The Burden of Government Debt

The recent ‘exchange’ on this topic (see Nick Rowe here, here, here and here, and apparently on the other side Dean Baker, Brad DeLong, Paul Krugman and Noah Smith) may just have confused many, so here is my attempt to unconfuse. I’m doing this because (a) the issue is tricky (as I know from my own experience) (b) I’ve written about this before (c) I happen to be teaching this stuff right now (d) Nick Rowe needs some support (although no help). Bottom line: government debt can be a burden on future generations (the current generation can use it to take resources from future generations) even if there is no impact on future output, but it is also likely to reduce future output, so we really should worry about the size of government debt in the longer term. But none of these worries applies when the economy is demand constrained, as it is right now.

There are a number of ways that the current generation can exploit (take resources away from) future generations, and paying themselves using the device of government issuing debt is one. This can happen because generations overlap, and even if there is no impact on future output. Take the most basic example. At any point in time there are two generations: old and young. Only the young work and they produce 2000. They plan to save 1000 for their retirement, so consuming 1000 in each period of their two period lives. (Ignore interest payments for simplicity.) Now the old at time T get a gift of 100 from the government, paid for by issuing debt to the young. Suppose the young cut their consumption to 900 to purchase this debt. The old at T are better off by 100, and consume 1100 at T. The gift effectively comes from the young at T, but as the young bought an asset, they may think they will be OK at T+1, when they sell that asset and have consumption that period of 1100. The government then pays back its borrowing at T+1 by taxing the now (at T+1) old by 100. The T+1 old do indeed get their money back by selling the asset, but they are also taxed, so their consumption is 1000 in T+1, not 1100 as they had hoped. The economy at T+1 produces and consumes as much as it would have without this temporary creation of government debt, but the sum of consumption in both periods of the old in T+1 is 1900, while the sum of consumption in both periods of the old at T in 2100. It is as if the young just paid the old 100 at T, which is what would happen in a one-off unfunded social security scheme.

Now have the debt paid back at T+2 rather than T+1. The young at T, who are the old at T+1, are indifferent: they consume 900 at T and 1100 at T+1. The young at T+1 buy the debt from the old at T+1, and consume 900. It is when they become old at T+2 that they are worse off, when taxes rise to pay back the debt. If we call ‘society’ at some date the combination of the two generations living at that date, then we can say society at T is better off and society at T+2 worse off. But what if the debt is never repaid? I have misgivings about the relevance of this thought experiment (see here), but for what it is worth the standard result is that future generations get exploited if the real interest rate is greater than the rate of growth of the economy. However, no exploitation need occur if the debt is used not to increase the consumption of the old, but to invest in assets that future generations can benefit from (see here).

All this assumes that there is no impact on what society can produce. But that is not a realistic assumption. In the example above I just assumed that the young would be happy to postpone 100 of consumption to buy some government debt. But suppose instead they were not, and substituted that debt for 100 of their 1000 saving for their retirement. If that saving was in the form of productive capital, then the government debt ‘crowds out’ that capital. Now one for one crowding out like that is probably too extreme, but I think there are good reasons to believe that some crowding out occurs when investment in capital is governed by the availability of savings. This effect occurs not because government debt is in any sense necessarily bad – you can get exactly the same effect from investment in housing depending on who inherits houses. Indeed, if society has too much capital (which is theoretically possible), having government debt crowd out capital would be a good thing. However the balance of evidence is that society probably has too little rather than too much productive capital, which means we should be concerned about the long run impact of government debt.

Need this have any relevance to the debate on stimulus versus austerity? Absolutely not: indeed quite the reverse. No sensible person is arguing that current increases in debt should be permanent – instead they should be reversed, gradually, once the economy recovers. Until the economy recovers, investment is being held back by lack of demand, not a lack of savings, so the crowding out issue does not arise. I think you could make a good case that, by stifling the economy today through austerity, you are damaging productive capacity in the future. So in the current circumstances it is austerity, not increasing debt, which is harming future generations.