International Crowding Out: The U.S. Debt and Foreign Interest Rates

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International Crowding Out: The U.S. Debt and Foreign Interest Rates


This study investigates the impact of changes in the real U.S. debt stock on the short-term interest rates of Canada, France, and Germany. The standard two country portfolio model is extended to examine whether increases in the real U.S. debt stock had a crowding out effect on international portfolios. The evidence presented suggests that international crowding out did not occur during the first monetary regime identified in the study, but did during the second. Thus, future increases in the real U.S. debt stock could have important implications for foreign capital markets.


Rising U.S. federal budget deficits and the associated high level of debt have become important issues because of their potential to increase the U.S. rate of return on capital and to crowd out private investment. A growing body of literature concerned with estimating the impact of increases in government debt financing on interest rates known as portfolio crowding out has developed. Friedman [21] has shown that the outcome of the portfolio effect depends on the portfolio substitution and wealth effects and the net result may be either crowding out or crowding in. Because the sign of the portfolio effect can not be determined a priori, Placone, Ulbrich, and Wallace [34] suggest that this is an empirical issue.

The majority of the empirical studies find the relationship between U.S. interest rates and U.S. debt stock or deficits to be either statistically negative or insignificant. For instance, Mascano and Meltzer [32] report no significant impact of the deficit on either long- or short-term interest rates, while Dewald [16] concludes that the real deficit is not an important factor in the determination of long- or short-term interest rates. Evans [18] examines the impact of federal deficits on U.S. interest rates by using a broad historical survey. He concludes that since the Civil War period, there has been little evidence that increases in the deficit significantly contributed to higher interest rates. Tatom [38] presents evidence that the ratio of the deficit to the GNP is negatively correlated with the change in short-term interest rates. Similarly, Hoelscher [24] and Placone, Ulbrich, and Wallace [34] find no significant correlation between the debt stock and short-term interest rates. Plosser [35] concludes that there is little empirical evidence that increases in the government debt drives up yields.(1)

Nevertheless, the evidence on portfolio crowding out is not conclusive. In particular, Cebula [11] uses a systems approach and provides evidence that the ratio of the deficit to the GNP has a significant positive impact on the rate of change in short-term interest rates, while Hoelscher [25] reports that large deficits are strongly correlated with long-term interest rates. Barth, Iden, and Russek [4] reestimate several of the models that find the relationship between deficits and interest rates to be insignificant and, by making small changes in the specifications of the models, they obtain a significant positive correlation between interest rates and the deficit. In addition, Feldstein [19,20] and Van de Water and Ruffing [40] maintain that the large deficits and debt burden incurred after 1980 led to increases in U.S. interest rates.

Although most studies that have measured the effect of increases in the U.S. debt concentrate on the U.S. economy, there is growing concern regarding the linkages between the U.S. and international financial markets and the impact of increases in the level of U.S. debt on interest rates in the international community. For instance, Fukao and Okuba [22] find a strong positive link between the U.S. short-term interest rates and the Japanese term structure of interest rates. Hartman [23] provides evidence that the Eurodollar market and the domestic U.S. money markets are closely related, while Cumby and Miskin [15] find a strong association between ex ante real interest rates in the United States and Europe. …