Duking It Out Over The Deficit Will debt wreak havoc on the economy? Not anytime soon.
By Anna Bernasek

(FORTUNE Magazine) – They're back--big, fat, eye-popping deficits. So does that mean higher interest rates are around the corner? The Bush administration has an answer, albeit a heretical one. "I don't buy that there's a link between swings in the budget deficit of the size we see in the U.S. and interest rates," said Glenn Hubbard, then chairman of the President's Council of Economic Advisors, last fall. The Bushies' sentiment does raise eyebrows among economists; even the normally restrained chairman of the Federal Reserve, Alan Greenspan, cited mounting deficits as a reason to forgo Bush's beloved tax cut unless they are made "revenue neutral." But the funny thing is, Hubbard & Co. may just be right, at least for now.

We're not suggesting that rates won't go up a little. Nor are we saying that deficits don't matter. It's just that in the current environment, deficits and interest rates are less intertwined than they were a decade ago. Here's why.

--As if we need to be reminded, the deterioration in the government's finances is staggering: In two years we've gone from a surplus to a deficit that may reach $400 billion, or 4% of GDP. But what's important is debt as a percentage of GDP. It's now 32%, vs. 45% a decade ago. In the next few years there isn't much danger of its rising back to the Reagan-era levels. Economists at Merrill Lynch have calculated that even with $400 billion budget deficits this year and next, the debt-to-GDP ratio would rise only to 36%. The test, of course, is over the long haul. If Washington fails to control deficits after the economy has started growing strongly again, we could be in trouble. But for now the burden looks manageable.

--Theoretically deficits can jack up interest rates and harm the economy as the government borrows money that would otherwise go to corporations, homebuyers, and anyone else looking for a loan. Economists have long referred to this as a "crowding out" of private investment. But that argument isn't as airtight as it once seemed. "It might be a reasonable description of what went on in the 1960s," says Kevin Hassett, an economist at the American Enterprise Institute, "but today you have to add in the international sector." What he means is that there is a lot more money available to borrow today. For instance, the U.S. bond market alone has more than doubled, from $8 trillion in 1990 to almost $20 trillion today; and Treasury debt as a percent of the entire U.S. bond market is a low 16%.

True, right now nearly every major nation is running large deficits. "At what level of government debt does the foreign-investment manager start buying the euro instead of the dollar?" asks Larry Fink, CEO of Black Rock, one of the biggest bond buyers in the market. With the euro up 11% this year, this is a valid concern. But Fink and others have been worrying for years about foreign investors dumping U.S. stocks and bonds, and a wholesale exodus simply hasn't materialized. The bottom line is that the U.S. economy is likely to remain a better bet for investors than anywhere else for some time.

--As the single biggest driver of interest rates, inflation is always a lurking concern. Deficits and inflation are linked because governments, unlike other borrowers, can print money. When debt loads become burdensome, there's a long, sorry history of politicians trying to inflate their way out of problems. But inflation has been under firm control now for 16 years (if anything, it's deflation that has Greenspan concerned), and the Maestro's decision to remain as Fed chairman for another term has helped reassure the markets. Furthermore, China's rise as a low-cost manufacturing powerhouse will continue to force manufacturers in the U.S. and elsewhere to keep prices low.

--There's one final reason that the return of deficits is not sending interest rates higher--market psychology. "The bond market is a gang of excitable human beings driven by what they feel rather than what they think," says Jim Grant, editor of Grant's Interest Rate Observer. It takes time for changes in the economy to alter market perceptions, especially such rapid-fire swings from deficits to surpluses to deficits again. "The bond market is like a 4-year-old kid. It can only focus on one thing at a time," says Ethan Harris, chief economist at Lehman Brothers. "When it wakes up to the fact that deficits are not going away anytime soon," interest rates will undoubtedly move higher. The good news? By that time the economy should be growing solidly again. And who knows, maybe then Greenspan can finally retire. --Anna Bernasek