The nation's economic policymakers are frustrated, to say the least. The Federal Reserve has pushed short-term interest rates down to their lowest levels in two decades, the economy seems comatose, and inflation is subsiding. Yet long-term rates, which directly affect such critical sectors as housing, have stayed relatively high and have risen in real terms as inflation has slowed.
The most common explanation of stubbornly high long-term yields is psychological: Investors in inflation-sensitive securities are becoming more fearful that Congress and the Administration will resort to overstimulus to ensure victory at the polls next year. But while he concedes that market psychology is important, economist Alan C. Lerner of Bankers Trust Co. thinks long rates are being held up by more than investor fears. "The combination of an exploding federal deficit combined with weak private savings," he says, "implies that government borrowing is crowding out private borrowers." To be sure, most economists question the "crowding out" thesis -- particularly since the federal deficit as a percent of gross national product has declined from its level in the mid-1980s. But Lerner argues that the best way to gauge the potential impact of the deficit on capital markets is to relate the red ink directly to personal savings rather than gnp.
"Such savings, which have been historically low since the mid-1980s," he says, "are the principal source of private domestic funds available for financing public and private borrowing." (Savings by business have also slowed recently, but are smaller and more affected by the business cycle.)
The past two decades, notes Lerner, have seen a "relentless upward march of the federal deficit as a percentage of personal savings -- from 5% in 1970 to an estimated 162% this year." The effect of this trend on capital markets, he notes, was muted in the mid-1980s because the U.S. was able to attract large pools of savings from abroad. But now that developments overseas have stanched the flow of foreign capital into the U.S., Lerner contends that "crowding out is back with a vengeance."
If Lerner is right, government policymakers face a daunting task: They must not only find a way to stimulate the economy while calming inflationary fears but also take action to bolster household savings and reduce the deficit over time. Until they do, warns Lerner, "long-term interest rates are likely to remain relatively high."