Government Spending and Borrowing Costs

Given the European debt crisis and the United States fiscal cliff debate, I was particularly intrigued by Keynes’ discussion of debt conversion. He outlines the arguments for and against large spending programs. The Depression-era rhetoric is eerily – though unsurprisingly – similar to the rhetoric today.

The liberal view in Keynes: “the effect which the…government can exert on [interest rates] is limited. Suppose, which is putting the case extremely high, that the effect might be as much as ¼ percent. This, applied to the millions of [government obligations] which are ripe for conversion, would represent a difference of 5 million pounds annually. Compare this with the expenditure of the Unemployment Fund—over 50 million pounds last year.” (130)

Barack Obama 2012: “What do you think a stimulus is? It’s spending – that’s the whole point!”

The conservative view in Keynes: “the less the government borrows, the better…are the chances of converting the national debt into loans carrying a lower rate of interest. In the interests of conversion, they curtail all public borrowing, all capital expenditure by the state.” (129)

Paul Ryan 2011: “When you take a look at the problems our country is facing, debt is No. 1. The math is downright scary and the credit markets aren’t going to keep on giving us cheap rates.”

Keynes frames the ultimate question as whether heavy government spending will increase borrowing costs to the point they outweigh the benefits of stimulus, so I tried to find out. I dug into some data on United States government spending as a percentage of GDP and regressed this against the 1 year and 10 year treasuries. The results seem to support the liberal view, but they obviously do not control for important variables like savings rates and broad economic conditions. (Data from 1980 to 2010, source is WhiteHouse.gov, St. Louis Fed, and FederalReserve.gov).

For the 1 year:

 

For the 10 year:

The low R-squared values indicate that very little of the variations in the interest rates are caused by variations in government spending as a percentage of GDP. The relationship is clearly positive, but is very weak.

In the United States, however, it appears that increased stimulus does not enormously impact borrowing costs, at least when [Gov Spending / GDP] ratios stay below 25%.

It is interesting to compare this with Europe and nations embroiled in sovereign debt crises. In 2011, Greece had government spending at 50.1% of GDP while Spain was at 43.6%. While even non-crisis afflicted nations such as the UK have high government spending, the European data tends to support the conservative argument that Keynes rejects.

See a full list below (country abbreviations are defined here):