In a last-ditch attempt to stop broad-based tax cuts, Democrats are again circulating their tired argument that current and prospective budget deficits will drive up interest rates. But if deficits do in fact send interest rates skyward, then why is the 10-year Treasury note trading near 3.5 percent -- a 45-year low?
The answer: A three-year deflationary recession, not deficits, is driving interest rates lower. As the economy turned down, deficits went up.
Still, the liberals tightly link interest rates and deficits. But there is an abundance of evidence that this is a weak leak.
Japan, for instance, which has much larger deficits than the United States, has a 10-year government bond with a yield of 0.59 percent. Germany, with deficits running about the same as the United States (3 percent of gross domestic product), has a 10-year government note at 3.8 percent. When President Clinton and his Treasury man Robert Rubin raised taxes in 1993, the 10-year note hit bottom at 5.25 percent. Today, with large tax cuts and rising deficit forecasts on the horizon, the 10-year is near a half-century low.
So, if deficits don't necessarily drive up rates, what does?
The preponderance of research argues strongly that inflation or deflation expectations and anticipated real returns on investment (i.e., economic growth) are the major determinants of interest rates. While there may be a connection between deficits and rates, it's a fuzzy connection.
As U.S. inflation descended from roughly 15 percent in 1980 to about zero today, long-term Treasury rates dropped from about 15 percent to 3.5 percent. During this period, as government revenues downshifted in response to disinflation, budget deficits were a recurring theme. But it was disinflation, not rising deficits, that drove interest rates lower and lower.
Washington revenue estimators, who project rising deficits in response to the tax cuts now being debated in Congress, are members of a Flat Earth Society -- they intend to persuade the public that the planet is not round and that tax cuts won't change the economy. Soon, they will claim Christopher Columbus did not really discover America.
But of course he did, and it corroborated his view that the world is not flat. Similarly, lower tax rates that raise the after-tax return for working and investing do in fact induce behavioral changes. Investors, unburdened by lower taxation, supply more capital to businesses and the economy by saving and investing more. Workers, meanwhile, supply more labor, including overtime hours worked. And when workers and investors get busy, projected deficits from tax-rate reduction never pan out.