The burden of government debt, again

Here is an attempt to clear up some of the confusion that still exists on this issue.

1) Government debt can be used to redistribute income to current generations from future generations, even if the aggregate level of consumption in each period remains the same. Proof by example: see here (or many similar proofs from Nick Rowe - his latest post on this is here).

Note: I think people get confused because although the first part of the proposition seems intuitive (if the government cuts taxes and pays for this by borrowing, surely those receiving the tax cut could spend it on themselves and be better off as a result), the ‘even if’ part seems wrong (if we are taking from the future to give to the present, current consumption must rise and future consumption fall). Those who have worked with OLG models, like Roger Farmer, find it easier to work through the logic as to how this is possible.

2) The size of government debt is not a good indicator of any burden. It is possible that government debt is positive, but there has been no attempt at intergenerational transfer. Proof 1: taxes on the young are cut, and the young save all the tax cut by holding the extra debt. Proof 2: borrowing for a capital project that benefits current and all future generations equally.

Note: This is important, as Noah Smith notes in this post. The size of government debt is not equal to the ‘burden’ on future generations. Indeed, positive debt is compatible with there being no burden at all.

3) There are probably much more important mechanisms going on right now that are transferring consumption from the future to the present: in some countries rising house prices, and climate change. No proof, just an opinion.

Note: despite this, if you think your grandchildren will have such a wonderful life compared to yours because of technological progress, you might not be too bothered. It is also worth remarking how potentially inconsistent it is to argue that we have to reduce debt now for the sake of future generations, and at the same time argue that it is too costly to take action now to mitigate climate change. 

4) Even if no intergenerational transfer is involved, high government debt could reduce future consumption for two quite plausible reasons: productive capital may be crowded out, and the tax required to pay the interest on the debt is distortionary (i.e. reduces output below optimal level). Proof: countless papers in the literature.

Note: I think it is wrong to describe both mechanisms as model specific, because you have to make quite extreme assumptions to avoid them. It is for this reason that I worry about high government debt in the long term. I have not heard anything to convince me that either mechanism is unimportant, or of any countervailing mechanism. (The need for safe assets could argue for high gross government debt, but not net debt, where the difference could be a large sovereign wealth fund.)

5) None of these arguments justify austerity at the Zero Lower Bound. Proof: countless posts by various people, including myself.

Note: For example, crowding out happens through high real interest rates, which are hardly a current problem. Nor is scarcity of labour arising from tax distortions.

Final thought. Think about government debt as a way of providing intergenerational insurance against negative demand shocks. When those shocks happen, the state pays out by cutting taxes (say) and increasing its debt. In normal times taxes rise again and the debt is gradually reduced. In this case allowing debt to rise following one of these shocks is no burden.  

Government debt and the burden on future generations

                In an earlier post, I looked at how we might think about the ‘cost’ of additional public debt, if that debt financed public investment, and our concern was intergenerational equity. Here I want to examine the question of how great the burden of extra debt is on future generations, if that debt financed not investment, but consumption spending or tax cuts that had only current period benefits.

                Our initial instinct would be that this burden is bound to be positive. The current generation gets the benefit of additional spending, or a tax cut, but future generations pay the cost in terms of finding the money to pay the interest on the debt. However, if the additional debt is never paid off, and remains a constant share of GDP, then there is a situation in which it is not a burden, which I discussed in that earlier post. Let the ‘growth corrected real interest rate’ be r-g.[1] Suppose r-g=0. In that case the interest on the outstanding debt each year could be entirely paid for by issuing new debt such that the total debt to GDP ratio remained unchanged. The debt is only a burden on the final generation, but there is no final generation.

                Normally r>g, so taxes do have to rise (or government spending has to fall) to pay part of the interest on the debt. Debt is a burden on that account. There is a trap that we can fall into here, which is the following. Suppose all the debt is owned domestically. What the government does is raise taxes to pay interest on the debt, so this is a transfer from tax payers to debt owners. The government is just taking with one hand and giving back with the other. If society is just paying itself, how can debt be a burden?

                It’s an easy mistake to make – I should know, because I made it in an earlier post, which Nick Rowe pointed out in a comment.  Incidentally, Nick has two excellent posts on these issues, here and here. The argument above is wrong because it can still involve a transfer between generations. This becomes very clear if we consider an unfunded pension scheme, which I will do in a later post. Someone who just gets interest on their wealth is clearly better off than someone who also has to pay tax increases to get that interest.

                If you are still not convinced, think of the following. Suppose the current generation gets a debt financed tax cut, but in a fit of conscience it decides to put it all into a trust fund to compensate future generations. (This is what happens under Ricardian Equivalence.) Suppose also that there is a final generation when all the extra debt is repaid, and it gets the complete trust fund. In real terms the size of the debt will cumulate up at the rate g, as each year a bit of new debt is issued to keep its total a constant proportion of GDP. However the trust fund cumulates with the real interest rate r. If r>g, the trust fund will exceed the amount of debt to be repaid, and so the final generation will be better off. As all this just involves intertemporal transfers, the final generation being better off must mean that the generations in between should have got some of the trust fund – they were losing out too.

                If there is a final generation (when the debt is paid off), then the answer to the question ‘is debt a burden’ is obvious. It is only if we think about never paying the debt off that we need to worry about the r>g condition. The argument I made in one of the earlier posts, and want to repeat now, is that there should normally be a final generation – the debt should be paid off eventually. This argument has nothing to do with intergenerational equity.

                Creating additional debt has two negative consequences aside from any intergenerational equity concerns. First, increasing taxes to pay the interest adds to the scale of tax distortions in the economy. Second, it seems likely that additional government debt will to some extent crowd out investment in productive capital, and this is a cost if, as also seems likely, we currently have less than the optimum amount of productive capital. (Economists will know that I am here assuming we do not have complete Ricardian Equivalence, and that the economy is not dynamically inefficient.) For both reasons, even if we ignored issues of equity, we should not be indifferent to the level of debt.

                So these arguments suggest we should aim to bring debt back to some target level. Those economists familiar with this area will know that there is one special, but frequently used, case where that is not true, and this paragraph is for them. As a consequence of Barro’s famous tax smoothing hypothesis, the short term costs of bringing debt back to some target can outweigh the long term benefits of doing so, if the real rate of interest is not greater than impatience (the rate of time preference). My own view is that this is a ‘knife edge’ result which really tells something different, which is that any adjustment towards a debt target should be very gradual. For more on this see another earlier post of mine.

                What the ideal level of debt should be is a complex question. But once we accept that in theory there is some ideal level of debt, this means that doing thought experiments where we forever depart from it are just that: thought experiments rather than practical policy. To put the same point more topically, if we accept that current levels of government debt are too high, we must have in mind some lower target for debt. If debt rises above this target, it should fall back towards it. In effect, that means there will be a final generation: any additional debt will eventually have to be repaid.

                So the burden of additional government debt for future generations involves the debt itself, and not just the growth corrected interest on that debt. However, the practical importance of this point for any particular generation is not great, because adjustment towards a debt target should be slow. Getting debt right is likely to be a cost for our children’s children as well as those generations currently alive.         

             

               

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[1] If r is the nominal interest rate, g is the growth in nominal income. If r is a real interest rate, g is the real growth rate.