Cheney Was Right All Along about Budget Deficits

Democrats opposed the Bush tax cuts from the beginning not because lower marginal tax rates are bad, but rather, because they believed they would lift deficits and interest rates.

The interest-rate effect is so large, goes this line of reasoning propounded by disciples of the "Rubin school," that the net effect of tax cuts would be harmful.

But now we hear that we can adopt the Obama health-care plan, increase an already massive deficit, and it will be no problem. But if raising taxes can reduce deficits and spur the economy, then cutting spending should do that too. So why are we increasing spending yet again? Democrats have no answer.

If Obama wants to pursue yet more spending, he should at least level with us and explain why he believes we can afford to risk higher interest rates.

The scale of our current budget problem is so enormous that the health plan exposes President Barack Obama and the Democrats as opportunists who always knew Robert Rubin was wrong. Nobody who believes in a strong link between deficits and interest rates can possibly support an expansion of entitlements at this time.

Look at the facts. The U.S. set the record for government spending in July--a whopping $332.2 billion in that month alone. No government in history has ever spent so much.

With the economy still on the ropes receipts were about $180 billion lower than that, bringing the deficit for the fiscal year-to-date to $1.27 trillion. By year's end, the deficit for this year will likely be almost $2 trillion and the total public debt close to $12 trillion.

Treasury Yields

The irony is there is talk of expanding government yet again because those deficits have yet to do anything to interest rates. The 10-year Treasury note was yielding a paltry 3.57 percent late last week, about one percentage point less than its average over the past 10 years and more than 2 percentage points less than its average over the past 20 years.

Interest rates are so low, of course, because the economy has been so depressed and perhaps because the Federal Reserve has been buying Treasuries with abandon. But how high might they go when the economy starts to recover and the Fed stops buying, which it recently signaled it would soon do? Could they soar so much that we dip into a recession just as this one ends?

Former Vice President Dick Cheney was ridiculed by Democrats when he said "deficits don't matter." If they don't rise with our current deficit, then the current recovery can be sustained. How strange it is that precisely now, Dick Cheney is the only thing between us and the abyss.

I have always agreed with Cheney's view, mostly because the link between interest rates and deficits is so tenuous in the literature, just as we have experienced over the past decade.

Deficit Link

But a paper that lays out the possible case for a strong deficit link to interest rates was co-authored six years ago by Obama's Office of Management and Budget Director Peter Orszag. That paper argued that a subset of the economics literature that found bigger interest-rate effects of deficits was more credible. Who knows, that might be right. But if it is, take a terrifying look at the interest-rate story.

The paper's read of the literature is that, "a rough range from this literature is that a sustained 1 percent of GDP rise in projected deficits would raise current yields by between 20 and 60 basis points." That effect is only apparent if deficits are sustained.

The deficit is looking like it will be about 13 percent of gross domestic product in 2009. If the government planned to run such a deficit for 10 years, then the deficit's impact on interest rates relative to a balanced budget baseline would be to increase them 260 to 780 basis points.

Baked In

It is anyone's guess what the future would hold, but such a scenario of high deficits forever seems impossible. The deficit effect may already be baked into interest rates, in which case the increase from here on may be smaller.

The Congressional Budget Office provides two scenarios for the next 10 years. One, extends the baseline and assumes that government will become relatively virtuous almost immediately. Under this scenario, the average deficit to GDP is projected to be about 4 percentage points higher than it expected in 2007. If that is a reasonable characterization of the current market expectation, then interest rates should be between 80 and 240 basis points higher during the next decade or so.

Under what may be a more realistic assumption about future taxes and spending, the difference between today's deficit outlook and 2007's is about 6.5 percent. If that is the market expectation, then interest rates will be between 130 and 390 basis points higher.

Needless to say, such interest rate spikes would be very troubling for the economy, were they to occur. They probably will not, even if Obama's health-care plan becomes law, because Cheney was right all along.

If Obama wants to pursue yet more spending, he should at least level with us and explain why he believes we can afford to risk higher interest rates.

But that talk will only happen in our dreams. The fact is, deficits are a problem precisely because politicians can get away with running them with near impunity. If interest rates did soar in the face of deficits, it would provide a constraint on the growth of big government.

Sadly, there will be no such constraint.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

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