The Consequences of the Federal Deficit: An Empirical Analysis

Authors

John T. Knadler, University of Kentucky

Abstract

One of the major issues of political debate in the United States during the past 20 years has been the potential consequences of rising federal deficits. Some politicians and economists argue for the traditional view that deficits increase interest rates and erode private savings, while those who hold the Ricardian equivalence view believe that economic agents are forward looking and will realize that a tax cut today will cause a future deficit, thus they will not change their behavior in response to the increase in wealth from the tax cut. My research was designed to determine through econometric regression analysis whether deficits cause an increase in interest rates and or a reduction in private saving. When I used a standard, two stage, least squares regression, I found deficits a significant factor only in decreasing savings; however, when I used an instrumental variable regression, I found that deficits were significant in increasing interest rates and had no impact on private savings. Thus, I conclude that both the Ricardian and the traditional view of deficits may be valid, depending upon one’s methodology.

One of the clearest economic results of the Great Depression that crippled the economies of the United States and the world in the first half of the 20th century was the coming to fashion of Keynesian economics. The basic thrust of that theory, from a policy perspective, was an intense focus on the short-run business cycle, with little attention paid to the long run because, as Keynes stated, “in the long run we are all dead.” Keynesians advocated low taxes and large increases in spending to stimulate the demand for goods. The corollary of this theory is that large deficits are given little attention; however, the experience of the United States in the 1970s of high unemployment, high inflation, and increasing interest rates made many economists rethink the Keynesian system. Beginning in the 1980s, the deficit began to become an intense political issue that led to various movements toward a balanced budget amendment, which never passed. The common fear of the deficit is that it leads to high interest rates; however, presently we are experiencing ever-increasing deficits, yet our interest rates remain at historical lows.

Recommended Citation

Knadler, John T. (2004) "The Consequences of the Federal Deficit: An Empirical Analysis," Kaleidoscope: Vol. 3, Article 12.
Available at: https://uknowledge.uky.edu/kaleidoscope/vol3/iss1/12