The federal deficit is the difference between the income of the federal government, primarily through income and corporate taxes, and its expenditures. Most of this deficit is financed through the sale of government bonds. Therefore, the size of the deficit will have an effect on the interest rate the government offers on its bonds.
The Federal Deficit
Despite its enormous size, the federal government operates on very much the same principles as any corporation or household. If the expenditures surpass income, the shortfall must be financed either by liquidating savings or borrowing. Since governments tend to have little to no savings they can tap into, the entire deficit is usually financed by borrowing. The federal government in the U.S. runs a large deficit and must, therefore, borrow heavily to make up for the shortfall. In addition, practically all state governments also operate on a deficit, and they too must borrow funds to continue operating.
The primary method of financing federal budget deficits is the sale of government bonds. These bonds are sold to institutional as well as individual investors, both domestically and on international markets. The holder of the bond is entitled to receive periodic interest payments, usually twice a year, as well as full repayment of the principal upon expiration of the bond. These bonds can range in maturity from less than one year to up to 30 years. The graphical representation of different interest rates paid for bonds of various maturities is referred to as the yield curve. The interest rates an investor can expect to receive from a short term bond can differ significantly from the rates offered by a 30-year bond.
The higher the interest rate offered by a bond, the greater the number of investors who will wish to invest in it. In other words, increased interest rates result in greater demand. Therefore, when the budget deficit is high, and a large quantity of bonds must be sold to finance the deficit, the government is forced to offer higher rates of interest to sell enough bonds. Since the interest rate on treasury bonds is the single most important rate of interest within the broader economy, this tends to elevate all borrowing rates from mortgages to the interest consumers much pay on credit card debt. Treasury bond rates are so critical because the U.S. government is the safest borrower, with virtually zero chance of default, and all other borrowers, such as individual consumers, must pay a higher rate of interest to access funds.
While high governmental budget deficits are usually associated with higher interest rates, various other factors influence the general rate of borrowing in the economy. Japan is a particularly interesting example, since it runs an exceptionally large deficit in relation to the size of its economy, yet has some of the lowest interest rates in the world. A high savings rate, which creates a substantial demand for government bonds, can keep rates depressed. A strong private sector that relies mostly on profits, as opposed to borrowed funds, for growth will also make the government the single substantial supplier of bonds, thus allowing government bonds to enjoy strong demand despite relative low returns.