Over the past two years, the long-term budget outlook has deteriorated markedly. Although many policy-makers and economists have expressed concern that this fiscal deterioration will reduce future national income and raise interest rates, Bush Administration officials and others have publicly denied the existence of such adverse effects. This paper examines the relationship between long-term fiscal discipline and economic performance, with two main results. First, as almost all economic research and standard textbooks suggest, declines in budget surpluses (or increases in budget deficits) reduce national saving and therefore reduce future national income, regardless of their effect on interest rates.
Second, simple correlations, careful empirical research, macro-econometric models, and the views of leading economists and policymakers all indicate that increases in expected future deficits raise long-term interest rates. Based on the literature, a reasonable estimate is that a reduction in the projected budget surplus (or increase in the projected budget deficit) of one percent of GDP will raise long-term interest rates by between 50 and 100 basis points. These findings suggest that the costs of increased deficits are significant over the long run, and need to be compared carefully to the potential benefits of the tax and spending programs that result in larger long-term deficits.
The powerpoint presentation is available here (1.55 MB).