Deficits, China, and Mortgage Rates

In late 2003, a Forbes review of former Treasury Secretary Robert Rubin’s book In an Uncertain World noted: "Rubin is quite certain that eventually the huge deficit will push up interest rates on 10-year Treasuries from the current 4.5 percent to 7.3 percent. Jot down his arithmetic rule for future use: For every rise in the deficit equal to 1 percent of gross domestic product, figure that long-term interest rates will rise by 0.4 percent."

Rubin was quite certain and quite certainly wrong. The budget surplus in fiscal 2000 was 2.4 percent of GDP. The deficit in 2005 was estimated at 3.5 percent of GDP. Since the "rise in the deficit" between 2000 and 2005 has been nearly 6 percent of GDP, Rubin’s arithmetic predicts that long-term interest rates should have risen by six times 0.4 percent, or 2.4 percentage points. Instead of rising by 2.4 points, however, long-term rates are that much lower than in 2000, when the budget surplus peaked. The yield on 10-year Treasuries dropped from 6.7 percent in January 2000 to 4.2 percent this July. The rate on 30-year mortgages dropped from 8.5 percent in May 2000 to 5.7 percent in July.

Those who predicted that deficits would raise interest rates have resorted to three excuses. One is to change the subject, adding new and contradictory definitions of interest rates. Another is to beg for a reprieve by emphasizing the word "eventually." The newest excuse is to claim the only reason long-term rates didn’t soar is that China supposedly bought a lot of Treasury bonds.

In January 2004, Robert Rubin, Peter Orszag and Allen Sinai presented a paper on sustained budget deficits at the American Economic Association, predicting a "drop in asset prices and increase in interest rates." They changed the subject by arguing that only real inflation-adjusted long-term interest rates would rise, or perhaps the spread between long-term and short-term interest rates would widen, in anticipation of estimated future deficits.

Yet the only way deficits could make real interest rates rise without making actual interest rates rise would be, paradoxically, if larger deficits caused lower inflation (thus widening the gap between interest rates and inflation). And the only way deficits could widen the spread between long and short-term rates without raising long-term rates would be if bigger deficits somehow compelled the Fed to lower short-term rates.

Creatively redefining interest rates cannot salvage the Rubin forecast. Today’s long-term interest rates are extremely low when compared with either short-term rates or inflation.

The forecast cannot even be rescued by hoping it may "eventually" turn out right. Studies cited by Rubin, Orszag and Sinai all claimed some convoluted measure of long-term interest rates would react immediately — not "eventually" — to increases in estimated future deficits.

In February 2004, I presented a critique of the Orszag-Rubin-Sinai paper at the U.S. Treasury, which is available at or by searching my name at This was my conclusion:

"Orszag, Rubin and Sinai have offered four hypotheses that purport to predict the effects of estimated future budget deficits on yield curves, real interest rates, the national savings rate, the current account deficit and investor confidence. If these were not intended to yield testable predictions, they would just be metaphysical speculations. Several of these hypotheses … are inconsistent with each other, or with previous versions of this whole exercise in conventionality (twin deficits theorists used to postulate that deficits made the dollar rise, not fall). All of the four central hypotheses are completely inconsistent with all direct evidence from U.S. time series and international comparisons. In summary, neither actual nor projected budget deficits raise real or nominal interest rates, steepen the yield curve, reduce national savings, cause ‘twin deficits’ or make the dollar go down or up. The logic behind such speculations is flawed and contradictory. The evidence is nonexistent."

Since then, a third excuse has become wildly fashionable — claiming budget deficits would have greatly increased long-term interest rates were it not for the People’s Bank of China. The Economist thus claims: "China has provided cheap finance to America’s consumers and its government by buying Treasury bonds. If the switch to a currency basket causes China to reduce its new purchases of dollar assets, then American bond yields could rise. … From this point of view, global monetary policy is now made in Beijing, not Washington."

The Economist is as wrong about China’s influence as Rubin was about deficits, and for similar reasons. In "Doomsday Is Doomed," I explained that "we already found out what happens when foreign central banks cut back sharply on their purchases of U.S. Treasury securities. The answer is nothing happens — absolutely nothing."

Foreign official purchases of U.S. Treasury securities fell steadily from $112.6 billion in the first quarter of 2004 to $15.2 billion in the first quarter of 2005.

But private foreign investments in U.S. Treasuries rose from $31.9 billion to $75.5 billion in that period. Foreigners have almost 45 percent of the $4.6 trillion in publicly held U.S. debt, yet that includes private foreign investors, worldwide.

China’s central bank holds a few hundred billion in U.S. Treasury securities — far less than the Federal Reserve ($717 billion). Central banks usually keep most reserves in short-term bills, not long-term bonds, so the oft-repeated notion that the People’s Bank of China has been buying many "Treasury bonds" is an unlikely conjecture. The U.S. Treasury never reveals whether any particular central bank is buying or selling bills, notes or bonds.

Central banks are classic buy-and-hold investors, having far less impact on interest volatility than bond traders. The volume of trading in U.S. Treasuries exceeds $561 billion a day, according to the New York Fed. That market for Treasury securities involves the entire stock of outstanding debt, not just new securities issued to finance deficits. And yields on Treasuries must compete with many investments.

In my 2004 Treasury paper, I suggested that "stubborn convictions about an invisible link between deficits and bond yields rest on ‘the quantity theory of bonds’: Treasury bonds are thought to be valued for their scarcity, like rare stamps or antiques, making the market value of Treasury bonds vary inversely with the volume of bonds marketed. … In reality, people do not buy a country’s bonds because of their scarcity but because they expect the return — including coupon and capital gains — to at least match the risk-adjusted return of alternative investments. Those alternative investments include all of the world’s stocks, bonds, bills, commodities and real estate. Governments do not borrow from the current flow of national savings, as the authors assume, but from the world’s stock of assets."

The level of long-term interest rates at home and abroad depends on such things as inflation, investment opportunities, risk and international arbitrage. It does not depend on U.S. budget deficits or on the relatively trivial portion of Treasury bonds that may or may not be held by the People’s Bank of China.