OK I gather that most people are moving on with their lives, so I’d better make this post now on everyone’s favorite question, “Does the government’s debt impose a burden on our grandchildren?” In this post, I want to explain why, as of Friday October 12, and after Nick Rowe went head-to-head against Brad DeLong, both Dean Baker and Paul Krugman were still saying false things. It was clear that they hadn’t yet fully removed themselves from their erroneous way of thinking about the issue–an erroneous way that I myself used to believe–even though they had now officially read what Nick Rowe had to say about the matter.
First, however, let me suggest that the phrasing in terms of “future generations” can easily become a trap. It’s quite possible that debt can raise the consumption of one generation and reduce the consumption of the next generation during the period when members of both generations are still alive. Suppose that after the 2016 election President Santorum tries to buy senior support by giving every American over 65 a gift of newly printed government bonds; then the over-65 generation will be made richer, and everyone under 65 will be made poorer (duh).
But that’s not what people mean when they speak about the burden of the debt on future generations; what they mean is that America as a whole will be poorer, just as a family that runs up debt is poorer thereafter. Does this make any sense?
[A] debt inherited from the past is, in effect, simply a rule requiring that one group of people — the people who didn’t inherit bonds from their parents — make a transfer to another group, the people who did. It has distributional effects, but it does not in any direct sense make the country poorer. [Emphasis in original.]
And now for Dean Baker:
I saw that Nick Rowe was unhappy that I was saying that the government debt is not a burden to future generations since they will also own the debt as an asset….The burden of the debt only exists if there is reason to believe that debt is somehow displacing investment in private capital, which is certainly not true at present.
As the above quotations clearly indicate, Krugman still thinks this is merely a distributional issue such that (say) some people alive in 2080 can be made poorer, but others must necessarily be made richer, by the level of interest payments that the government makes in 2080; yet clearly (so Krugman still thinks as of the above post on October 12) the country as a whole in 2080 can’t be made poorer by our debt decisions today, so right-wingers are nuts for worrying about us living irresponsibly at the expense of our grandchildren.
Dean Baker, for his part, thinks that debt payments per se can’t be a burden, since some people are being taxed while others (alive at the same time) are pocketing the tax revenues; it’s just a transfer payment at that future date. The only way our deficits today can hurt our grandkids, is if it somehow leads us to bequeath fewer tractors and drill presses to them.
The following simple counterexample shows that each of these points is wrong. It is an elaboration of the text descriptions Nick Rowe has been dreaming up, but it is better pedagogically because (a) you can “see it” in one fell swoop, and (b) it has more than 3 generations, making sure Krugman and Baker can’t get by with thinking this is still just an intra-annual redistribution that can’t make “future generations” poorer collectively.
So here’s the picture, and then I’ll explain to professional economists (and others who are comfortable with mathematical economic models) how to parse it:
The above depicts a pure endowment economy. Each period, 200 apples are produced; that is “real output” and it is technologically fixed for all time. There is no carrying forward of apples, since they will rot.
In any period, there are only two agents alive. Each agent lives for two periods. This is an overlapping generations (OLG) model, such that in each period, one agent is Old and the other is Young. The colors are chosen to make it easy for you to see each person’s two-period lifespan.
Preferences are described by the utility function U=sqrt(A1)+sqrt(A2), meaning we take the square root of apples consumed as a young person and add it to the square root of the apples consumed as an old person. So there is no altruism or envy, and there’s no time preference per se (just to keep the math easier). However, there is a desire for consumption smoothing, because of diminishing marginal utility within each period.
In the top half of the chart, we see the laissez-faire outcome. Each person owns half of the apples trees, and ends up consuming (of course) 100 apples each period. There are no loans made in terms of apples, because there would be no point to them: everybody maximizes utility by consuming his personal endowment each period.
In the bottom half of the chart, the government interferes with the laissez-faire outcome. The government runs a “primary deficit” of 3 apples in the first period, in order to make a gift of 3 apples to Old Al. Then it just keeps borrowing more and more in order to roll over the debt (at 100% interest) until period 6, when it (for the first time) imposes taxes to start paying down the debt. The debt is finally extinguished in period 9.
By comparing their lifetime stream of consumption in the top half with the bottom half, we can see who gains and loses from this whole operation. Specifically, the first five generations (Al, Bob, Christy, Dave, and Eddy) benefit, while the last five generations (Frank, George, Hank, Iris, and John) all lose. I have chosen blue colors to denote winners, and red colors to denote losers.
Here are some additional points about this example, to drive home why Dean Baker and Paul Krugman’s commentary has been so misleading–and why they still didn’t “get it” even as late as Friday October 12, in the quotes I provided at the beginning of this post:
==> There is no crowding out of private investment in this example. Real GDP is fixed at 200 apples per period.
==> This isn’t an issue of intra-time-period redistribution. The first five generations all benefit, the last five generations all lose. If this example doesn’t depict “the present voters using deficit finance to benefit at the expense of unborn future generations,” what would?
==> There are no foreign owners of government bonds. Each period, the government debt is “owed to ourselves.” But look at poor Frank in period 6. He is being taxed 86 apples and is then handed 96 apples by the government. The way Baker and Krugman have been guiding their readers through this, they would describe this by saying, “In period 6, that lucky ducky Frank actually gains 10 apples on net from the government’s operation, since he inherited all the bonds from people holding them in period 5.” Yet this is completely misleading. Frank is getting screwed more than any other person in the history of this economy.
Final point: It seems that by the next day, Saturday October 13, Dean Baker was finally starting to understand the gap in his arguments. But instead he played it off like this was some little technical quibble. If he had any honor, he would have said, “Holy cow! I have been writing complete nonsense on this matter for at least 11 months! Sorry everyone!” Yet, that’s not exactly how he phrased it…