Just to warn you, kids, there are at least another 3 posts in me on this topic. But it’s all new stuff. It’s kind of like every time they came out with a new Matrix: It wasn’t nearly as exciting as the first one you viewed, but you had to keep watching to the bitter end so you didn’t miss anything possibly important.
“Senyoreconomist” in the comments said that he uses my Lessons for the Young Economist as a text, and since I keep saying I made a mistake in it, he understandably wants to know what to tell his poor students when they get to this part. So here is the relevant section, and I’m underlining the passages that are either flat-out wrong or at least very misleading, in the context in which I make them. Note the similarity to what Krugman and Dean Baker have been writing on this issue all along; I arguably have here spelled out their perspective more clearly than they themselves did:
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. 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.
==> 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.
Now the good news is, there’s not that much to “fix.” I still agree with the reasons I’ve given above for possible mechanisms through which government deficits today, can impoverish our grandkids. However, in writing the above I was wrong to imply that the man on the street’s intuition is off. I thought (before Nick Rowe freed me) that the mere fact that our grandkids would be paying higher taxes to finance debt payments couldn’t make our grandkids poorer, since they would just be “paying themselves.” What I failed to see was that they won’t necessarily inherit the bonds as a bequest, but they might have to reduce their consumption earlier in their lives in order to acquire the bonds from the prior owners. That’s what I overlooked, and it’s why I ended up (erroneously) criticizing the man on the street’s hostility to deficit finance.
To correct this problem, all you need to do is give your students my Freeman article, which fills the gap and gives a nice little thought experiment to show how–even if we ignore the other mechanisms–there really is a sense in which deficit finance allows the present generation to “pass the bill” on to future generations.