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Republicans want to make the lower tax rates they pushed through last year
permanent-a good idea. Democrats are trying
to pull off an immaculate deception. They want tax rates to automatically
go back up when the rate cuts expire in 2011-bad idea.
Daschle and Gephardt are cloaking their pitch for
higher tax rates in fiscal rhetoric. Low tax rates, they say, have
created a "budget disaster" in which huge out-year deficits will
push long-term interest rates higher and growth lower. They actually
expect us to believe they want to raise our tax rates to make the
economy grow faster!
I'm not making this up. Honest.
There are so many things wrong with I hardly know
where to start. Rather than argue with budget projections or economic
projections, however, let's just drive a wooden stake through the
heart of the argument. Budget deficits, whether large or small,
have nothing to do with interest rates. My purpose in this piece
is to explain why that is so and to lay out some ideas of the way
we should think about deficits, debt, and interest rates.
Budget Deficits do not determine interest rates
In spite of the textbooks, budget deficits in the
ranges we usually see them don't matter much for the economy. Not
for growth. Not for interest rates. The multi-trillion dollar bond
markets don't care at all whether the government is a net seller
or a net buyer of $20 billion, or $100 billion in new paper in a
given year, even if those sales go on for as far as the eye can
see. They care whether the people who own the old paper today are
still going to want it tomorrow. That will depend on whether or
not they have received enough new information about future inflation
and tax rates during the night to change their minds about future
after-tax returns on bonds relative to other-mainly tangible--assets.
The rest is all rounding errors.
Interest rates are not determined by savings rates
and are not determined by the demand for credit. They are determined
by relative asset demand. Nothing else matters.
Two weeks ago I wrote a piece about our Asset Market
Shift Framework which described the mechanism determining asset
prices. The key fact defining an asset is a large existing stockpile
(relative to current production rates) whose supply is invariant
to price. This mechanism works as well for bonds and currencies
as it does for gold and Rembrandts.
The key to that analysis is the vertical supply curve.
If supply does not depend on price then the price, and therefore
the yield, or interest rate, which clears the market, is purely
demand-determined. This must be true for every asset market.
We can describe the demand for any asset with the
following equation:
(1) Asset Demand Aid /NW = A(r1, r2, ., rn, e)
The quantity demanded of asset (i), as a proportion
of net worth, is determined by the expected relative, after-tax
returns on all assets, (r1, ., rn), i.e., on their relative prices,
and on all other factors, represented here by (ei).
Chart 1 shows the US household asset composition
for September, 2001, as reported by the Federal Reserve Board in
their published Flow of Funds Accounts. Households held $48.8 trillion
of assets at market values, of which $15 trillion were tangible
assets. The remaining $33.8 trillion were held as financial assets
of one form or another. Of those, $3.3 trillion were in government
securities-the national debt-and the remaining $30.5 trillion were
in stocks, bonds, mortgages, mutual funds, certificates of deposit,
savings accounts and other financial assets not issued by the federal
government.
In principle, each slice of the portfolio pie will
have an asset demand equation similar to equation (1). Its price,
in equilibrium, will be whatever it needs to be to make investors
willing to hold the existing stock of the asset, given the existing
stocks and relative returns of all other assets and given net worth.
Asset equilibrium is a condition at one moment of
time-a snapshot-not a flow that we measure over a year, such as
we do with GDP.
As time moves on, however, asset stocks grow or shrink,
as does net worth, which forces asset prices to change. We produce
new tangible assets by building houses, factories, shopping centers,
and new cars. We create new government securities to finance the
budget deficit, or destroy them by using a budget surplus to buy
back debt. We create new private financial assets to finance capital
spending, home construction, or durable goods purchases.
Graphically, this would make the pie in Chart 1 larger.
Increases in asset categories would add to existing totals like
the rings of a redwood tree as it grows year by year.
If the stocks of all assets happened to all increase
at the rate of net worth growth, then the slices would get larger
but would not change shape from year to year. For example, Chart
2 shows what we would see one year after the snapshot taken in Chart
1 if all asset stocks and net worth were to grow by 8.5% during
the year.
To accomplish that the asset stocks would all have
to increase by 8.5%. We would have to produce $1.3 trillion (net
of economic depreciation) in new tangible goods, sell $2.6 trillion
in net new private securities, and increase the government debt
by $284 billion. If those things were all to happen, I would expect
asset prices to remain unchanged, since all asset are growing in
lock-step with net worth.
The interest rate neutral budget deficit is not zero.
It is the deficit which makes the stock of government debt grow
at the rate of net worth growth, i.e., at the rate of asset demand
growth. Net worth growth in the range of 5%-10% per year implies
neutral budget deficits of $165-$330 billion at today's debt levels.
These are far larger than even the scare-mongers' deficit estimates.
What does matter, however is inflation and net worth
growth, which depend on monetary policy, productivity, and tax rates.
Each of these can cause dramatic asset demand changes in a hurry.
Deficits in the ranges we see them in the US just
don't matter. Current projections are smaller than we would need
to produce for an interest rate neutral budget, which implies government
securities will increasingly become scarce in the future.
Push the deficit rhetoric at your own peril, Congressman.
I don't think the voters are dumb enough to bite.
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