PolySciFi Blog

Tuesday, February 08, 2005


Laffer, interest rates, and inflation

It seems whenever I find some free time to post, so does Matt, so we run dry for a bit and then blog splooge all over the place...

In the comments of the "George Bush is a Socialist" post, J.P. had written,
"Also, like every supply-sider since Laffer, you are conveniently ignoring the increase in interest rates that will result from this massive new debt, and the additional costs that will levy on businesses."

I had replied "I'll address this in a post as I need space to plot the deficit/debt versus interest rate."

This is that post.

The basic theory that J.P. is espousing is the following (correct me if I'm wrong). When the government increase its debt, it increases the market demand for loans. Simple macroeconomics says that if demand increases, price must also increase assuming all else is equal. In this case, the price of a loan is the loan's interest rate (ignoring closing costs and what not).

This theory is theoretically sound. However, the problem comes when the theory is applied to the real world, as all else is never equal.

For instance, if the incurred debt is accompanied by economic growth, then the amount of available capital increases (loan supply) and the price of a loan can fall. Or in my personal favorite factor, if inflation falls at the same time (perhaps through deregulation, trade liberalization, and productivity gains), then market forces work to push down the interest rates that can be charged (the inflation rate is the break even point for a loan).

As the government is but one of the borrowers in the market, and only occupying a relatively small portion of the capital market (~$400 billion/year of new borrowing a year in a $11 trillion/year economy), the effect of government borrowing on the price of a loan is relatively small compared to the economy wide effects of economic growth and low inflation.

So, you say, that's great and all. In theory. But what about in practice? Might not those effects I describe be drowned out by other effects I've not considered and might I be incorrectly weighting those effects?


But let's look at the data. Taking historical interest rate data from this site, historical debt numbers from this site, and inflation numbers (CPI) from this site, we can produce the following plots. [Email me - jodyneel@yahoo.com - if you want a copy of my spreadsheet.]

To judge the effect of Laffer economics (really only one aspect of it), let's plot national debt and the federal fund rate as shown below. The two look negatively correlated to me. So while we agree that when all else is equal, increasing debt should increase interest rates, this effect was apparently drowned by something else.

Well, what about inflation and debt? Inflation is an extra cost imposed upon business. Again as we see below, there's little correlation.

Just for fun, let's see what happens when we look at inflation and interest rates and see if my supply-sider hypothesis is correct...

Looks like the interest rate follows the inflation rate. Almost as if changes in the inflation rate were largely determining the interest rate. Of course, this makes sense by my explanation above wherein the inflation forms a natural floor for interest rates and market pressures keep interest rates close to that floor.

Just in case I get accused of choosing a favorable time period, let's look over the entire data set I have for the fed rate. Inflation and interest rates still look strongly correlated with interest rates still generally lagging inflation by a little bit.

(Click image for a higher res view of plot)

So why was the government able to float so much debt? Well looking back in history, Reagan was a huge deregulator, the Bush (41 and 43) and Clinton Presidencies were big trade liberalizers, and we've had massive productivity gains (God bless you Walmart - 25% of the US's productivity gains in the 90's). All of these factors brought down inflation and kept it low.

My bottom line: Debt only has a secondary effect on interest rates. If you're concerned about interest rates, then keep an eye on the inflation rate.

For a little fun for the Laffer enthusiasts in the audience, here's an interview with Laffer conducted last week. (h/t Poor and Stupid)

In the comments, J.P. suggests that the fed fund rate isn't a good measure of the economy's interests rates. So here's the 3 month T-Bill rate (an interest rate actually being paid by the government) plotted along side the fed fund rate.

And here's a plot of mortgages, corporate bonds (Aaa rated), the fed rate, and inflation.

I'll say it again, interest rates follow inflation (lag by a little - gotta have an expectation that they're not going to pop right back up), not debt.


This page is powered by Blogger. Isn't yours?