The Interplay between Government Deficit, Interest Rates, and Capital Inflow

Given the landslide the American economy has experienced within the past five years, I almost felt compelled to focus my paper on the issue of government deficit. In doing so, I came upon the textbook principle which states "If the government runs a deficit, interest rates increase and induce a capital inflow." It is my hope that I can relate this generally accepted doctrine to a May 13th, 2004 article I found in the Africa News entitled Uganda: Government Deficit Blocks Cheaper Loans.

Textbook Definition

Let us examine the aforementioned principle in greater detail in order to gain a true understanding of it in action. I think it helps to break down the standard piece by piece. For starters, it is apparent that there is a definite cause-and-effect relationship described in the doctrine, where the cause is government deficit. But, how does one define government deficit? Government deficit occurs when a country spends more on programs and the goods/services it purchases then it collects in tax revenue.

As a result, the country will begin to realize two changes in the economy. First, the interest rates will increase. This happens because the business sector has reacted to the augmented government spending by increasing its own production (and employment), leading to a higher GDP and a higher demand for money. But, since the money supply has not changed during this time period, interest rates are bumped up to compensate.

It does not take an Ivy League economist to know what happens when interest rates go up. In a nutshell, people begin to save more money so as to reap the higher returns. On the macro level, this is done domestically (when citizens place more money into savings) and in the international market, taking the form of a capital inflow into the country experiencing the budget deficit. Technically, the influx filters through the foreign exchange market first, where the dollar has by this point appreciated, due to the higher demand created by the raised interest rates.

Hopefully this provided a clear depiction of the situation. By taking it one step further, we see that the combination of capital inflow (expressed by the trade deficit) and private savings wind up financing both private investment and government deficit. It is important to note that once the economy adjusts back to full employment, the inherent increase in government spending (or tax base decrease) associated with a shift from a balanced budget to a deficit will drop private investment by that same amount.

Application of the Principle

The opening line of the article does a great job of summarizing the correlation between government spending and interest rates, when it says: "Bankers will be looking to gauge the Government's commitment to reducing the fiscal deficit in this year's budget before they can commit to further reductions in lending rates." In other words, only when the deficit shrinks will the interest rates be able to adjust downward. Just like in the though, is embroiled in a war against terrorists, albeit the terrorists they are fighting reside within their own borders. And, as history has proven, wartime often lends itself to government deficit.
So, if the deficit remains constant in the short term, what can the government do to possibly lower interest rates? As bank manager Robert Katuntu is quoted saying, "Our greatest benchmark is the Treasury bills." The government hopes to speak to Mr. Katuntu's point by introducing long-term treasury bonds that will resultantly lower t-bill rates. If this plan works, interest rates will drop, "encouraging increased credit extension in the private sector."

While I could continue to illustrate the government deficit principle, I think it might be more interesting to analyze a possible amplifier effect associated with government overspending. We sometimes forget just how a country that is running a deficit is able to cover its costs from year to year. As it turns out, Uganda, like many countries facing a budget crisis, must rely on outside funds (called donor funds) to pay its bills. Regardless of whether this money was borrowed or given as pure charitable aid, it still will end up costing the country in the end. Unless the Ugandan Central Bank allows the money supply to increase in deficit years, they have to raise t-bill rates to encourage the private sector to give the government this newly-infused money so that it can be destroyed. In essence, t-bill rates and interest rates will go up twice in ; once as a direct result of the deficit and a second time due to this donor fund effect. Ultimately, this leads to an even more severe jolt to the economy in deficit years. Perhaps the deficit identity should look more like this (where DFE stands for Donor Funds Effect):

S + (M - X) = I + [(G + DFE) - T]

Then again, I am not an economist. Perhaps, I should leave well enough alone and accept the principle as it is…!
POSTSCRIPT: {Credit must be given to Dr. Raymond Strangways for the knowledge gained from his "Macroeconomics" textbook.}