SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 46)

Financial Effects of Government Borrowing

by

Charles Lamson

Simply put, government borrowing, and thus the budget deficit that generated it, can have a considerable impact on the availability and cost of funds to other borrowers. Likewise, a government surplus that reduces the public debt can free up loanable funds for other borrowers. In either case, the changes in the spending plans of other borrowers will, in turn, affect the overall pace of economic activity and inflation.

A rise in government borrowing represents an increase in the government's demand for funds. A rise in the demand for funds will, ceteris paribus, raise the interest rate. The interest rate refers to the overall level of interest rates. In this case, the interest rate on government securities initially rises because of the increase in government borrowing. In turn, interest rates on other securities such as corporate bonds, municipal bonds, and perhaps even mortgages are also pulled up. As the yield on government securities rises, financial investors, seeking higher returns will be attracted to these securities. Some will rearrange their portfolios by selling, say, corporate bonds and buying government bombs. This selling of corporate bonds will tend to raise the rate on corporate bonds (lower the price), and the purchase of government bonds will tend to lower the rate on government bonds (raise the price). This process of substitution binds together all the interest rates in financial markets and generally causes all interest rates or the interest rate as moving up and down.

Why are we interested in this financial effect of government borrowing? Simply put, the rise in interest rates generated by the government's deficit financing will, ceteris paribus, tend to reduce the funds flowing to private borrowers, such as firms and households, as well as municipal and state governments. This phenomenon is known as crowding out, which means that the rise in rates could induce some who had planned to borrow and spend to cancel, postpone, or reduce their spending and borrowing plans. More specifically, the rise in interest rates will tend to lower investment spending by some firms relative to what it otherwise would have been, because the firms find that the higher cost of financial capital now exceeds the expected return on some previously planned investment projects. Similarly, the rise in rates on mortgage and consumer loans will reduce spending by some households, particularly on consumer durables and housing, relative to what it otherwise would have been.

A decrease in government borrowing represents a decrease in the government's demand for funds that will, ceterus paribus, tend to lower the interest rate. The interest rate on government securities falls because of the decrease in government borrowing. As the yield on government securities falls financial investors seeking higher routines will be attracted to other securities. Some will rearrange their portfolios by selling, say, government securities and buying corporate bonds. This selling of government bonds will tend to raise the rate on government bonds (lower the price), and the purchase of corporate bonds will tend to lower the rate on corporate bonds (raise the price). As in the case of an increase in government borrowing, this process of substitution binds together all the interest rates in financial markets and generally causes all interest rates to move up and down together.

From the above analysis, ceteris paribus, when the government deficit increased, the interest rate increased, and when the government deficit fell, the interest rate decreased. A word of caution is in order: Interest rates and deficits do not always move up and down together. In the real world where thousands of factors are changing at once, the relationship between interest rates and deficits can be obscured by a variety of factors. For example, on the demand side, decreases in the demand for funds by households and firms may offset the increase in the demand for funds by government. Indeed, this is exactly what we expect could happen in a recession. A cyclical drop in production that enlarges the deficit produces a reduction in household spending, particularly on housing and durable goods, and in business investment spending. Since less spending typically means less borrowing, the increase in the government's demand for funds will offset a fall in demand by others, and interest rates can fall despite the rise in the budget deficit.

On the supply side, a fall in the total demand for funds, reflecting, say, a fall in the budget deficit, may not result in a decrease in interest rates if, at the same time, there is a decrease in the supply of funds. How could this occur? The supply of funds reflects the willingness of surplus spending units (SSUs), both domestic and foreign, to supply funds and the Fed's provision of reserve assets to the economy. Accordingly, if a fall in the government's deficit, and, thus, its borrowing is accompanied by a decrease in the amount of funds supplied by the Fed, interest rates may not fall at all. Interest rates could even rise if the fall in the supply of funds generated by the decrease in reserves is relatively larger than the drop in demand.

Similarly, if foreign SSUs (households) decide that U.S. financial claims are more attractive than foreign claims, there could be a rise in the foreign supply of funds. Large inflows of foreign funds into the United States during the 1980s played an important role in financing the historically high U.S. government budget deficits. This inflow of funds from abroad limited the rise in U.S. interest rates and the crowding out of consumption and investment spending that otherwise could have occurred.

Recap

Ceteris paribus, if the government deficit increases, the interest rate increases and may crowd out private spending. Ceteris paribus, if the government surplus increases, the interest rate decreases. However, other factors can often cause interest rates to move contrary to these predictions. For example, during recessions, even though the deficit is increasing, the interest rate may go down because of decreases in the demand for loanaable funds by households or firms or increases in the supply of loanable funds orchestrated by the Fed. Likewise, both the interest rate and government surpluses may rise at the same time if the Fed is withdrawing funds from the U.S. economy. Inflows and outflows of foreign funds into the U.S. economy also affect the supply of loanable funds and the interest rate.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 560-562*

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