Reigning Wisdom's Shaky Economic Ground
Many economists and economic scribes have arrived at a particular gloomy paradigm to describe the current U.S. economy. This consensus is surprising because the paradigm itself is seriously flawed.</br></br>The paradigm consists of four propositions: First, government deficits are responsible for high interest rates; second, high interest rates are responsible for the "overvalued" dollar; third, the overvalued dollar is responsible for the huge increase in the U.S. trade deficit; and, finally, the trade deficit is just plain bad.</br></br>The validity of the propositions is limited and decreases rapidly as one moves down the list.</br></br>Consider the first proposition. As Treasury Secretary Donald Regan keeps reminding us, empirical analysis shows no statistically significant historical relationship between budget deficits and interest rates. Over the past three years, while the deficit has more than tripled, the prime rate -- the base interest rate that commercial banks charge on loans to their biggest borrowers with the best credit ratings -- has fallen to 11% from 18.9%. Adjusting interest rates for inflation to approximate the "real" rate of interest doesn't change the picture very much: During the same period the real rate fell to 7% from 10%, notwithstanding the tripled deficit.</br></br>Nevertheless, there is common-sense validity to the notion that larger government borrowing will, other things being equal, exert upward pressure on rates. (However, one point that's usually neglected by those who advance this argument is that efforts to reduce the deficit by increasing taxes may also exert upward pressure on interest rates because increased taxes will result in decreased private savings, rather than simply in reduced private spending.)