Government debt and interest rates

The negative impact of budget deficits on the U.S. economy has been exaggerated, says Ken Judd of the Hoover Institution. Although large budget deficits will tend to raise interest rates, the effect will be much smaller than some have predicted.

Despite the fact that the U.S. government is a large debtor, it is borrowing money from a credit market in which it is only one among many other debtors.

The value of current federal debt as a percentage of total debt held in the United States is only 12 percent.

Federal government debt is an even smaller fraction of total debt worldwide.

The U.S. government's debt equals about one third of U.S. gross domestic product, which is a low ratio by international standards.

Although it is possible for the Federal Reserve to use inflation to help reduce the value of the government's debt, the Fed has not resorted to such "inflationary finance" in the recent past, says Judd, and consequently, creditors are unlikely to demand higher interest rates to compensate for expected inflation.

Judd concludes that interest rates in the U.S. are unlikely to rise very much as a result of the government's deficits.

Source: Ken Judd, Are Deficits and Interest Rates Related? Weekly Essays, June 23, 2003, Hoover Institution.

For text http://www-hoover.stanford.edu/pubaffairs/we/2003/judd06.html
For more on Federal Reserve Monetary Policy http://www.ncpa.org/iss/eco/

FMF Policy Bulletin/ 1 July 2003