OK I think I’ve come up with even more obvious ways to make the point. (If you are stumbling on this as an innocent newcomer, see this post and its link to get up to speed.)
Before I do so, I want to be clear on what I’m trying to prove: Paul Krugman and others (a group that would have included me, two weeks ago) think that only the naive layperson could think “running up the government debt allows us to selfishly live at the expense of our grandchildren.” The zinger in their argument is to observe that when our grandchildren are forced to pay higher taxes to service/retire the debt (necessitated by today’s deficits), they aren’t going to be paying us, but rather they will be paying themselves. So–duh!–the layperson can’t possibly be right. Or, more specifically, if the layperson is right, it’s because of complications involving the distortions of taxes, or the distributional impacts of only some people being bondholders, etc. To drive home the fact that it’s the “they owe the debt to themselves” driving his argument, Krugman conceded that if foreigners hold the bonds, then yes, that debt truly is a burden on unborn generations.
Steve Landsburg chimed in to say he basically agreed with Krugman, except that Krugman didn’t go far enough: Landsburg said that even if the government in 100 years owes bond payments to foreigners, nothing really changes.
OK, so here’s what I’m saying: Krugman is totally, utterly wrong. (But again, I would have been equally wrong two weeks ago.) Landsburg ironically is correct, and so I was unduly harsh to him in this whimsical post. Landsburg is right to say that Krugman’s focus on the identity of the bondholders doesn’t really change things. But, what I am saying is that Krugman is WRONG whether foreigners or Americans hold the IOUs issued by Uncle Sam.
In my earlier post involving Abraham and Isaac, I focused on what I think the key issue is. However, lots of people in the comments still aren’t seeing it. So let me try to refine it even more:
There are only two time periods. In period 1, old Abraham has a tree that yields 100 apples. There is also a young Philistine who has a tree that yields 100 apples. In period 2, Abraham and his tree are both dead, but young Isaac is born. Isaac has a tree that yields 100 apples for 1 period, while the (now old) Philistine is still alive, and his tree yields 100 apples. After this period, everything is dead.
SCENARIO 1: The government comes along in period 1, and runs a budget deficit of 10 apples to finance a subsidy to Abraham. The Philistine lends the government 10 apples voluntarily, because it issues him a bond promising 11 apples in period 2.
Period 2 comes along. The government says to the newly born Isaac, “Hi! Welcome to the world. Give us 11 apples or we’ll kill you.” So Isaac complies, and the government retires the bond from the Philistine.
In summary, in period 1 Abraham consumed 110 apples while the Philistine ate 90. In period 2, Isaac ate 89 apples while the Philistine ate 111.
OK, now most people (maybe not Landsburg, because he likes to be difficult), including Krugman, would agree that in this starting scenario, the government in period 1 ran a deficit to benefit the old Abraham, by imposing a burden on the unborn future generation. Yes, the actual financing involved a loan from the Philistine, but he wasn’t really a net loser in the deal. If the layperson looks at that situation and says to Abraham, “You know, your extra 10 apples are coming at the expense of your unborn son,” there is nothing wrong with his analysis. No PhD economist can scold him for being unsophisticated. That is basically correct, and not because of fancy incentive effects or Cobb-Douglas production functions, but for the brute reason that Isaac in period 2 is going to be taxed to retire the debt that made Abraham’s extra consumption possible in period 1.
SCENARIO 2: Tweak things: Suppose in the beginning of period 2, the government defaults on its bond. Now who is harmed? The Philistine, of course. But when was he harmed? I think it’s fair to say he was harmed when the government defaulted. Up until that point–with the expectation that he was going to be repaid–the Philistine was content with arrangements.
SCENARIO 3: OK, now tweak things a different way. In this new scenario, the government doesn’t default; it pays the bond off in period 2. But, right before it does so, Isaac goes up to the Philistine and buys the bond off of him for 11 apples. The government then taxes Isaac the 11 apples, and hands them right back to Isaac to retire the bond (which he acquired from the Philistine 5 minutes earlier).
In this scenario, who “really” shoulders the burden of Abraham’s 10 extra apples in period 1? I think it is quite clearly Isaac. We are effectively back to Scenario 1, where everybody, including Krugman, thought Isaac bore the burden. That brute fact isn’t changed, if Isaac and the Philistine make a voluntary exchange 5 minutes before the government retires the debt.
So now does everybody see why it’s completely wrong to focus on “they will owe the debt to themselves”? In this particular scenario, when the government retires the bond, it is taking Isaac’s apples to give right back to him. Note that if the government defaults in this scenario (after Isaac has bought the bond from the Philistine), it doesn’t help Isaac: He benefits from not being taxed, but now his bond is worthless.
SCENARIO 4: Now we’re going to really tweak things. Throw out the Philistine, and go back to my original thought experiment. Isaac now lives both periods too. In period 1, Isaac lends the 10 apples to the government. In period 2, the government taxes Isaac 11 apples, then gives them right back to him to retire the bond.
In this final scenario, Isaac clearly suffers the burden from Abraham’s extra 10 apples of consumption in period 1. But let’s be more specific: When does Isaac suffer, and in what manner? IT IS NOT in period 1, when he lends the apples to the government. That was a voluntary decision on his part. If you don’t believe me, go back to Scenario 1 above. Quite clearly, we all agreed there that the Philistine wasn’t the one who “really” paid for Abraham’s consumption. Or, at least, whatever way you understood that the Isaac-in-period-2 was getting screwed over in Scenario 1, then that is just as true for Isaac-in-period-2 in Scenario 4. The fact that a younger Isaac lent money to the government in period 1 (in this last scenario) doesn’t alter this fact.
Last thing: In this final Scenario 4, suppose the government defaults in period 2. Well, now it doesn’t hurt Isaac-as-taxpayer, but it hurts Isaac-as-bondholder. Go back to our thoughts of the poor Philistine when the government defaulted on him in Scenario 2. We agreed that quite clearly there, the default hurt him. So, here, the default quite clearly hurts Isaac. Yes, Isaac benefits as a taxpayer, but that doesn’t restore him to equity, as if nothing ever happened.
In Scenario 4, Isaac goes into period 2 knowing he has to be harmed either as Isaac was in Scenario 1 (if the government pays off the bond) or as the Philistine was in Scenario 2 (if the governmen defaults on the bond). Either way, Isaac is getting harmed in period 2, and that’s the true harm that counterbalances the gain to Abraham in period 1. Someone who comes along and says, “No, this is pedestrian micro thinking, because any bonds in period 2 are basically owed to Isaac,” is totally confusing things. It’s not just a little off, it’s totally, utterly wrong to focus on the government taking 11 apples from Isaac in period 2, and then giving the apples right back to him, then concluding, “The burden must lie elsewhere.”
If you don’t like that, try an independent argument:
The government announces that next year, it will whip every citizen 100 times. But, if someone pays the government $1000 today, that person will be spared when the whip-master makes his rounds next year. OK, in this scenario, how is the government raising money today? Because it is threatening to impose harms next year.
New scenario. The government announces that next year, it will take $1100 from each citizen. But, if someone pays the government $1000 today, then the government will exempt that person from next year’s extortion. OK, in this scenario, how is the government raising money today? Because it is threatening to steal money next year.
Final scenario. The government announces that next year, it will take $1100 from each citizen. But, if someone lends the government $1000 today, then the government will issue him a bond that pays $1100 next year, which the person can use to satisfy the $1100 tax bill. OK, in this scenario, how is the government raising money today? Because it is threatening to steal money next year.
Does everybody see what’s going on now, and why Don Boudreaux and Nick Rowe (who were both relying on Buchanan) are right, while Krugman and Yglesias are totally wrong? The government wants to spend a bunch of money today, giving goodies to older people. If it tried to raise taxes to finance it, there would be an outcry. So instead, the government says to some wealthy investors, “OK, we are going to use our guns to extort money from some other people in 20 years. We’ll give you a cut of that loot, if you lend us some money right now to give to the older people so they vote us back into office.”
This is quite clearly a crooked scheme, and if future generations end up holding those IOUs, it doesn’t change the nature of it. There is a very definite sense in which the politically powerful citizenry who enjoy transfer payments due to government budget deficits, are living at the expense of future taxpayers. The layperson is right, and the fancy schmancy economists who doubt this are wrong.