Historically, the home building industry has been a staunch opponent of large federal budget deficits. After all, large deficits smack of fiscal irresponsibility in Washington. Worse yet, large deficits mean heavy borrowing by the Treasury that can put upward pressure on interest rates.

Incredibly, the federal budget swung into a surplus position in the late 1990s, and budget projections made in 2000 confidently proclaimed that deficits were a thing of the past. But the budget had fallen back into the red by 2002, and we're now facing a deficit of about $500 billion for the current fiscal year—the largest on record. This stunning turnaround has become a key issue in this year's political campaigns and has once again raised the eyebrows of the housing industry.

What Happened? About half of the budget deterioration since 2000 can be pinned on the economic recession of 2001 and the subpar economic recovery since then, reflecting effective performance of automatic stabilizers in the budget. Blame for this economic performance can be debated until the cows come home, but the fact remains that budget deterioration caused by economic weakness is, by its nature, both healthy and temporary.

Roughly one-fourth of the budget deterioration since 2000 reflects increases in federal spending on defense and homeland security, areas of the budget that promise to remain expansive regardless of the state of the economy or the party in power. Finally, it's fair to say that the revenue losses associated with the Bush tax cuts of 2001 and 2003 can account for the remaining one-fourth of the budget deterioration, although it's also fair to say that the economic stimulus delivered by these tax cuts should help “pay for themselves” over time.

Interest Rate Effects It's true that interest rates would have fallen further in recent years in the absence of expanding federal deficits. However, the absence of fiscal stimulus would have been a real downer for the U.S. economy, and the Federal Reserve might not have had enough ammo in the monetary policy arsenal to save the day.

The economy now is gaining stronger forward momentum, and the large cyclical component of budget deterioration will soon be swinging back the other way. Despite this projected cyclical improvement, both the Congressional Budget Office (CBO) and the White House Office of Management and Budget (OMB) are projecting a stream of deficits as far as the eye can see, particularly if the Bush tax cuts are made permanent.

The persistence of deficits in the out-years does not necessarily translate into upward pressure on interest rates. It's the size of deficits relative to the size of the economy that really matters. The current deficit/GDP ratio is riding temporarily high, and it recedes in coming years under both CBO and OMB projections—even if the Bush tax cuts are made permanent. These projections, of course, contain conservative estimates of growth in discretionary spending.

Bottom Lines Persistent budget deficits should not push interest rates up over time as long as growth of the economy at least keeps pace. To help ensure this, Congress should re-establish the budgetary rules that were allowed to expire in 2002–2003, including limits on overall discretionary spending and the so-called PAYGO rules.