Murphy, Former Disciple of Abba Lerner
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…
I would change “are a negative sum game” to “can be a negative sum game”, and I wouldn’t talk about the pressures for too much govenrment spending while conspicuously excluding the factors that make for too little government spending, but other than that your textbook is quite good.
I’ll be awaiting the new post.
DK, I don’t think you have a future writing for the Mises Institute.
Oh yeah, man, those overwhelming forces that make government spend too little, whatever will we do about them?!
If you’re worried about forces making government spend too little, you’d probably want not to emulate the Eurozone countries right now. Or listen to the frontrunners (whichever of the rotating flavors of the week) in the Republican primaries. Or follow Roosevelt during his great ’37 deficit frightening.
Daniel isn’t even suggesting here that too little government spending is a typical concern, but if economics is to be useful it can’t simply be a fairweather doctrine.
If piling on and casting aspersions on somebody’s career prospects is the typical Mises Institute method of debating issues of theory, I have to wonder how anybody accepts what comes out of it as rigorous. Burying your head in the sand isn’t going to empty out those poisonous dreams, sad to tell.
I would change “are a negative sum game” to “can be a negative sum game, and I wouldn’t talk about the pressures for too much govenrment spending while conspicuously excluding the factors that make for too little government spending
I would get a new career.
This all seems contingent on GDP being an actual economic measure, which it clearly is not.
RG, how is that possible, when you are the first person to mention “GDP” on this post?
The rationale of the Krugman’s argument is based on the assumption that a GDP = 1 measured economy is better than a GDP = 0.9 measured economy.
If we just look at the “they will owe it to themselves” portion of the stance it is still clearly absurd and leads us back to the root cause mistake mentioned above. I don’t own any bonds- I’m certain there are at least a few others within these borders that don’t either – but I’m still being required to pay for a portion of the debt of which I’ll never see a return on equity. The Krugman would most likely say that yes, in fact, you do receive that equity in the form of “public” goods which brings us back to the falacy that GDP = 1 economy is better than GDP = 0.9 economy.
I believe most of this discussion boils down to more sophisticated versions of the following points:
1. If there are loans being made then its better to get to benefit from the money being borrowed than to have to provide a contribution towards to the repayment.
2. If you both benefit from a loan and get involved in paying it back its possible to calculate whether you are a net gainer or loser by using various accounting techniques to calculate costs and benefit to you
3. Its possible for a whole generations aw well as individuals to be either gainers or net losers from total government borrowing
4. If you neither benefit directly or indirectly from the loan, or have to pay any part of it back , you would probably prefer the money be used for investing in capital goods because you may benefit indirectly from that
5. If you want to and have good forecasting tools to then its possible to spread out the benefits and the costs of the loan so its spread out equally between now and the future
5. If you are a beneficiary of a loan then you can take action as an individual to address point 4 with your share of it.
Government borrows and spends/invests.
If that spending/investment produces growth in tax revenues that results in increases in tax revenues (with no change in the rate of taxation) then overall people should be better off. ie. Repayment (interest plus capital) exceeds the growth rate. Assuming of course that its only the the government that produces growth [Which is a whopper if ever there was one]
Given that for the UK borrowing costs is 2.88% for the 20 year gilt, and growth around 1%, its a bad choice.
I suspect its the same in the US.
As for RG’s reply on GDP, a better measure is (tax revenues / tax rate) * (1 + size of black economy as a percentage)
Tax revenues are know exactly. Tax rates are known exactly. Given the black economies are relatively small, the calculation can’t be fudged, and is therefor accurate.
Next, is there a more effective way of getting value for money instead of the government borrowing it?
Yes, cut taxes on new investments. Secondly get out of the pensions business but force people to save. That produces lots of investment, and lots of growth.
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.
==========
Except at the moment, rates are falling. You need to mention printing money to make the case.
Murphy, I read what Rowe wrote, and I read what you wrote, and for the life of me I can’t see why you said that your textbook is wrong. I think you are still right.
In Rowe’s example, he is ignoring where the interest payment in apples comes from. He originally sets up his example so that the government borrows 100 apples from each person. OK, now the government owes each person in Cohort A 110 apples after time T, right? If the government was originally given 100 apples from each person, where does the government get the 10 apples to pay the interest to Cohort A, and where does the government get the 21 apples to pay the interest to Cohort B?
More importantly, how in the heck does a 100 apple bond pay 10 apples in the first period, and 21 apples in the second period? He just presumed that a 100 apple bond would keep paying more and more apple interest over time. Not only is he presuming real growth of apple production, but he’s also presuming rising interest rates.
If the government borrows 100 apples from each person, and interest rates are 10%, then the government would have to acquire 10 apples per person, EACH TIME PERIOD, in order to pay the interest to whoever holds the debt. But how can the government do that if they already spent the 100 apples from each person back on the same people via transfer payments? The government would be forced to tax those in Cohort A, so that the government can make good on its IOUs. If those in Cohort A each own a bond, then of course it’s awash, as each person pays 10 apples in taxes (assume equal tax rates) and receives 10 apples in interest.
But if in the next period Cohort A sells all the debt to Cohort B, then contrary to Rowe’s assumption, the price on each apple bond is not going to be 110 apples such that Cohort B receives 11 apples for 10% interest. The price of the bonds will remain 100 apples and the interest will remain 10% or 10 apples. If the price rises to 110 apples, then a 10 apple interest payment from the government is going to REDUCE the interest rate on the bonds. But Rowe was assuming the same 10%, so the market price can’t possibly rise. It will have to stay at 100 apples.
I don’t know how he can change his example to take this into account and yet keep the point he is trying to make intact.
Besides the above, there are further problems with his example. He is saying that as long as nominal consumption is growing from generation to generation, OVER TIME, such that no (additional) taxation arises, then no generation is “burdened”, or “worse off.” He is saying only if nominal consumption declines from one generation to the next, say because of the government taxing people in order to pay off what it owes, will people be “worse off.”
But your textbook explanation is not about comparing nominal consumption over time. You’re comparing the world that exists at any given time, with what COULD have existed at that time, had the government NOT borrowed and spent. I think your reasoning is correct.
If we compare the world that exists, with what could have existed had the government NOT borrowed and spent, then consumption would be HIGHER (see my tweek below), which means compared to that counter-factual world, future generations are worse off, but NOT because of the reasons Rowe gave.
Let me use his example and tweek it.
Suppose that the government DID NOT borrow 100 apples from each person in Cohort A, and DID NOT spend 100 apples on each person in Cohort A, and thus DID NOT create an IOU to each person in Cohort A.
Suppose instead that each person in Cohort A decided to take their 100 apples that they would have loaned to the government at 10% interest and invested them in future apple production instead. I know Rowe merely presumed that the supply of apples grew at a certain rate, but that rate was of course contingent upon a particular amount of Cohort A’s savings being redirected away from what could have been invested in the production of more apples, to the government’s spending of apples via transfer payments instead.
If we assume that the government doesn’t borrow any apples, and the apples instead go into productive investment, then Cohort A would have been able to produce, say, 120 apples for a 20% return (instead of 110 apples for 10% return), and Cohort B would have been able to produce say, 144 apples for (another) 20% return (instead of 121 apples for (another) 10% return).
If we compare this world to a world where government does borrow, then both Cohort A and Cohort B are worse off, but Cohort B would be MORE worse off than Cohort A is worse off. This is because while Cohort A consumes 120 – 110 = 10 fewer apples than they otherwise could have consumed, Cohort B consumes 144 – 110 = 34 fewer apples than they otherwise could have consumed. Cohort C would consume 172.8 – 110 = 62.8 fewer apples than they otherwise could have consumer. And so on.
The farther into the future we go, the worse off each generation will be compared to what they otherwise could have been if today we succeeded in shrinking government borrowing and increased production for not only ourselves, but our children and grandchildren too. Just imagine if our ancestors in 10,000 BC succeeded in establishing capitalism. Assuming a 5% annual rate of real growth starting from whatever they had at the beginning, we would have had 1.05^12000 = 1.86×10^254 times more wealth than they started with. Heck, even if they started started with axes and buffalo skins, that many times more wealth than this would have probably enabled us to colonize another solar system by now.
When government borrows and spends, they not only reduce current wealth production a little bit from where it otherwise would have been at the time. They also set into motion a future course of history an exponentially rising reduction in wealth than otherwise could have existed at each successive moment in time. By this reasoning, if current government borrows and spends ANY amount, then they will set off a rising cost stream the opportunity losses of which would result in future generations being more and more “burdened.” Our great great great great great great … great great great grandchildren, because of government’s borrowing today, will not have what from our perspective would be the size of the world’s current GDP, as their own personal wealth. Capital accumulation is to progress in economics as force is to acceleration in physics.
Of course, the government is not the monopolist over such squandering of wealth. We all do this every time we consume instead of saving and investing. But I don’t want to hear ANYONE saying nonsense about government borrowing somehow not burdening future generations, simply because they’re getting the same quantity of magical green pieces of cotton/linen. I mean come on people, economists of all people should know the difference between pieces of cotton/linen and spaceships to Alpha Centauri.
Because government is borrowing and spending apples today, they are burdening future generations of people with fewer apple consumption than they otherwise would have gotten, but not because the government’s interest payment of apples eventually exceeded the real growth rate of apples over time such that they have to raise apple taxes, making the reduction so visible that even Rowe can see it, but rather because the government is bringing about a reduction in production that otherwise would have been the case.
I mean really, why would anyone believe that economies are unaffected by borrowing and spending, let alone able to grow as Krugman and other Keynesians believe? I am sure than in the far future, people are going to look back at today and think our generation are a bunch of idiots. “They actually believed they could borrow and spend their way to prosperity. The fools. Most of the advocates had no idea that they were just brainwashed into accepting a worldview that perpetuates statism for the sake of itself, which is the only practical goal of…wait, what was the name of that character again? Attila? Was it Attiliaism? Oh yeah right, they called it Keynesianism, after that anti-semitic pederast.”
I think the three explanations in your textbook you cited above survive your own onslaught that was brought about by Rowe’s correct conclusions, but founded upon the wrong reasons. I think your reasons are right, it is Rowe’s reasons that are wrong, even if you both agree that debt is burdensome on future generations.
Sorry MF I stopped reading after the second paragraph. You kept saying things that Rowe presumed (like growing apple production), when he wasn’t presuming those things.
Sorry, I meant positive real growth in interest payments (apples), which makes it sound retarded because right after I said ALSO rising interest rates, as if they were different.
Nothing else I said depends on that goof.
Thinking in terms of alternative costs and future focused alternative valuational assessments should alert one to the conceptual problem (from the economic point of view) of the notions _emphasized_ below (none of these things is a fixed, context free “given” as static holders of boxes full of “value” and each gets its meaning only from alternative cost assessments by future imagining choosers). Values are relational. Stocks of goods don’t represent meaningful fixed stores of aggregate “valuation”. Water and diamonds and apples aren’t valued as stocks, with fixed cardinal and summable value across time, they are valued individually at the margin in relation to alternative trade-offs differently at each unique moment in time. (For example, in #4 the _burden_ on future generations is the unseen scenario where no money is borrow, alternative scenario output is greater, and taxed progressively diminish toward zero as a percentage of income.)
Once you see this problem you see that it’s impossible to distinguish first or and second order _burdens_, and burdens themselves can only be cashed out dynamically in terms of alternative costs which can’t be tracked in “given” boxes of fixed good aggregates or “given” boxes of fixed dollar aggregates from one period to the next.
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.’
Turns out, in our actual world, Lerner’s “second-order exceptions” are mammoth.. and they only begin to bullet point the exceptions.
“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.’
Layperson here:
1) Is there room in the discussion for an actor that represents an intended deflation of an apple’s worth. Perhaps the receiver of the initial apples as a loan, then sets about to genetically morph his tree into an apple tree with more apples per tree, albeit smaller apples with less capacity to satisfy one’s appetite for apples.
2) Is there room to model the friction of transferring the apples (by the government in today’s world). The 100 apples set aside to give to the lender would actually yield say 20 apples after the government consumes or allows to rot.