s President Bush presses for passage of his tax plan, it is clear that it is politically most vulnerable in terms of its impact on the deficit. That is because there are a number of Republican senators who may be persuaded to vote against a tax cut or at least one as large as the president is proposing for fear that it will increase the deficit too much.
Given the close margin in the Senate and the likelihood that all Democrats, with the possible exception of Zell Miller (D., Ga.), will oppose the bill, the White House cannot afford to lose more than one or two Republicans. Therefore, President Bush must convince wavering members of his party, such as Senator George Voinovich (R., Ohio), that the tax plan's impact on the deficit is not enough to justify voting against it.
Democrats, recognizing the Republican vulnerability, are hammering the deficit issue as hard as they can. The rhetoric will become even more heated in a few weeks, when the Office of Management and Budget and the Congressional Budget Office release their new budget estimates. Undoubtedly, they will show an increase in deficits from those projected last summer even without another tax cut.
For now, Democrats are laying the foundation for their attack and stocking up on intellectual ammunition. This sort of thing is usually done at think tanks and universities, but eventually will be boiled down into sound bites that will animate floor debate and press coverage.
The first shot was fired in December by Brookings Institution scholars Bill Gale and Peter Orszag in a paper with the deceptively bland title, "The Economic Effects of Long-Term Fiscal Discipline." Their purpose is to show that there is a large and close relationship between federal budget deficits and interest rates. They conclude that a sustained increase in the deficit of $100 billion will raise long-term interest rates by 50 basis points (half a percentage point) right away, rising to a full percentage point in 10 years.
In another paper, Gale looks at the impact of the Bush tax plan. He estimates that it will raise interest rates by 20 basis points immediately and 40 basis points later on. This suggests that higher interest rates could offset much of the stimulative effect of a tax cut.
Bush administration economists do not deny that a larger deficit will raise interest rates all other things being equal but they think the impact is much less than the Brookings economists believe. They base their estimate on the work of economists N. Gregory Mankiw of Harvard and Douglas Elemendorf of the Federal Reserve. This research indicates that a $100 billion increase in the deficit, which is the first-year impact of the Bush plan, would raise rates by just 1 or 2 basis points a trivial amount.
Some partisan Democrats are trying to say that the Bush administration believes that a higher deficit will have no impact on interest rates whatsoever. Former Clinton economist Brad DeLong recently called for the resignation of Council of Economic Advisers Chairman R. Glenn Hubbard for supposedly saying so, in contrast to what he wrote in his own textbook.
In fact, Hubbard's views are well within the mainstream of economists. In a December 10 speech at the American Enterprise Institute, he pointed out that many older textbook analyses of the impact of deficits on interest rates failed to take into account world capital flows, which are in the trillions of dollars per year. "The bottom line," he said, "is that real interest rates are not dictated by country-specific short-term deficits."
Of course, one can always find economists to support whatever position is taken, no matter how extreme. But serious economists look at what is published in the top economic journals as the best indication of what economic science knows. The latest review of the literature on this subject is by economist John Seater of North Carolina State University, published in the Journal of Economic Literature, an official journal of the American Economic Association. He found that there is no statistically significant impact of deficits or debt on interest rates.
The problem with making a final determination is that there are always lots of other things going on in the economy that make it difficult for economists to isolate the effect of any one variable. For example, in an economic expansion one would expect interest rates to rise because the return to capital is rising. This suggests that interest rates will rise this year regardless of whether the Bush tax plan is enacted. But if it is the case, some people will say that it is because of the tax plan, not because of normal economic forces.
A December report from the Federal Reserve Bank of St. Louis concluded, "the linkage between budget deficits/surpluses and interest rates is weak." That probably comes close to telling us what economists really know on the subject.