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  • Budget Deficits, National Saving, and Interest Rates
  • William G. Gale and Peter R. Orszag

Economic analysis of the aggregate effects of fiscal policy dates back at least to the work of David Ricardo. Modern academic interest was reinvigorated by the work of Robert Barro and others and by the emergence of large U.S. federal budget deficits in the 1980s and early 1990s.1 The result was a substantial amount of research, which is summarized in several excellent surveys.2 The rapid but short-lived transition to budget surpluses in the late 1990s, followed by the sharp reversal in budget outcomes since 2000, has raised interest in this topic again.

Economists tend to view the aggregate effects of fiscal policy from one of three perspectives. To sharpen the distinctions among them, it is helpful to consider a deficit induced by a lump-sum tax cut today followed by a lump-sum tax increase in the future, holding the path of government purchases and marginal tax rates constant. Under the Ricardian equivalence hypothesis proposed by Barro, such a deficit will be fully offset by an increase in private saving, as taxpayers recognize that the tax is merely postponed, not canceled. The offsetting increase in private saving means that the deficit will have no effect on national saving, interest rates, [End Page 101] exchange rates, future domestic production, or future national income. A second model, the small open economy view, suggests that budget deficits do reduce national saving but, at the same time, induce increased capital inflows from abroad that finance the entire reduction. As a result, domestic production does not decline and interest rates do not rise, but future national income falls because of the added burden of servicing the increased foreign debt. A third model, which we call the conventional view, likewise holds that deficits reduce national saving but that this reduction is at least partly reflected in lower domestic investment. In this model, budget deficits partly crowd out private investment and partly increase borrowing from abroad; the combined effect reduces future national income and future domestic production. The reduction in domestic investment in this model is brought about by an increase in interest rates, thus establishing a connection between deficits and interest rates.

We emphasize throughout this paper that the relationship between deficits and national saving is central to the analysis of the economic effects of fiscal policy. National saving, which is the sum of private and government saving, finances national investment, which is the sum of domestic investment and net foreign investment.3 The accumulation of assets, whether located in the United States or abroad, associated with national saving means that the capital stock owned by Americans rises. The returns to those additional assets raise the income of Americans in the future.

An increase in the budget deficit reduces national saving unless it is fully offset by an increase in private saving. If national saving falls, national investment and future national income must fall as well, all else equal. Therefore, to the extent that budget deficits reduce national saving, they reduce future national income. This reduction occurs even if there is no increase in domestic interest rates. In that case the reduction in national saving associated with budget deficits manifests itself solely in increased borrowing from abroad (the outcome under the small open economy view). This is the sense in which the effect of deficits on interest rates and exchange rates (which distinguishes the small open economy view from the conventional view) is subsidiary to the question of the [End Page 102] effect on national saving (to which the Ricardian view gives a different answer than the other two).

A key objective of this paper is to generate tests of the empirical effects of budget deficits on national saving and interest rates and therefore to help distinguish among the three models empirically. We test the Ricardian view against the small open economy and conventional views by estimating the effect on national saving of budget deficits associated with tax reductions, after controlling for government purchases, transfers, marginal tax rates, and other factors. Our empirical results imply that an increase in the budget deficit substantially reduces national saving: specifically, after...

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