-ranging discussion that covers the recent loosening of monetary policy, declining U.S. business investment, the flight to security in U.S. treasuries, sluggish global economic performance, and so on. When discussing the effects of budget deficits, though, he ignores all of those factors and focuses instead on two simplistic and meaningless graphs. One shows that interest rates are similar in six OECD countries, even though their current debt/GDP ratios differ. The other shows that the implied real return on Treasury inflation-indexed securities has fallen over the past few years even though projected budget deficits have increased.

Clarida's "evidence" proves only that factors other than deficits may affect interest rates. It says nothing about whether deficits affect rates. We venture that any good undergraduate macroeconomics student at Columbia University, where Clarida teaches, could tell him why his graphs are spurious. In particular, all of the issues that Clarida discusses so prominently in analyzing the world economy have served to reduce recent long-term interest rates, but his graphs control for none of them. (If we're going to play the game of ignoring other factors, does the reduction in investment that has occurred over the past few years, at the same time that long-term rates have declined, mean that interest rates don't affect investment?) Professor Clarida would surely not accept such naive arguments in the classroom, and they are no more acceptable in the policy arena.

Even the most recent Economic Report of the President disagrees with Clarida. In that report, the Council of Economic Advisers (CEA) accepts that a $200 billion increase in current deficits would raise interest rates by 3 basis points. By that measure, the $5.6 trillion decline in the 2002-2011 budget surplus that has occurred in the past two years (from $5.6 trillion in January 2001 to essentially zero in January 2003) would be projected eventually to raise long-term rates by about 84 basis points. The approach used by the CEA, developed in part by the new chair, Greg Mankiw, is a convenient role of thumb, but it probably understates the effects of sustained deficits on interest rates because it omits any effect from expected future deficits, and only accounts for deficits that have occurred to date.

It should also be emphasized that the degree to which deficits raise interest rates is a bit of a red herring. The real concern with budget deficits is that they reduce national saving, and thereby reduce future national income. This decline occurs regardless of whether deficits affect interest rates. To the extent that deficits raise interest rates, lower national saving may be matched by a drop in domestic investment. To the extent that deficits attract foreign capital, the rise in interest rates may be attenuated, but the reduced national saving would be matched by lower net foreign investment. In either case--and therefore regardless of what happens to interest rates--the net capital stock owned by American households falls, and their future national income falls as well. Obviously, the policies that create the deficits can induce offsetting effects, but holding other things constant, a bigger deficit will result in less national saving and lower future income.

--WILLIAM G. GALE AND PETER R. ORSZAG Senior Fellows, Brookings Institution, and Co-Directors of the Tax Policy Center

The Assistant Secretary responds:

I was pleased to read Dr. Gale's and Dr. Orszag's compliments about the "insight, subtlety, and nuance" of my interview with in The International Economy. As for government debt, deficits, and interest rates, we also agree: there is no simple link between the stock of a country's debt (or its budget deficit) and the real interest rate on that debt. I fully agree that other factors--such as a country's growth and growth prospects, as well the appetite for risk on the part of global investors--are also important in explaining long-term real interest rates. Indeed, in my judgment, these other factors clearly dominate the observed fluctuation in long rates among countries with similar inflation rates.

As for Figure 1, it is in fact drawn from my lecture notes for Economics U6018, "International Money and Finance," which I used to teach every spring at Columbia University. In my lectures, I presented a basic model of an integrated global capital market in which the world real interest rate adjusts to bring the global supply of saving into balance with the global demand for investment. In this model, fluctuations in any single country's budget deficit or surplus impact the common world real interest rate only to the extent they alter the global supply and demand balance. In this limiting textbook case, since all countries borrow at the common equilibrium world rate, the cross sectional dispersion of countries' debt-to-GDP ratios will not help to explain the common level of the world real interest rate. Of course none of the countries depicted in Figure 1 are "small open economies" and most of them operate under a regime of floating exchange rates (with Germany, Italy, and France of course tethered together through EMU) so that real interest rates adjust to offset expected real exchange rate changes. Thus, while "the relationship is as close to a flat line as you'll get in economics," Italy--with a debt-to-GDP ratio in excess of 100 percent--does indeed pay more to borrow ten-year money than does the United States--with a debt-to-GDP ratio less than 36 percent. As of March 14, 2003, that spread was 42 basis points.

[FIGURE 1 OMITTED]

Finally, we agree that there is no free lunch. As I state, "The lesson is not that it's irrelevant how much a government borrows, but the cost of that borrowing is the ultimate tax increase that will be required to support the debt. And that needs to be balanced against other needs that are pressing at a particular time, such as a weak economy, or the needs of homeland security."

--RICHARD H. CLARIDA Assistant Secretary for Economic Policy U.S. Department of the Treasury