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Sunday, February 15, 2009

"Bogus Arguments about the Burden of the Debt"

I saw Senator McCain on CNN talking about how the stimulus package is, essentially, reaching into the pockets of future generations and transferring their wealth to the present generation. He kept talking about how much poorer future generations will be as a result of the debt from the stimulus package (never mind that he voted for tax cuts that would have made the deficit much worse, e.g. "It’s 'generational theft,' said Senator John McCain, just a few days after voting for tax cuts that would, over the next decade, have cost about four times as much.").

So let's look at this and see if the generational theft charge has any foundation or, as is more likely given recent history, it is mostly scare tactics being used in an attempt to manipulate public opinion.

To begin, think about how the government finances, say, $10,000 in deficit spending. To use debt finance (as opposed to raising taxes or printing money), the government will print up a piece of paper - we call it a government bond - and write "IOU $10,000 plus interest" on it. It then trades the "IOU $10,000 plus interest at some point in the future" for $10,000 in cash. Thus, the private sector gives the government $10,000 and gets an IOU (a bond) in return.

Let's suppose the government then takes this money and spends it on a project such as a road that has benefits for a wide segment of the population. The end result, then, is that the money was borrowed from an individual and distributed through government spending (or transfer payments) to a larger segment of the population.

So far, there hasn't been any transfer of resources from the future to the present, only a transfer a resources within the current generation. What about when the bond is paid off, does that transfer resources across generations? Let's suppose it is a 30 year bond, and that the holder passes away and bequeaths it to his or her children. Thus, thirty years from now the bond comes due, and the holder cashes it in and is paid in full. But where does the money come from? The government pays it out of its tax revenue. That is, the government collects the $10,000 plus interest from the future generation, then gives taxes it collects to the bond holder.

But this is a transfer of resources within a generation, not across generations. A whole bunch of people in the future will have to pay higher taxes, and the taxes they pay will go to a smaller number of individuals holding the debt. But across the population the assets and liabilities cancel exactly, there is no net aggregate burden. Liabilities have passed to future generations, but so have the corresponding assets.

Thus, the current generation cannot use government deficits to literally reach into the pockets of future generations and steal their resources. But that doesn't mean that deficits are always harmless. There are three ways that debt can make future generations worse off, the question is whether these are important considerations right now. So let's look at three ways debt can be problematic and see if we should be worried about them in the present environment.

First, financing the debt can cause interest rates to rise. If interest rates rise, investment is lower and that can lower future economic growth. Thus, if this effect is operative and strong, there is a sense in which higher output today is traded for lower growth in the future.

This effect, commonly called crowding out, is worrisome when the economy is running at or near full employment and competition for resources is intense, but right now with interest rates as low as they are and with so much slack in the economy, this is not much of a worry. Government borrowing will not put upward pressure on interest rates, and hence private sector investment - to the extent firms are willing to undertake it in such poor conditions - won't be much affected.

Second, the collection of taxes in the future can cause distortions, and those distortions can lower economic growth. This is simply the usual supply-side economics story. This will likely bring the supply-side fanatics and ideologues out of the woodwork, but I don't believe the evidence supports the claim that these effects are large (e.g. see "Final grade on the Bush tax cuts: Failure to produce jobs"). So there's nothing much to worry about here either.

Third, if we borrow from foreigners rather than ourselves, the debt can impose a net aggregate burden within the US. To see this, use the example above where the government borrows $10,000, but this time let's suppose the money is borrowed from the foreign sector. In this case, we borrow from the foreign sector, and then at some point in the future the debt is paid off and this involves a flow of resources out of the U.S. Because resources flow out of the U.S. instead of simply being redistributed within the U.S., this imposes a net burden.

But there are two important qualifications. If we use the money to build something that provides benefits to current and future generations that exceed the value of the resources flowing out of the country, there is still a net benefit from the transaction. It depends upon what is done with the money. If it is used, for example, to build things like infrastructure and schools, then future generations get a benefit along with a bill, and it is the net effect that matters.

The second qualification is that while we borrow from foreigners, we also hold foreign assets and if you look at the net resource flow, the flow of funds outward from foreigners owning our debt, and the flow inward from our owning foreign assets, the net flow is positive. So overall these transactions do not detract from the living standards of future generations. [Update: I should have also added that these considerations are independent of countercyclical fiscal policy. The value from using countercyclical fiscal policy to enhance economic stability - something that does not necessarily require capital expenditures by the government (e.g. investment in infrastructure) - also needs to be taken into account.]

When you put all of this together, it seems very clear that the Republican opposition is misplaced and, though it's par for the courses they play on, unduly alarmist. But you may not believe me, so let me add two other sources for the same message.

Let's start with a textbook treatment from Baumol and Blinder's Macroeconomics text (9th ed.):

Bogus Arguments about the Burden of the Debt

Having gained some perspective on the facts, let us now turn to some of the arguments advanced by those who claim that budget deficits place an intolerable burden on future generations.

Argument I Our children and grandchildren will be burdened by heavy interest payments, which will necessitate higher taxes.

Answer It is certainly true that a higher debt means higher interest payments and, therefore, higher taxes on our children and grandchildren. But think who will own the bonds and therefore receive the higher interest payments as income: our children and grandchildren! Thus, one group of future Americans will be making interest payments to another group of future Americans. So we conclude that:

As long as the national debt is owned by domestic citizens, as the majority of the U.S. debt is, future interest payments transfer money from one group of Americans to another. These transfers mayor may not be desirable, but they hardly constitute a burden on the nation as a whole.

However, this argument is valid-and worrisome-for the portion of our debt that is held by foreigners, a share that has been growing rapidly and is now over 40 percent. Paying interest on this portion of the debt will burden future Americans in a concrete way: For years to come, a portion of America's GDP will have to be sent abroad to pay interest on the debts we incurred in the 1980s, 1990s, and 2000s. For this reason, many thoughtful observers are becoming concerned that the United States is borrowing too much from abroad.

Another valid element of this argument is that the taxes that will have to be raised to pay interest even to U.S. citizens may reduce the efficiency of the economy.

Argument 2 Repaying the enormous debt will ruin the nation.

Answer A first answer to this argument merely rephrases the answer to the previous one: Most of America's debt is owed to Americans. But this argument raises an even more fundamental point. Unlike a private family, the nation need never payoff its debt. Instead, each time the principal is due, the U.S. Treasury can simply "roll it over" by floating more debt. Indeed, that was done routinely for decades.

Was this a bit of chicanery? How could the U.S. government get away with making loans that it never intended to pay back? The answer lies in the fallacy of comparing the U.S. government to a family or an individual. People cannot borrow in perpetuity, because they will not live that long. Sensible lenders will not extend long-term credit to very old people because their heirs cannot be forced to pay up. But the U.S. government will never "die" - at least, we hope not! So this problem does not arise. In this respect, the government is in much the same position as a large corporation. GE never pays off its debt. It, too, rolls it over by floating new debt all the time.

Argument 3 Like any family or any business firm, a nation has a limited capacity to borrow. If it exceeds this limit, it is in danger of being unable to pay its creditors. It may go bankrupt with calamitous consequences for everyone.

Answer This is another false analogy. While private debtors and many foreign governments have to worry about defaulting on their debt, the U.S. government does not. Why not? First, because it has enormous power to raise revenues by taxation. If you had such power, you would never have to fear bankruptcy either.

But once again, the statement raises a more fundamental point - one that distinguishes the U.S. debt from that of most other nations. The American national debt is an obligation to pay U.S. dollars: Each debt certificate obligates the Treasury to pay the holder so many U.S. dollars on a prescribed date. But the U.S. government is the source of these dollars. It prints them! No nation need default on debts that call for repayment in its own currency. If worse comes to worse, it can always print whatever money it needs to pay off its creditors. This option is not open to countries whose debts call for payment in U.S. dollars, as a number of Southeast Asian countries learned in 1997 and Argentina learned in 2001.

It does not, of course, follow that acquiring more debt through budget deficits is necessarily a good idea. Sometimes it is a very bad idea. As we know, printing money to pay the debt will expand aggregate demand and cause inflation. In addition, as we will learn in Chapter 18, printing more dollars should make the international value of the dollar fall. We may not relish either of these outcomes. The point is not that budget deficits are either good or bad; they can be either under the appropriate circumstances. Rather, the point is that worrying about a possible default on the national debt is unnecessary and even foolish.

Next, Dean Baker:

Government debt can either increase or decrease the wealth of future generations. The debt itself is not a measure of the financial impact across generations. What matters is how the debt affects the strength of the economy when the government borrows the money.

It is easy to see that the national debt is not really a measure of intergenerational burden. While the taxpayers collectively can be seen as owing the debt, taxpayers (or at least some of them) also own the debt. This is not a payment across generations; it is a payment within generations.

If the United States let the debt rise to $10 trillion and then left the debt at $10 trillion for 100 years, just paying the interest, then in 2108 some of our children, grandchildren and great grandchildren would be collecting the interest on the $10 trillion, which would be paid from the taxes that the government collects.

This flow of money from taxpayers to bond holders doesn’t on net make people better or worse off 100 years from now. It is simply a redistribution from some members of future generations to other members of future generations. None of the interest is flowing to those of us alive now, since virtually all of us will have passed into history by then.

Whether or not the debt has made future generations poorer will depend on how it was incurred. If we ran up debts so that we could finance schools and colleges, and make sure that our children and grandchildren were well educated, then we probably made them richer than if we didn’t run up debt but left them illiterate. Similarly, if we ran up the debt to construct a modern physical and information infrastructure, then we probably made future generations much wealthier than if we had handed them a country that was debt free, but had no Internet and no computers.

In short, the debt is not an accurate measure of whether we have been generous to or short-changed the generations that come after us. The answer to that question depends on the economy and society that we pass on. There are many scenarios in which we would have impoverished future generations, even if we were to hand them a government that is free of debt or alternatively left them very wealthy, even if there is a substantial government debt.

There is an economic argument whereby deficits can reduce the wealth of future generations. If the economy is at its capacity (e.g. everyone who wants to work is already employed), then if we run a large deficit due to additional government spending or tax cuts, then we may be pulling people away from building up the economy’s capacity. Specifically, the government’s borrowing needs can lead to higher interest rates.

Higher interest rates can in turn lead to less investment. If businesses invest less in machinery, computers, and other investment items, then productivity will grow less rapidly. Productivity, how much workers produce in an hour of work, is the main long-run determinant of living standards. ... (Productivity almost always grows, so the issue is how fast it grows – it is almost impossible to envision a future in which workers are not substantially more productive in 20 or 30 years than they are today.)

If a deficit leads to high interest rates, which in turn reduce investment, then they will have slowed the economy’s growth and made future generations less well off than they would have been without the deficits. But it is important to remember that the way deficits can hurt future generations is not directly through the debt burden, but rather because they can reduce investment and therefore slow productivity growth.

The measure of the deficit’s impact on the living standards of future generations is not the size of the debt in dollars or even the size of the debt relative to the size of the economy. The impact of the deficit on future living standards would be reflected in the rate of productivity growth. If the deficit has actually hurt the living standards of future generations, then it would be because deficits lead to slower productivity growth than the country would have otherwise seen.

In fact, even as the economy has run up substantial deficits in recent years, productivity growth has been strong for most of the last 15 years. Productivity has grown at an average annual rate of 2.5 percent in the years from 1995 though the second quarter of 2008. This means that for each hour of work, we are getting 38.6 percent more of output today than we did in 1995. In principle if the country as a whole is spending the same percentage of its time working in 2008 as in 1995, then we can be enjoying a standard of living that is 38.6 percent higher than in 1995.

While there is an issue that a greater share of the economy’s output might be diverted to foreigners because of the foreign debt (see below), we still derive more income each year from our ownership of foreign assets than foreigners do from their ownership of U.S. assets. At the moment at least, we are still in the process of making our children much wealthier than we were, in spite of our $9 trillion debt.

    Posted by on Sunday, February 15, 2009 at 11:43 AM in Budget Deficit, Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (78)


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