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.