The existence of a causal relationship between budget deficits and investment requires a transmission mechanism between these two variables. Several authors such as Cebula, Hung and Manage (1995), Cebula and Belton (1992), and Cebula and Scott (1991) point to a positive relationship between budget deficits and interest rates. The existence of a relationship suggests that interest rates are that transmission mechanism.

On the other hand, researchers such as Evans (1985, 1987), and Kormendi (1983) find no relationship between budget deficits and interest rates which suggests the existence of an alternative transmission mechanism between budget deficits and private investment if one truly does exist.

These empirical studies support two opposing views in the relationship between budget deficits and interest rates: the Neoclassical view and the Ricardian Equivalence view.

According to the Neoclassical view, budget deficits crowd out private investment through having a positive relationship with interest rates. Positive budget deficits cause an increase in the demand for loanable funds which leads to an increase in interest rates.

Under the Ricardian Equivalence view there would be no crowding out of private investment when the government borrows money because people will reduce consumption and increase savings in order to offset the increase in future tax liabilities which they foresee as a result of government spending deficits.

Facts, like beauty, can lie in the eye of the beholder. 😉

The Shuttle tragedy is likely to dominate the news for a little while at least.  But Colin Powell, US secretary of state, is scheduled to appear before the United Nations Security Council on Wednesday to present the case for an early war against Iraq.  The twin themes of Iraq and the US economy are set to continue holding investor attention this week. Data covering US manufacturing, the service sector and employment will keep markets focused on the health of the US economy, but any upside could be limited by continuing hawkish rhetoric on Iraq.

In general, economists see a weak first half of the year followed by accelerating growth once war clouds pass. But there appears to be an unusually large range of forecasts, in part because of split views over what is holding the economy back.  Some analysts said the Fed’s phraseology of “reportedly” and “over time” suggested policymakers at the central bank see the recovery saddled with more than just war. Nevertheless, the central bank reiterated its view that economic risks were balanced between weakness and a possible rise in inflation.  I think the threat of rising inflation is overstated by the Fed and their statement was designed to provide comfort to the markets.

The Commerce Department said Thursday that gross domestic product, the broadest measure of U.S. goods and services, expanded at a 0.7% annual rate in the fourth quarter of last year, down from 4% the previous three months.  This number is still subject to two revisions which could reduce it further.  While growth zigzagged all year, the performance was the most anemic since the third quarter of 2001, when the country was in recession. Overall, the economy grew 2.4% in 2002, compared with 0.3% in 2001 so the year wasn’t a total disaster.

John Snow got a grilling on Capital Hill last week as Democrats were eager to show they weren’t powerless to stop the Republican majority.  They seemed stuck on the Cash Benefit plan revisions that could hurt seniors while easing the burden of pension obligations of big business.  It should also be noted that the replacement for ousted SEC chairman Harvey Pitt has yet to be sent to the Hill for conformation even though the Bush Administration announced their intentions months ago.  We will have much more on the SEC later.

The European Central Bank meets on Thursday, but analysts warn not to expect an interest rate cut.  The Euro has gained about 15 per cent against the dollar and about 7 per cent against sterling in the past year making exports leaner for European manufacturers. 

Friday’s US payroll figures are one of the most watched indicators but also the one with the widest variations in predictions although few economists expect a significant improvement.

Productivity is a major issue in this economy and has been for a number of years.

4th quarter GDP just came out at .7% . I think Q3 as it was 4%.
There may be an inability to measure productivity growth with accuracy. I have not seen a study or paper on the effect of the increasing service and information sector and the shrinking manufacturing sector on productivity. It only makes sense that as jobs change from manufacturing to services there is a significant increase in productivity and that measuring this change is difficult.