* THE CLINTON ADMINISTRATON’S OWN VIEW
Whatever we might think of the reasoning Greenspan used in convincing Clinton that deficit reduction was an essential policy goal, it still remains a fact that deficits were reduced and (briefly) turned into surpluses over the eight years of the Clinton Presidency. In January of 2001, the Council of Economic Advisers made the following argument:
The Omnibus Budget and Reconciliation Act of 1993 was the right policy package at the right time … long-term interest rates remained stubbornly high. … Bond yields were being predictably affected by the forces of supply and demand: the Federal Government was set to run a deficit of almost $300 billion … ...view middle of the document...
As Figure 3 shows, this is a powerful story. There is a clear and inverse relationship between the government deficit (federal, state and local as well) and investment from 1993 onward.
[Figure 3 here]
At the same time, as Figure 4 shows, there is a clear and consistent decrease in nominal long-term rates in the 1990s.
[Figure 4 here]
However, the evidence presented in this brief statement focuses exclusively on nominal values. We are told about the various interest rates in nominal not real terms. We are told about absolute increases in nominal investment but not about the relationship between investment and GDP. We are also told nothing about the direction of causation. The rise in investment might have increased incomes so much that deficits fell as a result of those increases.
The major reason budget deficits are considered to have negative consequences for economic growth is because the extra government borrowing “crowds out” some private borrowing from the credit markets. With only a certain amount of national savings, when government entities increase borrowing that allegedly causes interest rates (the cost of borrowing) to increase. The argument concludes with the assertion that the rise in interest rates reduces private investment. The reduced private investment, in turn, reduces economic growth. Reversing this problem with lowered deficits and ultimately surpluses allegedly creates the virtuous cycle that the Council of Economic Advisers referred to in the post-1993 period. Instead of crowding out private borrowing, the reduced deficits and ultimately surpluses involve “making room” for more private borrowing by lowering interest rates.
Testing the Assertions
How do we determine whether this explanation is accurate or not? The first thing we need to do is to understand what we need to measure. Absolute numbers in economic analysis usually mean nothing. If we say that the budget deficit is $300 billion in a given year we have no idea whether that is a dangerously large deficit or a small relatively manageable one. It is only after we compare it to Gross Domestic Product that we get an idea of its impact. So the first thing we have to do is to measure the budget deficit as a percentage of GDP. Though usually all attention is focused on the amount of federal borrowing, since states and localities often do significant amounts of borrowing for capital projects, it is important to also show the borrowing by both levels of government – again, as a percentage of GDP.
The next step in the argument is the alleged impact on interest rates. Since Alan Greenspan focused his discussion on the long-term interest rate (usually the 10-year Treasury bond), we should too. However, unlike the Economic Report of the President, we believe that information that “the 10-year Treasury rate fell below 6 percent in 1998” leaves out some crucial information – what happened to inflation at that time? The real burden of...