The economic recovery is proceeding apace. But several analysts worry it will soon be endangered by high interest rates and large budget deficits. What do they really mean?
It is quite easy to see why high interest rates may soon slow, if not stall, the economic recovery. At the moment, the surge in the economy is not particularly sensitive to the level of interest rates, but in the later stages of recovery, high interest rates can have a more dampening effect, many analysts say.
At present, the increase in the nation's output of goods and services, or gross national product, is being driven mainly by a swing in business inventory holdings and by a marked consumer spending spree.
Although high rates certainly encourage firms to cut their inventory holdings, the rebuilding of stocks early in the business cycle is usually financed in large part out of rising profits.
Consumers may be discouraged by high interest rates from making large, debt-financed purchases, but this does not apply to items that are not bought on credit. Moreover, with incomes rising and the chance of becoming laid off diminishing, even high rates cannot deter consumers from boosting their debt-financed spending to some extent.
But as the recovery continues, these sources of expansion will become less important. The swing in business inventories--from destocking to restocking--which is providing such a big push to the economy, can only last a limited time. Personal spending may continue high for longer, but further increases will depend on a continued rise in personal incomes.
In addition, as the pent-up demand for housing, cars and other goods that has built up during the recession is released, further expansion may be more sensitive to the level of interest rates.
Business investment usually starts to revive in the middle or later stages of recovery as businessmen respond to the increased demand for their products and become convinced that it is worthwhile to expand capacity. High interest rates make it less attractive to invest and, thus, would likely slow this part of the normal recovery.
High interest rates also depress American industries that rely heavily on exports or that compete directly with imports. A good return on U.S. dollars encourages currency holders to bid up dollars against foreign currencies. The extraordinary strength of the dollar today makes it cheaper to buy imports and more expensive for foreigners to buy American-made goods.
But where does the budget deficit come in?
Many now argue that large budget deficits and, even more important, the expectation of continued large budget deficits for the foreseeable future are also a threat to the recovery. These deficits, they argue, are pushing up interest rates to levels that will in time stifle the economic recovery.
It is true that, all other things being equal, if the government borrows more rather than less from the credit markets, it pushes up interest rates. If the supply of credit is limited, then additional demand from the government to finance large budget deficits will increase the price of borrowed money, or the interest rate.
However, the government does not just throw away the money that it has borrowed. It uses it to buy things that are made in the private sector, such as military hardware; to pay benefits, such as Social Security, which are then spent in the private sector; or to reduce taxes, thus increasing the spending power of individual and corporate taxpayers. All of these things tend to expand output and employment for as long as there is unused capacity in the economy.
Most economists believe the expansionary effects of government budget deficits are larger than the contractionary effects of the higher interest rates that they produce.
Why are they worrying?
Some of them fear prospective large budget deficits will encourage the Federal Reserve to tighten monetary policy further. This will itself push interest rates up, in addition to the effect of bigger government borrowings. But if economic expansion is actually choked off because of the higher rates, it will be because of the tighter monetary policy, which more than outweighs the expansionary effects of the budget deficit, and not because of the deficit itself.
Others, by contrast, worry the big deficits now in prospect may boost the economy too much. A very rapid recovery, fueled by unprecedentedly large government borrowing, could quickly lead to a resurgence of inflation, they say. But while this may be an argument against big budget deficits, it certainly is not one that suggests they are deflationary and depressing to the economy.
Some others who say large budget deficits could lead to a slower recovery argue the forecasts of big future deficits are raising interest rates today, as financial markets anticipate a clash in the credit markets. But they do not usually quantify this possible impact on the markets, so that it is not possible to compare the depressing effect of today's higher rates with the expansionary effects of the deficits to come.
Moreover, the argument assumes financial markets are anticipating a restrictive monetary policy from the Federal Reserve that will create the clash with large government borrowings. If a passive and accommodating policy were assumed, the interest rate effect may be different.
Finally, there are many who worry simply that extraordinarily large budget deficits will distort the economy--away from private investment, exports, housing and other interest sensitive areas and toward defense and personal spending--and that this may be damaging in the long run. This is very different from arguing that recovery may be stopped by the budget.