Why Interest Rate Policy Isn’t Enough to Give Economy the Jump-Start It Needs

One of the reasons people feel so blue these days is a belief that the U.S. economy needs help and that Washington is powerless to do much about it.

To be sure, politicians from both major parties have proposed legislation to help jump-start business activity. However, with the government’s budget deficit headed toward a record-smashing $400 billion this year, few believe that much can be expected from fiscal policy.

Indeed, a number of economists both inside and outside the Beltway are recommending that whatever legislation does emerge be deficit-neutral. In other words, what Washington gives with one hand, it should take with the other.

Back in December, I suggested in this column that Washington should assume the role of employer of last resort. I advocated that the federal government hire people to rebuild our crumbling infrastructure.

By putting people back to work, and money in their pockets, I felt that policy-makers could address simultaneously the twin problems of lack of confidence and insufficient buying power.

This and other measures would widen the deficit, if they were to work. When the economy is weak, it is not the time to try to reduce the budget deficit--as Herbert Hoover found about 60 years ago.

Needless to say, today’s politicians are mesmerized by the budget gap, much the same way that an animal freezes when caught by an automobile’s headlights.

I must admit that my colleagues in the financial community are holding the politicians’ feet to the fire. Huge deficits mean, of course, huge sales of securities by the Treasury to finance the deficits. It is questionable how much these markets can absorb in the way of government debt without interest rates moving dramatically higher.

For example, using Washington’s own calculations, it appears as though the government will have to borrow more than $630 billion this year. This would serve to finance this year’s expected deficit of $400 billion, plus roll over previously issued debt, and cover the needs of federally sponsored enterprises as well as federally guaranteed loans.

As big as this number sounds, it is even bigger when compared to the supply of savings. Again, using the government’s own figures, this $630 billion would represent twice the savings that the U.S. economy is expected to generate this year.

By contrast, in 1960 (a budget surplus year) the government still had to raise $5 billion. However, this represented less than 14% of that year’s savings. As you might imagine, interest rates then were only a fraction of what they are today.

Rates are especially high in bond markets. Here the bellwether 30-year government bond yields more than 8%--about the same as it did 26 months ago, at the beginning of 1990. By contrast, three-month Treasury bills, which also yielded 8% about two years ago, today only yield about half as much.

The Federal Reserve has succeeded in pushing down short-term rates, but it has not been able to nudge long yields lower. The Treasury tried to push long rates down by attempting to decrease the supply of these issues, hoping that their price would rise. But because the Treasury’s borrowing needs are so immense, it could only lop $2 billion off its recent offering--and it had to make it up by increasing the supply of shorter-dated issues.

This resulted in a poor reception and a backup in shorter-term interest rates--for the moment negating some of the Fed’s monetary ease. With Washington’s debt outstanding equal to 70% of the gross national product, the highest in nearly 40 years, the Treasury has little choice but to sell longer-dated issues so it can avoid creating congestion in the shorter-term markets.

Needless to say, this will keep pressure on long-term interest rates. My own view is that these yields will continue to rise, reaching as high as 9% by year’s end. Rates this high in an economy this weak pose a serious threat to the longevity of this recovery. Mortgage rates, already up more than half a point from their January lows, would rise a point or more, threatening the housing market. Other borrowing costs would rise too.

Little wonder why the politicians have no serious plan to jump-start the economy--and why, in turn, people are depressed. The economy, it would seem, will have to continue to recover slowly, so slowly that it might take until well into 1993 before the country begins to feel better. And so slowly that it could die an early death.

I would hope that we’ve learned our lesson from this episode. Just like someone who has a heart attack and survives takes the warning seriously by going on a diet, exercising, etc., I would hope that the American people will take this deficit scare as a warning too.

Don’t cut the deficit now--but once the economy does grow faster, use that opportunity to reduce the deficit once and for all, so that next time the economy goes into a recession, fiscal policy can be used to soften the blow.

This may be our last chance.