By
Ramil Abbasov
Africa-Press – Eritrea. Deficits and Interest Rates: A Complicated Dance Policymakers Can’t Ignore
Budget deficits have long been at the center of economic debate, yet their relationship with interest rates remains anything but simple. The conventional wisdom is clear: when governments run large deficits, they borrow more, driving up the demand for loanable funds and, consequently, interest rates. But the real world, as recent events have shown, doesn’t always stick to the textbooks.
The traditional “crowding out” theory warns us that when governments borrow heavily, they edge out private borrowers, raising interest rates and stifling private investment. This mechanism assumes a relatively static supply of savings. When demand outpaces supply, prices—or in this case, rates—rise. It’s a neat theory and, in many cases, an observable one. Yet, it’s not the only lens through which to view fiscal deficits.
Enter Ricardian Equivalence, a concept advanced by Robert Barro in the 1970s. According to this theory, rational consumers anticipate that today’s deficits will become tomorrow’s taxes. In response, they save more, effectively offsetting government borrowing. If true, deficits wouldn’t budge interest rates at all. But real-world data rarely reflects such perfect foresight or behavior, rendering Ricardian Equivalence more of an intellectual exercise than a practical guide.
Another framework, the portfolio balance model, suggests deficits matter because they change the composition of financial assets. More government bonds on the market mean investors need higher returns—higher interest rates—to be persuaded to hold more debt. And then there’s the interaction between fiscal expectations and monetary policy. If fiscal authorities run persistent, unsustainable deficits, central banks might eventually be forced to monetize the debt, leading to inflationary pressures and, via the Fisher effect, higher nominal interest rates.
Empirical studies further complicate the story. Research shows that the relationship between deficits and rates exists but is often modest. For example, a seminal study by Laubach (2009) found that a 1% increase in projected U.S. deficits could raise real interest rates by about 20 to 25 basis points. That’s meaningful, but not catastrophic. Similarly, cross-country analyses indicate that while deficits often lead to higher rates, the effect is influenced by debt levels, monetary policy settings, and global financial conditions.
Emerging markets tell a more dramatic story. With weaker institutions and higher perceived risk, these economies experience sharper interest rate spikes in response to fiscal deficits. Investors demand a premium to compensate for the greater risk, and borrowing costs escalate quickly. This vulnerability underscores the importance of credible fiscal management, especially for countries lacking deep, liquid capital markets.
Recent history, notably during the COVID-19 pandemic, turned many assumptions on their heads. Advanced economies unleashed unprecedented fiscal stimulus without seeing the expected surge in interest rates. Central banks’ aggressive bond-buying programs kept borrowing costs low even as deficits ballooned. For a moment, it seemed the old rules no longer applied.
But as we moved into 2022 and beyond, inflation roared back, and monetary authorities responded with aggressive tightening. Interest rates rose sharply, and suddenly, large deficits started to look more dangerous. Governments faced higher debt servicing costs just when their economies needed continued support. The lesson? The “new normal” of low rates was more fragile than many believed.
Timing matters. During economic downturns, when private investment is subdued, government borrowing doesn’t crowd out much. In fact, deficit spending can fill the gap, supporting recovery without pushing rates much higher. But in periods of full employment and strong growth, deficits are more likely to ignite crowding out and higher rates.
Coordination between fiscal and monetary policy is also vital. An accommodative central bank can absorb much of the upward pressure on rates caused by deficits. But this comes at a cost: the risk of overheating and inflation. Conversely, a tightening central bank can exacerbate the impact of deficits on rates, as governments and private borrowers compete for scarcer funds.
Global capital mobility has muted the link between deficits and rates for many countries. Investors from around the world seek out safe, liquid assets, and U.S. Treasury securities remain a preferred destination. This “exorbitant privilege” allows the U.S. to run larger deficits with smaller rate impacts than most countries. But even America isn’t immune. As debt levels climb and political dysfunction raises questions about fiscal sustainability, investor confidence could wane, leading to a painful repricing.
So, what should policymakers take away from this complex picture?
First, fiscal interventions should be timely and targeted. Deficits are more defensible during recessions, when they can stabilize demand without crowding out private activity. In boom times, governments should consolidate to preserve fiscal space for future crises.
Second, fiscal credibility matters. Investors need to believe that today’s borrowing won’t spiral out of control. Clear, credible medium-term fiscal plans—and the political will to stick to them—can keep borrowing costs low even amid large deficits.
Third, policymakers must consider the interaction between fiscal and monetary policy. Deficits funded in a low-rate environment might seem benign, but if inflationary pressures mount, central banks will be forced to tighten, raising borrowing costs for everyone.
Fourth, emerging markets must tread especially carefully. They lack the safety nets and market depth that shield advanced economies. For them, even modest fiscal slippage can spark a debt crisis.
Finally, not all deficits are created equal. Borrowing to invest in infrastructure, education, and innovation can boost an economy’s productive capacity, making future debt servicing easier. Borrowing for unproductive current consumption, on the other hand, leaves little to show but a bigger bill.
The world has entered a new phase of fiscal and monetary complexity. Governments are grappling with the aftermath of pandemic spending, rising geopolitical tensions, and the need to transition to greener economies—all while facing aging populations and slowing growth. Deficits are here to stay. The key challenge is managing them wisely.
In the end, the relationship between budget deficits and interest rates is neither mechanical nor immutable. It’s a dance, shaped by economic conditions, policy choices, and investor psychology. Policymakers must stay nimble, balancing the need for fiscal support against the imperative of long-term sustainability. The cost of getting it wrong is high—and in today’s volatile world, the margin for error is thinner than ever.
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