HOW CAN interest rates be so low if the federal deficit is so large? And why isn't cheap money doing more to stimulate economic recovery?
For years, economists have taught that big public deficits tend to drain capital markets and force private borrowers to compete with the U.S. Treasury. That in turn bids up interest costs for both government borrowers and private ones.
Well, the federal deficit for this fiscal year is now projected at a record $368 billion, according to the Congressional Budget Office. Yet as the deficit has gotten bigger, interest rates have steadily declined. Why? Because the Federal Reserve has used monetary policy to keep cutting rates, to their lowest level in two decades.
Remarkably enough, inflation has stayed low and no "crowding out" of business borrowing by government borrowing seems to be occurring.
With an election looming, Federal Reserve Chairman Alan Greenspan has discovered the virtues of cheap money. Throughout the 1980s, we heard dire warnings that the deficit was so big that the Fed was being forced to keep interest rates artificially high in order to attract investors to finance it. Yet government borrowing rates, and the prime rate, and mortgage interest rates, are now back to the levels of the early 1970s.
Indeed, the economy is so devastated from the excesses of the 1980s that the Fed's relatively loose monetary policy is about the only thing producing even the most feeble of recoveries. It turns out that in a weak economy, deficit or no deficit, the Federal Reserve has plenty of room to lower interest rates.
This year is exceptional because an election happens to coincide with a recession. It's not hard to run a successful cheap-money policy when the economy is flat on its back and demands for credit are depressed.
Ordinarily, the Federal Reserve System -- dominated by bankers -- is more responsive to lenders than to borrowers. Creditors have an understandable phobia of inflation, which erodes the value of their loans. As soon as the tonic of cheap money gets the economy growing briskly again, the Fed tends to tighten the screws, lest inflation break out.
The Fed often eases up in election years, when it tends to run a more generous money policy -- in deference to the White House incumbent (who appoints Federal Reserve governors). But is the Fed hypersensitive to inflation? Why can't the Fed run a lower-interest money policy year-in and year-out, to the general benefit of the economy, without triggering inflation?
James Galbraith, formerly staff director of the Congressional Joint Economic Committee and now an economist at the University of Texas, observes that the Federal Reserve is probably doomed to its stop-go policy of stimulating recoveries and then snuffing them out, unless other policies change. One such necessary innovation is what economists call an "incomes policy" -- a kind of social contract between labor and industry to assure that wage increases in a booming economy do not outstrip the real productivity growth of workers. That would remove one major source of inflationary pressure during good times (when workers enjoy more bargaining power) and would thereby give the Fed more latitude to let the good times continue.
Another necessary, though unfashionable, strategy is what nations like Japan and France euphemistically term official "guidance" on the use of credit. In the 1980s, a great deal of credit went to speculative and unproductive uses -- leveraged buyouts, real estate bubbles, savings and loan euphoria. Government picked up the pieces by bailing out some of the losers. The Federal Reserve initially ran a very tight money policy, and relented only when the economy went into steep recession.
But, as Mr. Galbraith observes, tight money is itself a form of credit rationing. It rations credit away from home buyers, manufacturers, and also results in an overvalued dollar, which does double damage to American exports. Credit-rationing through tight money actually rations credit into speculative investments, because it forces lenders to look for high-yield, high-risk uses for their money.
The alternative to the credit-rationing of tight money is a gentler form of government guidance to discourage banks from gambling on speculative ventures and encourage them to steer credit to more sober and productive uses. That, in turn, can allow the Fed to be more liberal with interest rates generally, producing a virtuous circle of low interest costs and prudent lending.
In this election-recession year, events have disproved several economic shibboleths. It turns out that big deficits don't necessarily cause high interest rates. It turns out that low interest rates don't necessarily cause inflation. And it turns out that cheap money, by itself, will take economic recovery only so far.
We need a recovery strategy for the long term. It would be a shame if Alan Greenspan's low interest rates were nothing but a temporary election-year gift for George Bush.
Robert Kuttner writes a column on economic matters.