CP

budget surplus. As a result, the government paid back existing debt faster than it is-

sued new debt. The net result was a decrease in the national debt. If these surpluses

had continued, the government would be a net supplier of funds rather than a net bor-

rower. However, the events of 9/11, when combined with the current recession and

the Bush administration’s tax cuts, have caused a current budget deficit.

International Factors

Businesses and individuals in the United States buy from and sell to people and firms

in other countries. If we buy more than we sell (that is, if we import more than we ex-

port), we are said to be running a foreign trade deficit.When trade deficits occur, they

must be financed, and the main source of financing is debt. In other words, if we im-

port $200 billion of goods but export only $100 billion, we run a trade deficit of $100

billion, and we would probably borrow the $100 billion.^19 Therefore, the larger our

trade deficit, the more we must borrow, and as we increase our borrowing, this drives

up interest rates. Also, foreigners are willing to hold U.S. debt if and only if the rate

paid on this debt is competitive with interest rates in other countries. Therefore, if the

Federal Reserve attempts to lower interest rates in the United States, causing our rates

to fall below rates abroad, then foreigners will sell U.S. bonds, those sales will depress

bond prices, and that in turn will result in higher U.S. rates. Thus, if the trade deficit

is large relative to the size of the overall economy, it will hinder the Fed’s ability to

combat a recession by lowering interest rates.

TheUnitedStateshasbeenrunningannualtradedeficitssincethemid-1970s,and

thecumulativeeffectofthesedeficitsisthattheUnitedStateshasbecomethelargest

debtornationofalltime.Asaresult,ourinterestratesareverymuchinfluencedbyin-

terest rates in other countries around the world—higher rates abroad lead to higher

U.S. rates, and vice versa. Because of all this, U.S. corporate treasurers—and anyone

else who is affected by interest rates—must keep up with developments in the world

economy.

Business Activity

Figure 1-4, presented earlier, can be examined to see how business conditions influ-

ence interest rates. Here are the key points revealed by the graph:

1. Because inflation increased from 1961 to 1981, the general tendency during that
   period was toward higher interest rates. However, since the 1981 peak, the trend
   has generally been downward.


2. Until 1966, short-term rates were almost always below long-term rates. Thus, in
   those years the yield curve was almost always “normal” in the sense that it was up-
   ward sloping.


3. The shaded areas in the graph represent recessions, during which (a) both the de-
   mand for money and the rate of inflation tend to fall and (b) the Federal Reserve
   tends to increase the money supply in an effort to stimulate the economy. As a re-
   sult, there is a tendency for interest rates to decline during recessions. For example,
   on three different occasions in 1998 the Fed lowered rates by 25 basis points to

Other Factors That Influence Interest Rate Levels 45

(^19) The deficit could also be financed by selling assets, including gold, corporate stocks, entire companies,
and real estate. The United States has financed its massive trade deficits by all of these means in recent
years, but the primary method has been by borrowing from foreigners.

An Overview of Corporate Finance and the Financial Environment 43