In a recent post on the (non)-importance of debt buildup worldwide, Antonio Fatas makes the point that debt is not necessarily a problem. While I agree with that statement: a great deal hinges on the qualification “not necessarily”.
Paul Krugman goes further than Antonio. According to Paul debt is “money that we owe to ourselves”. That is at best misleading and at worst; false. Money is money we owe to ourselves. Debt is money that some of us owe to others.
In the real world, debt matters; and it matters a lot. Why? Because different generations are not all connected by operative chains of bequests. Government debt is the liability not only of current generations, but also of future generations. An increase in government debt always places a burden on future generations. The right question is: do the benefits of increased government debt outweigh the cost?
Paul, in a separate post, invites us to think of a world where some people (spendthrift Sams) spend more than others (Judicious Janets). I like that model; but lets develop it a little bit further and suppose that Sams and Janets reproduce (asexually since this is, after all, a brave new world). That allows us to think about the real world in which different generations coexist.
In a model that I developed here, there is a stationary population that consists of a bunch of Sams and Janets of different ages. The Sams spend more than their income when young, and less when old, by borrowing from the Janets. Janets do the opposite. They spend less than their incomes when young and more when old. Sams and Janets are selfish, and although they love their children, they don’t love them all equally.
Several centuries of social evolution has created a society composed of equal sized populations of Sams and Janets. In each population, there are ancient dynasties and newly created dynasties all of whom are borrowing and lending to each other in amounts that depend on their ages and their types.
Let's expand this idea a little further. Although the incomes earned by Sams and Janets are equal every year (the Scandinavian model) the amount that they each earn fluctuates from one year to the next. In most years, income is high; but occasionally there is a recession and income is low. Since Sams and Janets are risk averse, they insure themselves against these fluctuations by trading in the financial markets.
Sams and Janets trade two financial assets. One asset, debt, is a promise to pay one dollar next period whether income is high or low. The other asset, equity, is a claim to the future stream of income. Since there are only two events in each period, income my be high or low. The financial markets are complete and Sam and Janet are perfectly insured against fluctuations. But their unloved children are not.
So far so good. Along comes Government Gus. Government Gus issues a boatload of debt that it sells to existing generations of Sams and Janets. Government Gus is in a heated political race with the opposition, and seeking political popularity, he spends the proceeds of government debt creation on pork belly projects that favor existing dynasties of Sams and Janets. Since interest rates are currently low, Government Gus borrows $10 trillion in the form of 1% consols; these are promises to pay $10 billion in coupon payments to the bearers of the securities every year forever. To finance these interest payments, Government Gus introduces an income tax.
Now we can evaluate Paul’s statement that “debt is money that we owe to ourselves”. Not quite. The benefits of the pork barrel spending have all accrued to existing generations of Sams and Janets. But debt finance has created a perpetual stream of tax obligations that fall not only on current generations of Sams and Janets; but also on all future generations. That is the sense in which Paul’s claim is misleading. ‘We’: are not a homogenous group. Debt benefits some groups at the expense of others.
What about Antonio’s qualification that debt is “not always bad”. That depends on what causes recessions. John Cochrane points out that, if recessions are all supply side events, those pork belly projects are an unambiguous theft from our children. But if most recessions are caused by deficient “animal spirits” as I believe they are and have modeled here, the additional pork-belly spending may increase income (and employment) by shifting the economy into a higher, more efficient, equilibrium. Spending on roads, bridges and Warp drive technology that benefits future generations, as well as current ones, would be even better.
Lets recap; if aggregate income and employment is determined by aggregate supply, government borrowing to finance current expenditure is an unambiguous transfer from future to current generations.
If aggregate income and employment is determined by aggregate demand, government borrowing to finance current expenditure can potentially increase income and employment and make everyone better off.
Irregardless of whether recessions are induced by supply or demand failures: government debt creation has distributional consequences. A better way of financing expenditure in the midst of a deep recession, (Europe take note), is to create lots of little pieces of colored paper and distribute them to all of the hungry Sams and Janets out there who don't understand why Gus is standing idly by while they go hungry.