In late 2011 and early 2012, there was a fierce debate among several prominent economists on the possible ways in which government deficits today could impose a burden on future generations. Specifically, Keynesian economists Dean Baker and Paul Krugman were arguing that right-wing concerns over the debt burden were nonsensical, because (for the most part) our grandkids would “owe the debt to themselves.”
At the time, GMU economics chair Don Boudreaux cited the work of James Buchanan to show verbally why Krugman’s arguments were simply wrong. Nick Rowe, a monetary economist in Canada, used simple numerical examples (which would appeal to professional economists) to try to make the same basic point. Many other economics bloggers (and their readers) weighed in, over the course of several weeks, in what was truly a remarkable discussion. I summarized the affair on my own blog in this lengthy post, for readers who want to see the complete history.
I was amazed, therefore, when Dean Baker on October 10 kept repeating the same basic mistake that—we had thought!—was cleared up back in January. Paul Krugman too doubled down on the error. Since this is such an important topic, and since the advocates of bigger government deficits keep repeating this incorrect argument in an attempt to make these deficits seem benign, it’s worthwhile to spell out in this forum exactly what their mistake is.
What Baker and Krugman want to explode is the man-on-the-street’s moralistic objection to government budget deficits as being irresponsible and a burden on future generations, who will have to deal with higher government debt. Baker and Krugman think that this is yet another example of where “micro” thinking breaks down when we try to aggregate it into the “macro” economy. They concede that it makes sense for an individual household to worry about irresponsibly running up debts today, and thereby imposing pain in the future when those debts have to be paid off—or at least, when more of the household’s income needs to be devoted to interest payments on the higher debt.
However, so long as future Americans end up holding the Treasury bonds issued by Uncle Sam, Baker and Krugman think that our generation cannot irresponsibly run up the debt today, and pass on a burden to our kids and grandkids. The difference arises (they claim) because all of the interest payments (mostly) stay within America, to the extent that “we owe it to ourselves.” Sure, Baker and Krugman admit that some of the U.S. federal debt ends up being held by foreigners, and to that extent our grandkids will be poorer because they’ll have to make interest payments flowing out of the country. But besides this complication, Baker and Krugman argue that the mere fact of taxing and paying interest on bonds per se can’t burden our grandkids, since (some of) our grandkids will be the ones pocketing the interest payments!
In other words, if our generation today runs up a big government debt, all that means is that the government in (say) 2100 will have to take more from American taxpayers in order to give more to American bondholders. But Americans collectively in 2100 will be neither richer nor poorer because of this; it’s just a greater volume of wealth redistribution at the time. Thus, Baker and Krugman conclude that higher government deficits in the present generation, cannot possibly affect the average standard of living of Americans in future generations, unless we bring in all sorts of side issues like taxes having disincentives on work effort and such.
Now that I’ve carefully spelled out where Baker and Krugman are coming from, let’s see why they are totally wrong. Back in April I wrote a fable in The Freeman that walked through the fallacies, but for our purposes here I can boil it down succinctly:
Suppose the government today borrows an extra $100 billion in order to expand drug coverage for seniors. Assume that the young workers today “pay for it” in the direct sense that they reduce their consumption by $100 billion, in order to invest in the additional $100 billion in government debt that has to be issued. (Thus, we are assuming unrealistically, for the sake of argument, that the higher government debt doesn’t “crowd out” private investment, just so we can see quite clearly why Baker and Krugman are wrong on this issue.) Clearly the older folks are better off because of this deal: they get more drug coverage from government spending, and don’t have to pay higher taxes to finance it.
Now further suppose that the young workers don’t touch their bonds, which happened to be 30-year Treasury securities rolling over at (say) 3 percent. After 29 years have passed, the originally young workers are now old. The original seniors—the ones who benefited from the $100 billion in extra drug coverage—are long dead. A new group of workers—who weren’t even alive when the $100 billion was borrowed—are now on the scene.
The now-old retirees sell their 29-year-old bonds at their current market value of $236 billion (that’s the original $100 billion compounding at 3 percent annually for 29 years in a row). At this point, the middle generation—the ones who were young workers originally, and now are retiring and living off of their savings—have been made whole. Yes, they reduced their consumption by $100 billion back when the government ran a budget deficit, but at the time they voluntarily lent that $100 billion to the government, because they thought getting $236 billion in 29 years when they were retiring would make the whole deal worthwhile. They didn’t lose from the whole operation.
Finally, suppose that the young workers (who were recently born) hold on to their government bonds for one more year, when they mature with a market value of $243 billion. In order to pay off the bonds, the government imposes a one-time surtax on current workers of exactly $243 billion. It thus takes the money out of the workers’ paychecks, and then hands it right back to them to redeem the 30-year bonds that they are holding.
The way Dean Baker and Paul Krugman have been “educating” their readers since late 2011 on this issue, they would be forced to argue that in our story above, the young workers weren’t hurt by the original $100 billion borrow-and-spend scheme. After all, the government 30 years later simply took $243 billion from those workers, and then gave it right back to them. So clearly it’s a wash, right?
But we can see it obviously wasn’t a wash. The original, old generation benefited greatly, the middle generation did all right, and the young generation—not even alive at the time of the original $100 billion deficit—got skewered. Yes, they “owed the federal debt to themselves,” but that is hardly consolation to them. They acquired the bonds by reducing their consumption by $236 billion the year before the big tax bill hit. This abstinence was not rewarded with additional consumption at some future point, but instead was necessary just to break even after the government whacked them with a big tax bill to retire its exponentially rising debt.
As this short tale illustrated, the man on the street’s intuition is correct: today’s budget deficits can impoverish future generations, even if future Americans hold all of the Treasury bonds. There really is a sense in which voters today can run up the credit card and stick the bill to unborn future generations.