High Deficits, Low Bond Yields: What Gives?

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When President Clinton left office on Jan. 20, 2001, the 30-year U.S. treasury bond was trading at 5.55 percent. The U.S. government had just posted its third straight year of budget surpluses. Fiscal rectitude was a key feature of Clintonomics/Rubinomics under the theory that such prudence would encourage bond investors to accept lower rates of return, thus lowering interest rates and boosting economic growth. In fiscal 2000, the surplus was $236 billion. In 2001, the federal budget was again in the black, registering a $128 billion surplus.

Since then, we've had five straight years of budget deficits, totaling some $1.5 trillion in red ink. Now with just those sets of facts–and the Clinton-era assumption that budget deficits drive interest rates–you might guess the 30-year would be yielding 7 percent or higher today. Yet as I write this entry this morning, the 30-year is actually yielding 4.55 percent–a full point lower than it was when Clinton left office, despite a return to deficit spending. (Not to mention the continued lack of action on America's growing entitlement problems.)

So what's the deal? Bond rates are lower of late because investors are betting on a slower economy and lower inflation, a belief strengthened today by a weak manufacturing report.

Longer term, though, it's not so much that "deficits don't matter" (to quote Dick Cheney, who himself was quoting the Reagan-era take on budget balancing) but that deficits aren't the only thing that matters. To the extent that deficits influence interest rates, economist theorize, it's by 1) "crowding out" private investment, as government borrowing competes with private investment; and 2) raising inflation expectations as deficits hint at a government that cannot control spending.

But in our globalized world economy, there is a glut of foreign savings–as our massive trade deficit implies–eager to snap up U.S. debt. In addition, globalization has also unleashed powerful deflationary forces–such as distance-diminishing technology and the effect of offshoring on wages in developed economies–that make an inflationary spiral unlikely as more global competition pushes firms, workers, and economies to be more productive.