Those looming deficits. Yawn.

Before I get voted off the island, let me say that I’m in favor of much smaller government, lower spending and lower taxes.  I’m also a supporter of reducing budget deficits.

That said, however, I cannot find a reason to get that worked up by the budget future of the U.S. or most developed countries.  I started thinking this way over 20 years ago when I was an undergraduate and Robert Barro came to campus to tell us that the trade deficit we were running at the time was not that big of a deal, nor was the budget deficit that the trade deficit was helping finance.  This was my first exposure to Ricardian equivalence, a concept that I still think is basically right.

Of course studying economics at Chicago didn’t really dissuade me from this view.  Our macro courses paid scant attention to government finance of any kind, and no one in Chicago (or elsewhere) was paying attention to fiscal stimulus or any other  Keynesian voodoo.  We studied real business cycle (RBC) models.  I never became a master of these models, nor did the hyper-technical, ethereal nature of these models seem to be something I would be interested in or something I would be good at.

But I did gain a sense of what was important in the macroeconomy: real things.  By this I mean machines, hours worked, human capital, technology, infrastructure, networks, relationships, and time.  Prices, deficits, interest rates, exchange rates—these are things determined in markets by the supply and demand for real things.  They are not in themselves real things.   [If you and I each sell each other one billion dollar bonds, are we both worse off or better off?]

The way to judge government spending is to determine whether we are spending money on things that have value (relative to opportunity costs), not how those expenditures are financed or how much money is being moved around and to whom.   Taking money from person A and giving it to Person B is just a transfer; it doesn’t have real consequences unless people start doing things with their real stuff to avoid those transfers, such as putting their capital in less productive uses in order to avoid taxes.

In a closed economy (which we are definitely not, but hold that thought for a moment), the idea that a society can live beyond its means is impossible.  We cannot borrow from our children’s future.  We can only borrow from the present.  People who buy those government bonds know that those bonds can only be paid back from future taxes.  This is the main idea behind Ricardian equivalence.  It doesn’t matter whether spending increases are financed by taxes or bonds.    If I want to buy a car, the important question is not whether I pay cash, or get a 4-year loan or a 6-year loan (assuming each option will leave me solvent).  The important question is whether I buy a Toyota or a Lexus.  I don’t want a Lexus government.  I want a Toyota government.  Policies that diminish productivity, reduce investments in technology and human capital, and lead individuals to divert real resources from productive uses to unproductive uses are the policies we need to be most concerned about—not how big the budget deficit is.

The humungous caveat to this analysis, however, is foreign debt.  We cannot borrow from future generations since they don’t exist, but we can borrow from the Chinese and other creditors.  This is a genuine concern, but not one that I am terribly worried about yet, at least in the short-term.   As long as people have faith in the US Government meeting its obligations (and every time there is a crisis, people flock to US Bonds), they have every incentive to keep those bonds.  A mass sell-off would only hurt the seller, since it would lower the price of bonds.

So let’s focus on what matters: what are we doing with our time, our talents, and our stuff—and how can we keep government away from it.

14 thoughts on “Those looming deficits. Yawn.

  1. “””I want a Toyota government.”””

    I.e., one which keeps accelerating no matter how hard you press down on the brake? OK, doesn’t seem hard to arrange…;-).

  2. I wish I could be as optimistic as you, Sven. A couple reasons why I’m not.

    First, public debt is very different from private debt. In the later case, you have one person risking his own future earnings against a present benefit, and the lender risking his own present benefit against future earnings. The persons taking the risks and receiving the benefits are known to each other, and the the wealth risked is closely connected to the person taking the risks. In public debt, by contrast, A decides to risk B’s money by giving it to C on terms D decides. In this case, the dynamics, and incentives, are completely different. So although it may be true that, from some Olympian perspective, it still looks like just a transfer, B is clearly in a much worse position than if he were the lender in the private debt scenario, just as C is in a much better position.

    Second, your point about “real things” mattering more than non-real things is well taken. But the public debt in European countries, as well as in the United States, is getting so large that the debt service, which is not a “real thing,” is threatening to crowd out real things. It is also draining the wealth from productive sectors to maintain it. Thus it greatly affects real things, and its size may begin to cripple them.

    I agree with you that “Policies that diminish productivity, reduce investments in technology and human capital, and lead individuals to divert real resources from productive uses to unproductive uses are the policies we need to be most concerned about—not how big the budget deficit is.” But the debt is indeed threatening to diminish productivity, reduce investments, and divert real resources from productive to unproductive uses. And because the size of the debt is so big, there may be no way ever to come out from under it.

    1. Distributional consequences (how gains and losses are distributed between A,B,C, and D in your example) are important. I agree. But my post was about the aggregate consequences rather than the distributional consequences.

      I didn’t emphasize well enough in my original point that how government spends its money is the key variable here. Government-forced transfers aren’t that important. But government spending involves diverting real resources (like person hours of labor) from the private sector to the public sector. The real effect of that is to reduce private sector output and, as a consequence, lower government revenue.

      In the long-run, government spending reduces spending on other stuff. So the question is, from a social perspective is the stuff the government buys worth as much as the stuff that consumers no longer can buy because the government took their money?

      Higher and higher debt servicing costs indicates the reduced productivity of the economy. But the real effect on the economy would have been roughly the same whether the spending had been financed in a pay-as-you-go fashion or in terms of issuing bonds. Remember that bond buyers reduced spending (and thereby output) to buy those bonds in the first place. If they had taxed people instead, private sector output would have been reduced by the same amount approximately. Similarly, going forward, the math is the same.

      It is all about the spending, baby!

  3. Sven, as a non-economist, I am with you for a lot of what you say here, but am puzzled about one part. At one point you say, “We cannot borrow from our children’s future.” And then two sentences later say, “People who buy those government bonds know that those bonds can only be paid back from future taxes.” How is that not borrowing from our children’s future? The whole idea is that those taxes are going to be levied on succeeding generations.

    1. The point is that the government takes money from the present, not the future. We can’t take money from the future because we can’t travel through time and take money from future generations.

      Government borrowing/spending can have important distributional consequences, however, since everyone isn’t taxed equally, nor does everyone buy bonds equally, nor does government spending benefit everyone equally. But all those inequalities wash out when you add them up to the population level.

      And I would re-emphasize that when we borrow from foreigners, we are borrowing from our children’s future (though at the global level we can’t borrow from the future, either).

      1. Well, of course it is right that there’s no time travel here, and no way to take money from people who don’t exist yet! And you’re right that government takes money from the present in this sense, that the money that is buying the bonds is being withdrawn from other possible purposes. Nevertheless, government is indeed imposing claims on future generations; it is obligating them as surely as I obligate my future self when I borrow money from you to repay over time. Money that our children would otherwise have for other purposes is already spoken for, and not available to them. And it is government that has imposed that claim or obligation on them. So in that sense at least it seems false to claim that we cannot borrow from our children’s future. In our laying claim to it, that’s exactly what we do.

      2. Mark, As I said above, the distributional consequences can be profound–both economically and morally. Some of our children will be worse off in the future because of government borrowing, some will be better off, and some will be unchanged.

        But my point is that the aggregate level, we don’t borrow from the future. We just use coercive power to divert resources to day and make commitments to use that same coercive power to divert resources in the future.

        Where I would like to move the debate is to the following two questions:

        1) Government spending (and government finance) has important distributional consequences that we ought to pay more attention to. Are those consequences desirable?

        2) Government spending has important implications for economic growth. What are these?

        So much of the public debate is about “living within our means” and “not burdening our children.” etc. Both parties misuse the household finance metaphors in this regard. Those metaphors are just not that relevant. The important questions are the ones listed above.

      3. I’ll follow you to the two near questions but, if you’ll forgive me, argue that the metaphor is important. Any instance of borrowing is worthwhile if the benefits of the use of what is borrowed outrun the costs of servicing and repaying the debt. If the government takes the income from the bonds and launches it into space, not too many future children will benefit from the borrowing. If it invests it in ways that pay back more than the cost of servicing the debt, then lots of future children will benefit. And presumably there are lots of possibilities in between.

        But I don’t see how that is at all different from the household case, except for the distributional issues you mention. Instead of my thinking about either my present self vs. future self, or myself vs. my child, now it is us vs. some subset of taxpayers a generation or two down the road. And you’re absolutely right that distributional issues are raised in thinking about those tradeoffs. Those seem however like a complication, not a fundamentally different question, for the tradeoff decisions made within a household. We still ask, and should ask, about the degree to which we are justified in imposing burdens on our children that they have no say in. That’s not to say that’s a burden that can never be met. It’s that it is a real burden which will fall on the shoulders of real people, and real people we care about. That’s true in both micro and macro cases.

        One question it seems to me that liberals (classical or otherwise) ought to ask in this regard is this: why think there is a single answer to the question, is this borrowing justified? Why should we suppose that fundamentally different evaluations of the tradeoffs ought not to be respected, in favor of a coercively-enforced resolution of the issue, as is the case when government borrows?

        What I have in mind is that there are all kinds of conditions people are in with all kinds of implications for their future generations (or lack of them). Why should we think there is a one-size-fits-all answer to the question of how to distribute costs and benefits between the present and the future? Why not, here as otherwise, think the story may be significantly different between individuals, and that liberty to choose how to make those tradeoffs is something that ought not to be collectivized?

      4. Here is what I mean about the government not being like a household. When I make a charge to my credit card, I can consume more now until the debt comes due, at which time I have to divert consumption into paying off the debt. My children are affected from my having to pay back the debt.

        But wen the nation borrows (ignoring the foreign debt issue again), what we do is borrow from ourselves. In essence, domestic debt isn’t really debt; it is just coercive transfers and spending.

        Your point about launching money into space is very much in line with what I’m arguing. The critical thing is what government does, not whether it finances its activities through debt or through taxes.

  4. “A mass sell-off would only hurt the seller, since it would lower the price of bonds.”

    It would also hurt the government’s budget, as the cost of rolling over existing debt would be much higher.

    In the previous sentence:

    “As long as people have faith in the US Government meeting its obligations (and every time there is a crisis, people flock to US Bonds), they have every incentive to keep those bonds.”

    That’s exactly the issue. Re: Greek bonds, people are demanding a risk premium. Lucky for us, as long as our bonds seem safe relative to other bonds (or places to store money), we’ll command the lowest rate.

    The breakdown comes if a safer bond (or other mechanism to store money) poofs into existence.

    BTW, there was an article in the WSJ about an investor who is buying long-range, out of the money, puts on Treasuries to hedge against this rather large long-tail risk. Low cost default insurance for holders of US gov’t debt.

    Those prices will be the canary in the coal mine.

    1. Interesting points. I agree that if the “full faith and credit” of the US government should crack, all bets are off. That would be a whole new world. As would a world where a significantly safer money house comes into existence–at least we know it won’t be the Euro any time soon.

      I think the main thing people are forgetting about Greece is that fact that they were lying about the amount of their deficit to a degree that creditors were sufficiently ticked off. Cochrane was right in that Greek sovereign debt should have been allowed to fail and that letting it fail actually strengthens the Euro rather than weakening it.

      And I don’t buy Krugman’s argument that being in the Euro makes it harder for countries like Greece to do better. Sure, they could soak creditors by devaluing their currency, but they would pay for that in the long run as countries always do. But having a strong currency is a good thing, even if your fiscal house is a complete mess.

  5. “A mass sell-off would only hurt the seller, since it would lower the price of bonds.”

    I should’ve added:

    (a) it only hurts the later sellers. The smart money gets out first with little loss. The drop would be very rapid.

    (b) it also hurts those that don’t sell. Assuming no default, their $X investment is now returning less than market. Opportunity cost. See (a) — that’s the reason to get out first.

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