Alan Reynolds

In late 2003, a Forbes review of former Treasury Secretary Robert Rubin's book "In an Uncertain World" noted: "Rubin is quite certain that eventually the huge deficit will push up interest rates on 10-year Treasuries from the current 4.5 percent to 7.3 percent. Jot down his arithmetic rule for future use: For every rise in the deficit equal to 1 percent of gross domestic product, figure that long-term interest rates will rise by 0.4 percent."

 Rubin was quite certain and quite certainly wrong. The budget surplus in fiscal 2000 was 2.4 percent of GDP. The deficit in 2005 was estimated at 3.5 percent of GDP. Since the "rise in the deficit" between 2000 and 2005 has been nearly 6 percent of GDP, Rubin's arithmetic predicts that long-term interest rates should have risen by six times 0.4 percent, or 2.4 percentage points. Instead of rising by 2.4 points, however, long-term rates are that much lower than in 2000, when the budget surplus peaked. The yield on 10-year Treasuries dropped from 6.7 percent in January 2000 to 4.2 percent this July. The rate on 30-year mortgages dropped from 8.5 percent in May 2000 to 5.7 percent in July.

 Those who predicted that deficits would raise interest rates have resorted to three excuses. One is to change the subject, adding new and contradictory definitions of interest rates. Another is to beg for a reprieve by emphasizing the word "eventually." The newest excuse is to claim the only reason long-term rates didn't soar is that China supposedly bought a lot of Treasury bonds.

 In January 2004, Robert Rubin, Peter Orszag and Allen Sinai presented a paper on sustained budget deficits at the American Economic Association, predicting a "drop in asset prices and increase in interest rates." They changed the subject by arguing that only real inflation-adjusted long-term interest rates would rise, or perhaps the spread between long-term and short-term interest rates would widen, in anticipation of estimated future deficits.

 Yet the only way deficits could make real interest rates rise without making actual interest rates rise would be, paradoxically, if larger deficits caused lower inflation (thus widening the gap between interest rates and inflation). And the only way deficits could widen the spread between long and short-term rates without raising long-term rates would be if bigger deficits somehow compelled the Fed to lower short-term rates.

 Creatively redefining interest rates cannot salvage the Rubin forecast. Today's long-term interest rates are extremely low when compared with either short-term rates or inflation.

Alan Reynolds

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