Do budget deficits affect long-term interest rates? U.S. federal budget deficits are back big time. What will be their long-term consequences? Seven big thinkers enter the ring, gloves up.

• Position: A Symposium Of Views

GLENN HUBBARD

Former Chairman of the Council of Economic Advisers under President George W. Bush, Russell L. Carson Professor of Economics and Finance at Columbia University, and Research Associate of the National Bureau of Economic Research and the American Enterprise Institute

President Bush has proposed a tax cut to shore up near-term growth prospects and raise output in the long tern. The Council of Economic Advisers estimated that the proposal would add about a percentage point to GDP growth this year and next. As I describe below, my own calculations suggest that in the medium and long run, the President's proposal to eliminate the double taxation of corporate income would add about one-half of one percent to the level of GDP every year.

While there are few critics of the President's proposal on tax policy grounds, some economists and policymakers have argued that to the extent the President's proposal is debt-financed, it will raise long-term interest rates, limiting or even wiping out the pro-growth effects on capital accumulation. While intuitive, the argument can be easily overstated. While an autonomous change in the budget surplus in a large open economy like that of the United States can effect world interest rates, that effect is likely to be small--in particular, relative to the pro-growth effects of the current tax proposal.

Conventional economic analysis enables us to quantify the likely effect of additional government borrowing on interest rates. Let's start with the basics: To the extent that incremental government debt "crowds out" capital, the higher return to capital increases the required return on other assets, including bonds, driving up interest rates. How can we measure the productivity of capital being crowded out? A simple measurement can be obtained from the portion of total U.S. output paid to suppliers of labor. Because gross capital income is about one-third of total U.S. output, the marginal product of capital increases by about 0.67 percent for each decline in the capital stock by 1.0 percent [that is, (Percent change in Y) - (Percent change in K) = (-0.33 percent) - (-1.0 percent) = 0.67 percent].

One percent of the U.S. capital stock (using 2001 data) is approximately $280 billion. Using the estimate by the Council of Economic Advisers for the United States as a large open economy, one dollar of incremental government debt reduces the U.S. capital stock by about 60 cents; hence crowding out one percent of the capital stock requires an increase in government debt. For modest changes in government debt, then, each $100 billion increase in the stock of government debt would be predicted to increase long-term interest rates by about 1.5 basis points. The present value of borrowing to finance the President's proposal to eliminate the double taxation of corporate income, accordingly, might increase long-term yields by about 10 basis points.

How likely is this to offset the economic growth stimulated by the President's proposal? Here it is useful to focus on the long-term effects of eliminating the double taxation of corporate income. Most easily measured economic gains come from increasing the capital stock and improving the efficiency with which the capital stock is used. Both of these changes raise U.S. output. Based on research by many economists on the impact on capital formation of changes in the cost of capital, the higher capital stock from the proposal should raise output by about 0.25 percent each year going forward. Using estimates from the 1992 Treasury report on corporate tax integration, improved efficiency of the capital stock should add about another 0.25 percent each year to output going forward. This extra 0.5 percent of output going forward dwarfs the interest rate effect of deficits in this range (I will spare you the calculations.)

None of this should imply a "free lunch" or that deficits are "good." While I believe the President's proposal to eliminate the double tax on corporate income and decrease marginal tax rates is good tax polity and economic policy, I remain concerned about the looming fiscal imbalances in the nation's entitlement programs--Medicare and Social Security. These programs require timely reform.

PETER G. PETERSON

Chairman, The Blackstone Group, Chairman, Federal Reserve Bank of New York; and founding President of the Concord Coalition

By championing permanent cuts in federal revenues unaccompanied by significant cuts in budget outlays--and no cuts at all in fast-growing senior entitlements--this Administration, supported by Congress, has now set our nation on a course of rising and virtually endless budget deficits.

This is a cause for grave concern. Most important, chronic deficits soak up national savings and crowd out productive investment. Along the way, they also raise interest rates, by 25 to 50 basis points (according to most studies) for each one percent increase in the long-term federal deficit as a share of GDP. Since America's savings pool is already very shallow, relative both to other developed nations and to our own history, the impact of large deficits is especially harmful. From 10.9 percent of GDP during the 1960s, the U.S. net national savings rate slid to 4.8 percent during the 1990s and has fallen more recently to two consecutive postwar lows--3.3 percent of GDP in 2001 and 1.7 percent in 2002. Current fiscal policies are due to push net national savings still lower.

This brings us to history's bottom line, as insisted on by one economic luminary after another, from Adam Smith and Karl Marx to Alfred Marshall and John Maynard Keynes: No country can enjoy sustained living standard growth without investing, and no country can sustain high investment without saving. All of these thinkers agreed that nothing undermines the "wealth of nations" as predictably as a government that cannot live within its means.

To be sure, temporary deficits...