Federal budget deficits, U.S. interest rates, and rates of return

In yesterday’s New York Times, Nelson Schwartz writes about a seeming area of agreement between the two presidential candidates: an increase in the budget deficit. As Schwartz notes, this potential bipartisan development is quite a change from recent years, when the consensus seemed to be that short-term budget deficits had to be decreased, which they were. So what’s behind this reversal? Or rather, what’s are the reason why this reversal might be a good public policy idea? Well, it may have something to do with declining interest rates and potentially high rates of returns on public investments.

Long-term interest rates in the United States and other high-income countries have been on the decline for decades now. The reasons behind the decline are myriad (aging populations, higher inequality, and a global savings glut), but the short story is that the global investors are demanding much more U.S. government debt than the federal government is supplying. If growth in demand for something outstrips the growth of supply, then the price is going to increase. And since the price of a bond and its yield (the amount of interest paid out by a bond divided by its face value) are inversely related, interest rates are going to go down. This means that the United States government can now borrow money from the rest of the world at a very low price: 2.24 percent over 30 years (before accounting for inflation).

But when policymakers make an investment decision, they’re not going to look just at the cost of borrowing but also the potential return on that investment. Luckily in this area of low interest rates, there’s an area where investment would give the federal government a decent return: public infrastructure. A variety of analyses, including one by the International Monetary Fund, show that the rate of return on public investments is quite high right now due to a lack of investment in the past. So the federal government could borrow money from the markets and put those funds toward infrastructure improvements that would earn a return at a higher rate.

Increasing the federal budget deficit to finance other projects, such as tax cuts, increases in government transfer programs such as Social Security would probably not have the same rate of return. But increasing the budget deficit would help push up the supply of government debt, which in turn would push down the price of bonds, boost consumption and investment, and increase economic growth. It’s just a matter of picking which government spending opportunities make the most sense for the economy as a whole.