16 Oct 2012

Debt Burden: Old Murphy vs. Young Murphy

Debt, Economics, Krugman, Shameless Self-Promotion 11 Comments

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.

11 Responses to “Debt Burden: Old Murphy vs. Young Murphy”

  1. Matt Tanous says:

    Any chance you will “fix:” this in new editions of the book?

    • Bob Murphy says:

      Oh for sure, if we do a 2nd edition, this will be changed. I just don’t know when that will happen.

  2. K Sralla says:

    I am still not sure that Nick Rowe (or anyone else has fundamentally engaged James Buchanan’s original argument #1. I asked about this some months ago, and I was assured that modern economics has moved on since Buchanan’s classic paper. Perhaps this is so, but let’s see if I can remember Buchanan’s argument well enough to state it coherently.

    1) The *current* generation who purchases government bonds is actually under *no present burden*, since presumably they have a full menu of investment choices (stocks, bonds, ect.). Nobody holds a gun to their head and demands they purchase the government debt. They might instead choose to purchase equities or other securities, or gold for that matter, instead of the bonds. So in this view, there is really no burden on them now, nor on their successive generations who inherit the bond portfolio from them.
    2) The present generation of individuals who own *no investments* are certainly under no present burden at the time of debt issue, provided taxes are not raised.
    3) The future generations of individuals who own *no investments* will indeed fall under the burden of higher taxation to finance the public debt, and therefore are the only people who concievably might inherit a burden from the debt issue sometime in the future.

    Conclusion: No group at the time of debt issue is under any present burden, provided taxes are not raised immediately. Certainly not the folks who purchase no bonds, and not even the folks who purchase the bonds, since they indeed enjoy a full menu of investment options. It would therefore be perverse reasoning to hold that they have undertaken the present debt burden.

    The only individuals who might possibly be burdened by the debt issue are indeed the future generation of folks who are born to families who own no investments. This group of individuals will pay higher taxes, but recieve no transfer payments in the form of bond yields. From this Buchanan concludes that the potential burden of debt is indeed passed along to future generations, regardless of whether the debt is purchased internally or externally.

    In this light, the calculus of public debt issue is rather straightforward. If the bonds purchased by the investors yield a better return than a basket of stocks or other equities *would have* yielded these same investors, plus the public investments in infrastructure ect. in fact yield an economy in the future that produces higher real income which offsets the higher taxes for the future generations of *non-investors*, then the public debt on the whole has been good for society, and collectively the country has become wealthier.

    If on the other hand, the government bonds produce a lower return than private equities *would have given*, and the infrastructure investments are squandered on public projects which do not produce higher real income, then the public debt issue has indeed made society poorer. According to Buchanan’s argument, it matters very little in the long run whether the debt is purchased internally or externally, since the calculus is still the basically the same.

    • Nick Rowe says:

      K Sralla: Very good comment, to remind us of Buchanan.

      It is a *very* long time ago I read James Buchanan. he was the person who, IIRC, originally changed my mind on the debt burden question.

      I see no reason to change what Buchanan said. All i have been doing (or trying to do) is give examples to illustrate what he said, and express it in an overlapping generations framework.

      Judging by the fact that Bob and I are still having to argue this point, I’m not sure that modern economics has moved on much at all. Many have still not caught up with Buchanan.

    • Bob Murphy says:

      The only individuals who might possibly be burdened by the debt issue are indeed the future generation of folks who are born to families who own no investments.

      No, that’s not right. In my canonical example, 4 out of the 5 people who are hurt, at one point in their lives own all of the gov’t debt.

      • Nick Rowe says:

        Bob: you are right. I missed that bit. It’s the people who pay the higher taxes who get hurt. If a future cohort bought and sold the bonds, but didn’t pay higher taxes, that cohort is better off.

  3. Bob Murphy says:

    KSralla in case you’re not seeing it: Suppose today the IRS tells me, “Next year we are imposing a lump sum surtax of $100,000 on you.”

    Then Geithner says, “Hey Bob, I’m hard up for money. If you lend me $50,000 today, I’ll pay you $100,000 next year. But this loan to me is totally voluntary, I promise we won’t take any action against you if you refuse. I’m just giving you an investment option.”

    So 100% on a 1-year government bond is great, so I take him up on it. I give Geithner $50,000 today, then next year he gives me $100,000, and then I give that $100,000 to the IRS. The IRS then makes a $100,000 gift to a poor single mother.

    In this example, the single mother is clearly helped, and the general taxpayer is hurt a little. But I clearly get crushed.

    • Tel says:

      Where did the IRS get the extra 50k from? Federal Reserve I presume… or maybe I just better don’t think about it before I lose my lunch.

  4. K Sralla says:

    Yes, in my outline of Buchanan’s proposal, it is stipulated that taxes are not raised on the present generation. If taxes are in fact raised on the generation living during debt issue, of course they abosorb the present burden. But the entire issue is whether the government can shift the debt burden forward in time by not raising taxes on the generation living during debt issuance. The way Buchanan has laid out the argument, clearly they can.

  5. senyoreconomist says:

    Thank you! 🙂


  6. Tel says:

    Hope it’s OK to bring forward Krugman from an earlier episode (I’m too slow to keep up with you guys):

    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?

    Krugman has an easy escape from the Murphy logic in that he merely points to the GDP in the apple tree example; so if GDP is constant then we can conclude that “America as a whole” is not any poorer. You see, even if every individual American is poorer, that does not imply anything about the “America as a whole” metric. Keynesians of course (being socialists in disguise), don’t believe in individuals, they only believe in aggregates. Your utility function with the square roots may say something about individual preferences, but it says nothing about “America as a whole” — not to a Keynesian at any rate.

    Beyond that, Krugman has not in fact anywhere agreed with your utility function containing square roots. Thus, he can throw away your entire example on that basis alone.

    The way Diamond and Saez do the analysis is to argue that because the rich are rich, their marginal utility of income is very low, which means that at the margin their income doesn’t matter for social welfare.

    Oh sure, Krugman did say that, which does appear to imply diminishing marginal utility, but I’ve probably quoted him out of context or some such. There’s absolutely no reason to believe that all his examples should be globally self-consistent. Please hit the mental reset button before reading my next posting.

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