Deficits, Explicit Debt, Implicit Debt, and Interest Rates: Some Empirical Evidence

[Author Affiliation]Zijun Wang, Private Enterprise Research Center, Allen Building, Room 3028, Texas AM E-mail z-wang@neo.tamu.edu; corresponding author.Andrew J Rettenmaier, Private Enterprise Research Center, Allen Building, Room 3028, Texas AM E-mail a-rettenmaier@tamu.edu.[Acknowledgment]We are grateful to Kent Kimbrough (editor) and two anonymous referees for their comments, which significantly improved the paper. Financial support from the Lynde and Harry Bradley Foundation and the National Center for Policy Analysis (NCPA) is acknowledged.1. IntroductionThe effect of government borrowing on interest rates has been a controversial issue for about three decades. The federal deficits of the 1980s and the early 1990s caused speculation as to whether higher interest rates would follow. The current deficits have renewed interest in the link to higher interest rates. Since the influential work of Barro (1974), much of the discussion has focused on whether the Ricardian equivalence hypothesis holds. Bernheim (1987), Barth et al. (1991), Seater (1993), Elmendorf and Mankiw (1999), and Engen and Hubbard (2005) provide excellent reviews of the literature on the topic. Recent contributions include Cebula (1997); Gale and Orszag (2003); Laubach (2003); and Ardagna, Caselli, and Lane (2004) among others. Although empirical evidence obtained in earlier studies is mixed, as argued by Gale and Orszag (2003), major macroeconometric models imply an economically significant connection between changes in deficits and long-term interest rates. Empirical evidence assembled by recent studies seems to lean toward the existence of the relationship, but there is still no consensus about the magnitude of the effect.A missing piece in the debate is a formal investigation of the effect of the implicit debt, as embodied in unfunded obligations of Social Security and Medicare. Theoretically, it could be argued that because the Ricardian equivalence proposition assumes that households are rational and make decisions for long horizons, then like the often-discussed public debt (explicit debt), the implicit debt (computed based on 75-year, 100-year, or infinite horizons) might also have a role to play in the determination of interest rates. The point we raise here is not new. In his 1996 paper "Reflections on Ricardian Equivalence," Barro writes "... (T)he basic invariance proposition for intergenerational transfers... (is) that the government's transfers implied by budget deficits or pay-as-you-go social security would be fully undone if family members were connected through voluntary transfers based on altruism" (p. 2). More recently, Gokhale and Smetters (2005) also note that (Social Security's) pay-as-you-go financing may "crowd out" private saving and hence increase interest rates (p. 12).1 Therefore, it is problematic to test the Ricardian equivalence hypothesis without considering the effect of the implicit debt. Empirically, the explicit debt, although large in absolute amount (about $4300 billion by the end of 2004), is only a part of the federal government's total obligations. According to the Office of the Chief Actuary of the Social Security Administration, the Social Security program alone carries unfunded obligations ranging from about $3700 to $11,200 billion in present values at the beginning of 2004 under various assumptions. These numbers are even larger if the trust fund balances are subtracted. In particular, projected Old Age, Survivors, and Disability Insurance payroll tax income will begin to fall short of outlays in 2017, which means that Social Security will require transfers from general revenues in the next decade (Social Security Trustees 2005).While previous studies have investigated the effect of Social Security wealth on saving and consumption (e. …