OK my piece de resistance. I’m going to post this on Facebook, so let me start from scratch:
I am responding to Paul Krugman’s recent claims on why the standard political debate on the government debt is totally wrong-headed. (For a good summary of his position, see this NYT piece.) Specifically, Krugman conceded that if foreigners held U.S. government bonds in (say) 100 years, then those future American taxpayers would indeed be burdened by having to service the debt. However, Krugman said that empirically, Americans basically would “owe the debt to themselves” and so today’s deficits wouldn’t impose a burden, at least not for the simplistic reason that the average fan of Rush Limbaugh or Sean Hannity would believe.
I would have agreed with Krugman two weeks ago; indeed, in my own textbook I made similar observations. To be sure, I still thought it was irresponsible and would impoverish future generations if the government ran big deficits today, but I didn’t think it was because “hey, our grandkids will eventually have to pay this debt off, and at that time it will be painful to them.”
I was wrong. Krugman is wrong. The difference is, I realized it and–now that the scales have fallen from my eyes–I am the most zealous defender of the layperson’s view on this. The person who made me see the light was Nick Rowe in this post, but now that I understand what the issues are, I realize in hindsight that Don Boudreaux (relying on insights from James Buchanan) was right from the get-go as well. (However, I wouldn’t have seen it by just relying on Boudreaux’s general arguments. It took Rowe’s simplistic thought experiment to finally make it click in my thick skull.)
OK, so consider the following simple world: Every period, there are only two people alive, an old person and a young person. Each person lives two time periods. (I.e. the young person turns old the next period, then dies and is replaced by a new young person.) Each person owns a tree that yields 100 apples to be eaten. The apples can’t be stored for future consumption, and they are seedless so we can’t plant new apple trees. This is what economists call a “pure endowment economy with no physical saving.”
People’s preferences are intuitive. Other things equal, they want more apples in any given time period. There is no altruism nor envy. People also prefer to “smooth” consumption over time. So for example, someone would rather eat (100, 100) apples in periods (t1, t2) rather than eating (99, 101). However, someone might be prefer to eat (99, 105) rather than (100, 100) because the preference for more apples outweighs the preference for smoothing. (I’m being a bit loosey goosey here, but we could make this really rigorous if needed.)
Now consider the following two histories of this simple world:
I need to be quick, so you might need to read some of the links above for the full explanation of this chart. But let me fill in some of my assumptions: In the second example, all of the government’s deficit financing is purely voluntary. I.e. somebody who gives up apples as a young person, for a promise to eat more apples in the future, prefers that stream of consumption to his original endowment possibility of (100, 100).
So compare the outcomes for each person, in the original history versus the second history. Clearly Old Al in period 1 likes the deficit scenario better; he gains. Clearly Young John in period 9 is the same in either scenario; he isn’t affected by the deficits. Also–not as obvious but by stipulation–Bob, Christy, Dave, etc. prefer the deficit scenario to the original scenario. For example, Bob prefers (90, 111) to (100, 100).
So this is looking pretty good, huh? We’ve got a bunch of people who are better off, and one guy who is the same. Looks the government improved the free-market outcome, right?
Oops there’s one person left to consider: Iris. How do you think she feels about this arrangement? Originally she consumes (100, 100). In the deficit scenario, she consumes (41, 100). So she is clearly harmed by this.
But look how I’ve constructed this example. In period 9, the government taxes Iris 100 apples, and then hands them right back to her. So Krugman would look at that and say, “It’s a wash. Iris hasn’t been hurt by the gigantic government debt being passed down through the generations, because in period 9 Iris was unaffected by it–she owed the debt to herself. It’s a total wash.”
Now we can see precisely why that is a silly argument. Sure, if the government handed Iris a bond promising 100, then taxed her to retire the bond, it would be a wash. (We’re neglecting deadweight losses of taxation, etc.) But the government didn’t hand Iris the bond for free, instead it auctioned it off to her in period 8 for 59 apples.
Now somebody like Steve Landsburg is going to look at the chart above and say, “I don’t know why you Austrians keep picking on poor old deficit finance. It gets a bum rap. The real burden imposed on Iris is the taxation in period 9. Her ability to engage in a mutually agreeable bond deal with the government, actually makes her better off than if she were forced to consume (100, 0). So deficit finance actually helps Iris; it’s the taxation that hurts her.”
OK sure Steve, that’s technically right. But COME ON. Once the government in period 1 gives a freebie of 10 apples to Old Al, and doesn’t have the political cajones to directly tax Bob to pay for it, future generations have their fates sealed. As that government debt gets kicked down through the generations, somebody has to get screwed: either the taxpayer who retires the debt, or the bondholder left holding the bag when the government defaults. Depending on the timing, the chickens might not come home to roost until the people who must singly or jointly suffer the brunt of this pain, weren’t even alive when the original transfer happened.
The layperson is basically right, and Krugman et al. are basically wrong. Government deficits today do impose a burden on future generations, because of the “naive” fact that the debt needs to be serviced/repaid. Yes, if the government does something with today’s expenditures that might help our grandkids, then perhaps they will thank us for it. But either way, it is a complete non sequitur to say, “The national debt per se can’t hurt our grandkids, if they owe it to themselves.”
In closing, here’s an analogy of the positions:
LAYPERSON: Whoa, that nutjob went into a restaurant and killed 5 people with a gun.
KRUGMAN: You idiot, you should study physics. Energy is always conserved.
LANDSBURG: Krugman has a good take on this issue, and I would add just one caveat: Guns don’t kill people, bullets do.