Monday, March 29, 2010

High Interest Rates, Not Deficits, Cause Inflation

Treasury rates jumped last week as the 10-year bond moved up to around 3.85 percent, about 20 basis points or so in the last week or two. Former Fed head Alan Greenspan calls this the “canary in the coal mine,” and he blames budget deficits and the huge overhang of the federal debt. Ask almost anybody in the money business, including the bulk of the investor class, and they will tell you that budget deficits drive up interest rates. I’m here to tell you that is wrong. It may seem reasonable, but it’s still wrong.

This “deficit causes high rates” theory embraced by Alan Greenspan, and by David Stockman during the Reagan years, and by Robert Rubin during the Clinton years, has no statistical basis in fact. Actually, one could make the case that higher deficits are consistent with declining interest rates, since the worst deficit numbers typically occur when the economy is in recession and there is no private credit demand. During economic recoveries, deficits shrink as tax revenues come pouring in. But interest rates rise during expansions as real investment returns improve.

The real cause of high interest rates? Inflation.

If prices are rising, investors demand higher interest rates as inflation premiums to compensate for their money-value loss. Basically, long-term interest rates fell from 1980 all the way through 2009 — 30 years as the inflation rate dropped from 14 percent to roughly zero. That’s three decades of deficits going up and down and up and down. Rates continued to fall.

Let me add that a stable King Dollar holds down inflation. That is a much more powerful tool for interest rates than business-cycle swings in the budget deficits.

Oh, by the way, deficit/interest-rate mongers fall into a tax-hike trap. The real issue for holding back deficits over the long run is to curb excessive federal spending and to keep marginal tax rates low enough to spur incentives for economic-growth-producing tax revenues. In other words, the Laffer curve.

Lower tax rates mean a stronger economy. A stronger economy means more tax revenues. More tax revenues mean lower deficits. And keep King Dollar intact to hold back the inflationary tide.

Of course, the real problem here is federal spending, not taxes.