Debt Can't Burden Future Generations?

Paul Krugman and other advocates of government spending have recently claimed that the layperson’s approach to government debt is all wrong. (I summarize the debate here.) Contrary to the moralizers, Krugman and his allies claim government debt per se can’t burden future generations as a whole. Our descendants will “owe it to themselves,” at least if we disregard Treasury bonds held by foreigners. Any taxes raised to service the debt would simply flow into the pockets of Americans in their capacity as bondholders. Krugman argued that the “national debt” was not just a liability, but also an asset.

One major problem with this viewpoint is that it ignores a government deficit’s tendency to divert resources out of private investment and into consumption chosen by the political process. Deficits, therefore, cause future generations to inherit fewer tractors, tools, and other equipment, reducing their ability to produce and making them poorer.

Besides the effect on physical investment in capital goods, James Buchanan showed that there is a completely independent route through which government budget deficits today can impoverish future generations. Once we realize “the nation” is composed of different individuals who enter the scene at various points, live for varying lengths of time, and then die, to say “We owe the debt to ourselves” is a complete nonsequitur.

To repeat, Buchanan put his finger on an effect that operated above and beyond the fact that government deficit spending today would tend to lower private investment. Even if we imagined that all government deficit spending today were paid for through a reduction in private consumption — so that we bequeathed the same stockpile of capital goods to our heirs — it would still be possible for our descendants (taken as a whole) to be made poorer by the policy.

To understand how this works, imagine the government in the year 2012 is going to spend $100 billion throwing a gigantic party. Other things equal, the people alive in 2012 would love this massive bout of consumption. However, if the government were to levy a tax on the people in 2012 to pay for it, they would revolt.

Now, instead, suppose the government issues an official piece of paper that declares, “In 2112, the U.S. government will count up how many taxpayers are in the country. It will then assign each of these x taxpayers a head tax of $10 trillion/x. The $10 trillion in tax revenues thereby collected will then be handed over to whoever owns this piece of paper at that time.”

After making everyone aware of the official piece of paper, the government in 2012 could then auction it off to the highest bidder. Assuming investors trusted the promise and used a long-term nominal interest rate of about 4.7%, the government in 2012 could raise $100 billion — the present discounted value of the $10 trillion cash payment that wouldn’t occur for another century — and thus pay for the party.

In this scenario, the layperson is right to say that the present generation threw their party and made the poor saps in 2112 pay for it. The taxpayers in 2112 are collectively going to hand over $10 trillion to some of their own members — they can’t wire the funds back through the decades. However, this observation doesn’t render the whole enterprise a wash.

The reason is that the people in 2112 who are getting paid the $10 trillion aren’t getting it for free. On the contrary, they would have earlier paid the present discounted value of the bond in order to acquire it. So when we do the accounting correctly, we see that the taxpayers in 2112 are clearly hurt (because of the gigantic tax bill), but that their loss doesn’t translate into an equal gain for the bondholders. That’s why their generation as a whole is poorer because of the wild party the people in 2012 threw.

Losing Proposition

This critical point is worth spelling out. Consider an individual who participates in receiving the tax receipts in the year 2112. Perhaps this person paid $955 the year before (2111) in order to have a claim to $1,000 (that is, one ten-billionth of the face value) of the gigantic bond when it matured. The full $1,000 he received in 2112 would not constitute a net gain to the person, since most of it would just be the principal he had given up the year before. The actual benefit to this person from the whole operation would be to receive a higher interest rate (given the risk of default) than he would have earned had he lent his $955 in the private sector. So this person could reckon that the tax-and-distribute operation in 2112 was worth, say, $5 to him.

It is against this $5 (give or take) benefit to the bondholder that the full $1,000 in tax collection must be contrasted. In other words, the individual taxpayer (responsible for one ten-billionth of the gigantic bond) is out $1,000, while the bondholder to whom that money is transferred gains only about $5.

Now if we focus on some different bondholder, who perhaps got into the game earlier (say, in the year 2085), then his gain would be higher than $5, because he earned above-market interest rates for a longer period. Even so, the only way the $1,000 loss to a taxpayer would be exactly counterbalanced by a full $1,000 gain to a bondholder is if the bondholder initially got the bond for free. This could happen for children who inherit claims from their parents, but that’s about it. Anybody else who had to put up his or her own money to get a piece of the big bond would not have had gains equal to the losses of the taxpayers. Thus, the group “people alive in 2112” is collectively made poorer by the scheme.

Now consider the original generation who threw the party. Yes, there were investors in 2012 who had to reduce their potential consumption by $100 billion when they bought that piece of paper from the government. But as those investors grew old, they could have sold the paper (a financial asset) to younger investors and used the funds to finance their retirement. Thus, the investors in 2012 didn’t actually lose out from the deal, which was voluntary for them, when we consider their lifetime income.

To sum up: Many people alive in 2012 gained, and nobody lost, while the people alive in 2112 had losses that outweighed the total gain. This is true even though the people in 2112 “owed the $10 trillion to themselves.”

If an imperialist government paid for popular spending programs by levying a tax not on its own citizens, but on a conquered land, the scheme would, of course, be a gigantic theft working across space and through the currency markets. Deficit finance is similar, working across time and through the bond markets. It allows today’s citizens to pay for government goodies by levying a tax on unborn generations who have no say in the political decision.

Sincerely,

Robert Murphy
Original article posted on Laissez Faire Today