* THE CLINTON ADMINISTRATON’S OWN VIEW Whatever we might think of the reasoning Greenspan used in convincing Clinton that deficit reduction was an essential policy goal, it still remains a fact that deficits were reduced and (briefly) turned into surpluses over the eight years of the Clinton Presidency. In January of 2001, the Council of Economic Advisers made the following argument:
The Omnibus Budget and Reconciliation Act of 1993 was the right policy package at the right time … long-term interest rates remained stubbornly high. … Bond yields were being predictably affected by the forces of supply and demand: the Federal Government was set to run a deficit of almost $300 billion … With an oversupply of government bonds and the prospect of even more to come, bond and stock prices were depressed, and yields were correspondingly high…

In 1992, the new Administration was elected on a promise to turn the deficits around. After a tough political battle in 1993, the Administration was able to deliver on that promise … The markets responded quickly to this serious effort to address the deficit by lowering expectations of future inflation, and long-term interest rates accordingly fell….

As economic growth and further restraints on spending … turned the huge deficits into surpluses, a new fiscal environment emerged. The 10-year Treasury rate fell below 6 percent in 1998 and 1999… that rate stood at only 5.7 percent in November 2000. …

Ultimately, the combination of falling prices for investment goods and reduced interest costs stimulated dramatic growth in investment… investment grew 13 percent per year between the first quarter of 1993 and the third quarter of 2000.

The result has been a virtuous cycle, in which the right policies in 1993 kicked off a chain reaction of smaller deficits, lower costs of capital, higher investment, increased technology in the workplace, and faster economic growth.

As Figure 3 shows, this is a powerful story. There is a clear and inverse relationship between the government deficit (federal, state and local as well) and investment from 1993 onward.

[Figure 3 here]

At the same time, as Figure 4 shows, there is a clear and consistent decrease in nominal long-term rates in the 1990s.
[Figure 4 here]

However, the evidence presented in this brief statement focuses exclusively on nominal values. We are told about the various interest rates in nominal not real terms. We are told about absolute increases in nominal investment but not about the relationship between investment and GDP. We are also told nothing about the direction of causation. The rise in investment might have increased incomes so much that deficits fell as a result of those increases. The major reason budget deficits are considered to have negative consequences for economic growth is because the extra government borrowing “crowds out” some private borrowing from the credit markets. With only a certain amount of national savings, when government entities increase borrowing that allegedly causes interest rates (the cost of borrowing) to increase. The argument concludes with the assertion that the rise in interest rates reduces private investment. The reduced private investment, in turn, reduces economic growth. Reversing this problem with lowered deficits and ultimately surpluses allegedly creates the virtuous cycle that the Council of Economic Advisers referred to in the post-1993 period. Instead of crowding out private borrowing, the reduced deficits and ultimately surpluses involve “making room” for more private borrowing by lowering interest rates.
Testing the Assertions How do we determine whether this explanation is accurate or not? The first thing we need to do is to understand what we need to measure. Absolute numbers in economic analysis usually mean nothing. If we say that the budget deficit is $300 billion in a given year we have no idea whether that is a dangerously large deficit or