I think I’ve got this debt stuff resolved, after spending about a week on an intellectual odyssey. This is truly one of the biggest shifts in my thinking on something that I thought I had down pat, in my life.
First, let’s go to Nick Rowe’s taxonomy of the various positions one could hold on government debt:
There are 4 possible positions to take on the debt. One of them doesn’t make sense; the other 3 do. Which of those 3 is right is an empirical question.
Here are the 4 positions. I gave each one a name. I made up the quotes.
1. Abba Lerner. ‘The national debt is not a first-order burden on future generations. We owe it to ourselves. The sum of the IOU’s must equal the sum of the UOMe’s. You can’t make real goods and services travel back in time, out of the mouths of our grandkids and into our mouths. The possible second-order exceptions are: if we owe it to foreigners; the disincentive effects of distortionary future taxes; the lower marginal product of future labour if the future capital stock is smaller.’
2. James Buchanan/uneducated person on the street. ‘The national debt is a burden on future generations of taxpayers. Foreigners are basically irrelevant. Any second order effects of distortionary taxes and lower capital stock are over and above that first order effects of the taxes themselves.’
3. Robert Barro/Ricardian Equivalence. ‘The national debt is not a burden on future taxpayers (except for the deadweight costs of distortionary taxation) but only because ordinary people take steps to fully offset the burden on future generations by increasing private saving to offset government dissaving and increasing bequests to their heirs to offset the debt burden.’
4. Samuelson 1958. ‘If the rate of interest on government bonds is forever less than the growth rate of the economy, the government can run a sustainable Ponzi finance of deficits, where it rolls over the debt plus interest forever and never needs to increase taxes, so there is no burden on future generations.’
I personally was taught 1 as an undergraduate. And I believed in 1 until about 1980, when I spent some time reading Buchanan and Barro arguing with each other. And I worked 4 into my own beliefs soon after.
And now, I believe 1 is false. The truth is some sort of mixture of 2,3, and 4. What precise mixture of 2,3,4 is true is an empirical question.
Now, the awkward part. Here is how I handled this issue in my introductory textbook:
Government Debt and Future Generations
In popular discussions, opponents of government deficits often claim that they represent theft from unborn generations. The idea is that if the government spends an extra $100 billion to make voters happy but without “paying for it” through raising taxes, then the present generation has gotten to enjoy an extra $100 billion whereas future taxpayers will have to bear the cost. Is this typical claim really right?
As with the popular association of government debt and inflation, the answer is nuanced: Yes government deficits do impoverish future generations, but no they don’t do so for the superficial reason that most people believe.
When thinking about any debt, be it government or private, keep in mind that all goods are produced out of present resources. There is no time machine by which people today can steal pizzas and DVDs out of the hands of people 50 years in the future. If the government spends an extra $100 billion to mail every voter a lump sum payment to go spend at the mall, it doesn’t matter whether the expenditure is financed through tax hikes or borrowing. Either way, it is the present generation (collectively) who pays for it.
Now of course, in practice there is a difference in how this burden is shared among the present generation, and that’s the whole reason that it’s popular to run budget deficits. If the government raised everyone’s taxes in order to send them all the money back in a check, that would be pointless. But if instead the government borrows $100 billion from a small group of investors and then mails this money out to everybody else, the average voter feels richer.
One way to see the fallacy in the standard “we’re living at the expense of our children” analysis is to realize that today’s investors bequeath their government bonds to their children. It is certainly true that higher government deficits today, mean that future Americans will suffer higher taxes (necessary to service and pay off the new government bonds). But by the same token, higher deficits today mean that future Americans will inherit more financial assets (those very same government bonds!) from their parents, which entitle them to streams of interest and principal payments.
So what does all this mean? Are massive government deficits really just a wash? No, they’re not. The critics are right: Government deficits do make future generations poorer. But the reasons are subtler than the obvious fact that higher debts today lead to higher interest payments in the future, since (as we just explained) those interest payments go right into the pockets of people in the future generations. So here are [three] main reasons that government deficits make the country poorer in the long run:
==> Crowding out. When the government runs a budget deficit, the total demand for loanable funds shifts to the right. This pushes up the market interest rate, which causes some people to save more (moving along the supply curve of loanable funds) but also means that other borrowers end up with less.9 In effect, the government competes with other potential borrowers for the scarce funds available. Economists say the government borrowing crowds out private investment. At the higher interest rate, entrepreneurs invest fewer resources into making new factories, buying more equipment, etc. So long as we make the very plausible assumption that the government will not use the borrowed money as productively as private borrowers would have, it means that future generations inherit an economy with fewer factories, less equipment, and so on. This is a major factor in explaining why government deficits translate into a poorer future.
==> Government transfers are a negative-sum game. Another way that government debt makes future generations poorer is through the harmful incentive effects of the future taxes needed to service the debt. For example, if the government runs a deficit today, and needs to pay back $100 billion to creditors in 30 years, that does indeed make the country poorer at that time. But the problem is not the $100 billion payment per se—that comes out of the pockets of taxpayers, and goes into the pockets of the people who inherited the government bonds. Rather, the problem is that in order to raise the $100 billion, the government would probably raise taxes (rather than cut its spending), and this action would cause dislocations to the economy over and above the simple extraction of revenue.10
==> The option of borrowing leads to higher spending. Yet another danger of government deficits is that they tempt the government into spending more than it otherwise would. Recall from Lesson 18 that all government spending, no matter how it is financed, siphons scarce resources away from entrepreneurs and directs them into channels picked by government officials. Because the public typically resists new government spending less vigorously when it is paid for through higher deficits, the possibility of issuing government bonds leads to higher government spending (and hence more resource misallocation, compared to the pure market outcome) than would occur if the government were forced to always run a balanced budget.
So we see that government deficits really do make everyone poorer (on average), but the mechanisms are subtler than the simple increase in the amount of money the federal government owes to various creditors. But as the bullet points above indicate, the way to alleviate these problems of deficits is to cut spending, not to raise taxes on the present generation! In other words, if the real problems of government deficits are that they take resources out of the present capital markets, and make it more likely that the government will hike tax rates in the future, then it would be no “solution” to close a budget deficit through tax hikes in the present. That would be a cure worse than the disease.
You see the problem. Believe it or not, I was getting ready to write a (qualified) defense of Krugman on all this stuff, back when Don Boudreaux et al. were taking pot shots at him.
But now, due to Nick Rowe’s persistence, I see the error of my ways. It’s not even that the textbook excerpt above is totally wrong, but rather that it is leaving out a huge issue that shows why it’s very misleading to frame matters the way Krugman and Dean Baker (and Murphy!) were doing.
I’ll explain in the next post…