It’s time for another installment of Things That Nobody Talks About Anymore. This is the Government Debt Edition, where I pour my heart out discussing a topic that five people still care about. Today I want to refute the argument that you may have heard from time to time from New Keynesians like Paul Krugman: government debt is not really a problem because We Pay It to Ourselves. Krugman has ridden this hobby horse many a time, making arguments like this:
I want to expand a bit on something Dean Baker said yesterday:
As a country we cannot impose huge debt burdens on our children. It is impossible, at least if we are referring to government debt. The reason is simple: at one point we will all be dead. That means that the ownership of our debt will be passed on to our children. If we have some huge thousand trillion dollar debt that is owed to our children, then how have we imposed a burden on them? There is a distributional issue — Bill Gates’ children may own all the debt — but that is within generations, not between generations. As a group, our children’s well-being will be determined by the productivity of the economy (which Brooks complained about earlier), the state of the physical and social infrastructure and the environment.
. . . .
People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.
That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. And as Dean says, talking about leaving a burden to our children is especially nonsensical; what we are leaving behind is promises that some of our children will pay money to other children, which is a very different kettle of fish.
This argument might sound plausible on its face — if you have never heard the counterarguments.
I recently finished Bob Murphy’s course on the History of Economic Thought at Liberty Classroom, and he armed listeners with four arguments to refute the “We Pay It To Ourselves” trope. I’ll do my best to summarize them here. The fourth argument is the one that takes on Krugman’s points most directly.
First, it’s not really true that we pay the debt entirely to ourselves. Foreign governments like China own over $6 trillion of the $20 trillion debt. It’s not a majority of it, but it’s a sizable chunk.
Second, government debt funds government spending, which consumes resources that would otherwise be available to the private sector. This is bad because government spending is less efficient than the private sector. It’s easy to see why. The private sector runs on voluntary transactions. If A gives a dollar to B for a widget, it’s because A thinks he’s better off with the widget than the dollar. B thinks he’s better off with the dollar than the widget. The very fact that the voluntary transaction occurred means that, at the time of the transaction, both parties believed they were coming out ahead.
The same cannot be said for government transactions, which are funded by taxes — which are collected, not voluntarily, but by the threat that men will come to your front door with guns to throw you into a cage if you don’t pay them. The fact that a government transaction happened is not, by itself, proof that society is better off.
By crowding out the private sector, and consuming resources that would otherwise be used by the private sector, the government insures that the private sector must compete more for remaining resources. This drives up prices and hurts everyone. We may need government for certain public goods like the common defense, but paying for it comes at a real cost.
Third, ultimately debt must be paid by taxation, and taxation itself distorts the system and makes us poorer. If people want to discourage the use of gasoline, they pass a gas tax. Don’t like sugary sodas? We pass a soda tax. Same with cigarettes, alcohol, etc. Well, passing a tax on income derived from work means less work is done. Taxing investment gains means less investment. These activities still happen, just like people still smoke and drink and use gasoline, but there is less of it on the margins. Less investment and work hurts the economy.
But it’s Murphy’s fourth point that I find most interesting, and that punches Krugman’s arguments directly in the face. Murphy makes use of a chart that I believe is proprietary and that I should not reproduce here. If you want to see it, try out Liberty Classroom! But I’m taking it as a challenge to describe it in words.
Essentially, to make things simple, Murphy pretends for the sake of argument that the first three points I just made are all wrong. Foreign countries own no debt; the private sector is not deprived of resources; taxes create no distortionary effects on incentives.
Murphy asks you to imagine a very simple society that always has two people, one young and one old. In Murphy’s simplified society, the currency is apples. Everyone grows 100 apples per generation, and absent government intervention they would consume them. But then government intervenes and has young people consume fewer apples when they are young, in exchange for a promise to get even more apples when they are old.
In generation 1, you have Al (old) and Bob (young). (The names begin with letters from the alphabet in sequence.) The government borrows 3 apples from young Bob to give to Old Al. It promises to pay young Bob 6 apples when he is old.
In generation 2, Al is dead. Bob is now old and Christy is young. The government borrows 6 apples from young Christy to repay Bob, who is now old. Note that, at the same interest rate, the government must borrow more apples from young Christy than it borrowed from Bob when he was young — because the government has to pay back old Bob with interest. Christy gives up 6 apples when young, but will get 12 when she is old.
Then, in generation 3, Bob is dead, and we have young Dave and old Christy. The government borrows 12 apples from young Dave to repay (now old) Christy. It must borrow more apples from young Dave from than it borrowed from young Christy. As time goes on, the number of apples demanded and paid grows each generation.
And then it all blows up. Finally, the amount of interest becomes so large that it is impossible to pay the current old generation by simply borrowing apples from the young generation.
That’s when the taxation starts.
If you keep running the scenario, you’ll see that young Frank lends the government 48 apples to repay old Eddy. But when Frank gets old, you can’t borrow enough from young George to repay Frank. So the government pays old Frank the 96 apples he is owed by a) borrowing 10 from young George and also b) taxing old Frank 86 apples. The government taxes old Frank to pay old Frank.
It’s more convincing to see it visually, but the point is that, over time, future generations are indeed worse off because they end up being taxed to pay the bondholders. We are literally “paying it to ourselves” — by being taxed, so the government can repay our investment. This makes future generations poorer, by reducing the value of their investments. They will still make the investments — Frank still comes out ahead 10 apples — but their investments will pay less because they are being taxed to pay for the spendthrift ways of past generations.
So, even in a society where “we pay it to ourselves,” we tax ourselves to pay it. Ultimately, the earlier generations are still robbing from later generations.
Government debt is intergenerational theft. It’s wrong. Don’t let the Paul Krugmans of the world tell you otherwise.
UPDATE: When I said foreign governments own a sizable chunk of the debt I meant to write $6 trillion but accidentally wrote billion.
This is part of the problem with the huge debt: every “illion” sounds like a zillion. And so a blogger proofreading his post might write “billion” when he meant “trillion” and fail to catch it on a read-through before posting.
Thanks to LDA.