Phillips Curve Musings: Addendum on Budget Deficits and Interest Rates

In my previous post, I discussed a whole bunch of stuff, but I spent a lot of time discussing the inappropriate use of partial-equilibrium supply-demand analysis to explain price and quantity movements when price and quantity movements in those markets are dominated by precisely those forces that are supposed to be held constant — the old ceteris paribus qualification — in doing partial equilibrium analysis. Thus, the idea that in a depression or deep recession, high unemployment can be cured by cutting nominal wages is a classic misapplication of partial equilibrium analysis in a situation in which the forces primarily affecting wages and employment are not confined to a supposed “labor market,” but reflect broader macro-economic conditions. As Keynes understood, but did not explain well to his economist readers, analyzing unemployment in terms of the wage rate is futile, because wage changes induce further macroeconomic effects that may counteract whatever effects resulted from the wage changes.

Well, driving home this afternoon, I was listening to Marketplace on NPR with Kai Ryssdal interviewing Neil Irwin. Ryssdal asked Irwin why there is so much nervousness about the economy when unemployment and inflation are both about as low as they have ever been — certainly at the same time — in the last 50 years. Irwin’s response was that it is unsettling to many people that, with budget deficits high and rising, we observe stable inflation and falling interest rates on long-term Treasuries. This, after we have been told for so long that budget deficits drive up the cost of borrowing money and also cause are a major cause of inflation. The cognitive dissonance of stable inflation, falling interest rates and rapidly rising budget deficits, Irwin suggested, accounts for a vague feeling of disorientation, and gives rise to fears that the current apparent stability can’t last very long and will lead to some sort of distress or crisis in the future.

I’m not going to try to reassure Ryssdal and Irwin that there will never be another crisis. I certainly wouldn’t venture to say that all is now well with the Republic, much less with the rest of the world. I will just stick to the narrow observation that the bad habit of predicting the future course of interest rates by the size of the current budget deficit has no basis in economic theory, and reflects a colossal misunderstanding of how interest rates are determined. And that misunderstanding is precisely the one I discussed in my previous post about the misuse of partial-equilibrium analysis when general-equilibrium analysis is required.

To infer anything about interest rates from the market for government debt is a category error. Government debt is a long-lived financial asset providing an income stream, and its price reflects the current value of the promised income stream. Based on the price of a particular instrument with a given duration, it is possible to calculate a corresponding interest rate. That calculation is just a fairly simple mathematical exercise.

But it is a mistake to think that the interest rate for that duration is determined in the market for government debt of that duration. Why? Because, there are many other physical assets or financial instruments that could be held instead of government debt of any particular duration. And asset holders in a financially sophisticated economy can easily shift from one type of asset to another at will, at fairly minimal transactions costs. So it is very unlikely that any long-lived asset is so special that the expected yield from holding that asset varies independently from the expected yield from holding alternative assets that could be held.

That’s not to say that there are no differences in the expected yields from different assets, just that at the margin, taking into account the different characteristics of different assets, their expected returns must be fairly closely connected, so that any large change in the conditions in the market for any single asset are unlikely to have a large effect on the price of that asset alone. Rather, any change in one market will cause shifts in asset-holdings across different markets that will tend to offset the immediate effect that would have been reflected in a single market viewed in isolation.

This holds true as long as each specific market is relatively small compared to the entire economy. That is certainly true for the US economy and the world economy into which the US economy is very closely integrated. The value of all assets — real and financial — dwarfs the total outstanding value of US Treasuries. Interest rates are a measure of the relationship between expected flows of income and the value of the underlying assets.

To assume that increased borrowing by the US government to fund a substantial increase in the US budget deficit will substantially affect the overall economy-wide relationship between current and expected future income flows on the one hand and asset values on the other is wildly implausible. So no one should be surprised to find that the recent sharp increase in the US budget deficit has had no perceptible effect on the interest rates at which US government debt is now yielding.

A more likely cause of a change in interest rates would be an increase in expected inflation, but inflation expectations are not necessarily correlated with the budget deficit, and changing inflation expectations aren’t necessarily reflected in corresponding changes in nominal interest rates, as Monetarist economists have often maintained.

So it’s about time that we disabused ourselves of the simplistic notion that changes in the budget deficit have any substantial effect on interest rates.

7 Responses to “Phillips Curve Musings: Addendum on Budget Deficits and Interest Rates”


  1. 1 Bradley Lewis July 10, 2019 at 6:11 am

    Great column!! I particularly like your starting points that (1) we have a major misapplication of partial equilibrium analysis that doesn’t apply (as well as other misapplications), (2) that Keynes did not explain it very well to economists (a surprise, perhaps, because Keynes in writing for the general public was usually very clear, but I agree) and (3) we have a situation of cognitive dissonance.

    MMT (Modern Money Theory) is more in the news today because it does have some logical approaches to understanding our situation, and it is front and center in taking on the cognitive dissonance, which means it comes into a lot of criticism precisely because of that.

    Thanks for a great start in working our way out–I hope–of some conventional wisdom in the economics profession and among a wide variety of commentators who haven’t understood what you’re pointing out.

  2. 2 Frank Restly July 15, 2019 at 12:59 pm

    David,

    “So it is very unlikely that any long-lived asset is so special that the expected yield from holding that asset varies independently from the expected yield from holding alternative assets that could be held.”

    1. Relative quantities matter – The “specialness” of any asset is in part a function of the quantity available for sale. For instance, 30 year bonds are only 30 year bonds when they are first sold – after that they become 29 year bonds, then 28 year bonds, etc., etc. Additionally, their issuance was suspended from 2002 through 2006.

    2. If what you say is true, then spreads between corporate and U. S. government debt should be constant – except they are not:

    Compare:
    https://fred.stlouisfed.org/series/BAA
    https://fred.stlouisfed.org/series/DGS30

    The tightest credit spreads were see in 1978 (about 1%) and 1990 thru 1998 (about 1.25%). They have varied widely from this baseline – including a jump to 3.76% in 1982 (coming out of recession) and a jump to 5.56% in 2008 (in the middle of a recession).

  3. 3 David Glasner July 15, 2019 at 1:19 pm

    Frank, It does not follow from anything I said that yield spreads between different assets vary. My point is only that changes in the yields for one asset class are constrained by the yields on other asset classes, so you can’t assume that an increase in the quantity of new 30-year and 10-year Treasuries offered in the market will have a significant affect on the yields of those asset classes.

  4. 4 Frank Restly July 16, 2019 at 2:42 am

    David,

    Your first statement was:
    “…unlikely that…the expected yield from holding that asset varies independently from the expected yield from holding alternative assets…”

    Now your statement is:
    “…that changes in the yields for one asset class are constrained by the yields on other asset classes…”

    Generally speaking, there is a risk / reward tradeoff in asset classes.

    With government debt considered as near riskless (in terms of default risk) yields on that debt are as you say “constrained” by yields on corporate debt. Generally speaking, you will never see Treasuries offering a higher rate of interest than corporate debt with the same term structure.

    My point was that the reverse is not true. Yields on corporate debt are not constrained by yields on government debt, hence the wide range of credit spread over time.

    You further explain:

    “…And asset holders in a financially sophisticated economy can easily shift from one type of asset to another at will, at fairly minimal transactions costs…
    That’s not to say that there are no differences in the expected yields from different assets, just that at the margin, taking into account the different characteristics of different assets, their expected returns must be fairly closely connected…”

    This makes a broad assumption that assets are only bought and sold in a single economy – as opposed to multiple interconnected economies each with their own political / legal structure and their own central bank.

    And it makes the assumption that market segmentation does not occur – meaning that a participant is able to buy one asset, but not another because of legal impediments.

    As an example, the U. S. federal open market committee (FOMC) is legally permitted to purchase bonds sold by the U. S. Treasury. It is not permitted to purchase corporate debt.

    A similar situation occurs in tax deferred mutual funds. You can buy bond funds and you can buy stock funds. But you can’t buy a residence (home), a rental property, a rare car, a set of paintings, or even a stamp collection without incurring a tax penalty. Likewise, you can’t convert your investment to an absolute cash position. Any sale one mututal fund must be reinvested into another.

  5. 5 David Glasner July 16, 2019 at 8:35 am

    Frank, There is a world market for crude oil. There are also local markets for crude oil. There are also markets for different types of crude oil, e.g., light or heavy, high-sulfur low sulfur. Sometimes because of local conditions, the differential between WTI (west Texas intermediate) and Brent sweet can vary substantially but the price of WTI cannot move independently of the price of Brent and the price of Brent cannot vary independently of the price of WTI. The same applies to prices and expected yields of different kinds of assets. Prices and yields can vary but they always are constrained by the prices of alternatives and the entire structure of prices and yields is determined within a system of interrelationships encompassing them all.


  1. 1 Phillips Curve Musings: Second Addendum on Keynes and the Rate of Interest | Uneasy Money Trackback on July 10, 2019 at 8:23 pm
  2. 2 Irving Fisher Demolishes the Loanable-Funds Theory of Interest | Uneasy Money Trackback on August 7, 2019 at 6:31 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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