Commentary

Senator Daschle’s Odd Theory of Interest Rates

Senator Tom Daschle’s (D-SD) recent speech on the economy claimed long-term rates depend on future — not current — budget deficits. “Monetary policy alone can’t bring down long-term interest rates,” says the senator, “if our long-term budget outlook remains so precarious.” The senator, with all due respect, should take a course in Econ 101.

The 1993 tax increase, claims the senator, “lowered our long-term interest rates and increased business confidence.” Actually, the interest rate on 10-year bonds was 5.68 percent in August 1993 when the Clinton tax hike was enacted, but the rate began to rise after the tax hike, reaching 7.96 percent by November 1994. It may be a coincidence, but long-term rates did not begin to fall until Republican advocates of tax reduction won both houses of Congress.

Since early 2000, a slowdown followed by recession caused predicted budget surpluses to turn into small deficits. Sen. Daschle calls this “the worst fiscal deterioration in our nation’s history.” According to his theory, that sharp swing from surpluses to deficits should have caused an equally sharp increase in long-term interest rates. Instead, the rate on 10-year bonds dropped by more than two percentage points — falling from 6.66 percent in January 2000 to 4.57 percent by September 2001. Long-term rates have edged up lately, but that is because the economy is showing signs of recovery, and investors sold bonds to buy rising stocks.

The international evidence is no more kind to Daschle’s theory. The table compares last year’s budget surplus or deficit, as a percent of GDP, with recent interest rates on 10-year bonds. Like the United States, most major economies offer yields of 4.9-5.5 percent on 10-year government bonds, regardless whether their governments are buying or selling such bonds. That is because financial markets are global, not just national. Some countries with budget surpluses, notably Canada, have higher long-term interest rates than the United States, possibly because of risk of exchange rate losses.

Ironically, two huge economies with budget deficits — the Euro area and Japan — have lower long-term interest rates. Japan, with by far the biggest and more durable budget deficits (6.4 percent of GDP), has by far the lowest long-term interest rates (1.4 percent). That is because the Japanese economy is severely depressed, offering few good opportunities to invest, and because most prices have been falling (deflation). Obviously, low long-term interest rates on government bonds are not always a good sign.

  Budget Surplus  
Or Deficit (-)
% of GDP
  Interest Rate  
10-year
Govt. Bond
Sweden 3.8 % 5.2%
Canada 2.8 5.5
Denmark 2.0 5.1
U.S. 0.6 5.2
Australia 0.1 5.9
Euro area -1.2 4.9
Japan -6.4 1.4
Source: The Economist

It is ostensibly because of his faulty theory of interest rates that the Senate Majority leader insists that any tax relief “should consist entirely of one-year measures.” None of his lavish new spending proposals, by contrast, face any time limit at all. Sen. Daschle favors “tax credits, grants and loans” to subsidize broadband Internet service. He wants American taxpayers to “double civilian R&D funding,” underwrite “new energy technologies,” and provide more cash for “physics, computer science, mathematics and electrical engineering.”

He thinks the billions spent on homeland security are only “a small fraction of what we need.” He somehow calls all this “embracing fiscal discipline.” He even hints that his “comprehensive economic plan” means “we can go back to paying off our debt.” Actually, it is neither feasible nor desirable to overtax people during hard times just to repay U.S. bondholders. But there is certainly no risk of that happening with Sen. Daschle’s ambitious spending schemes.

Sen. Daschle may be a skilled legislator but he is a bungling amateur economist. If anyone had the slightest evidence linking any interest rates to federal surpluses or deficits, we would have seen it by now. High interest rates can cause deficits, but deficits do not cause high interest rates.

Sen. Daschle’s old bond market “confidence” game, which Herbert Hoover likewise used to promote tax increases in 1932, is a flimsy excuse for redefining “stimulus” as permanent large increases in spending but only niggling one-year tax breaks.

Alan Reynolds is a senior fellow at the Cato Institute.