When Deficits Do Leave a Burden For Our Children
John Shwarz recently wrote an Op Ed at the Intercept entitled The Idea That Deficit Spending Is a Burden On Our Children is the Dumbest Propaganda. In this post, I intend to explain that things are more complicated than Schwarz suggests. In particular, deficits can reduce living standards in the future. However, in certain circumstances, that is not the case; I’ll explain where. I will conclude by writing about the real propaganda that Schwarz has failed to address.
I’ll start with Schwarz’ arguments that deficits don’t place a burden on the next generation. His main argument is that debt owed by the government to American people, firms and other organisations is not a concern because it is “debt we owe to ourselves.” He also makes a separate argument concerning debt owed to foreigners which I will pick up later.
His argument is as follows: if the government gives the current adult generation some money and borrows from that same adult generation to do so, it will not make the next generation worse off. The next generation will inherit the principal and the interest on the government debt. They will also have to pay higher taxes or receive less money from the government in order to pay off that debt. However, he argues, the financial burden of repaying that debt is canceled out by the wealth inherited. The current adult generation will leave to the younger generation the wealth necessary to pay off the accumulated government debt.
This argument has flaws, though. One of them is that it does not take into account the inefficiencies and/or social costs from lower government spending or higher taxes beyond the direct financial costs.
Let’s say the government borrows money to do something Schwarz thinks is good. I’ll assume he is left wing since he writes for the Intercept. If the government borrows money now to pay for healthcare spending that could be good because the government is more efficient than private insurance companies and this tends to reduce inequality. However, if the government cuts health care spending in the future to pay down its debt, that could be bad because the government is doing less to maximize efficiency and reduce inequality. Even though the future generation has inherited an amount of wealth equivalent to the cuts to government spending on healthcare, the future generation is still worse off because the efficiency and social safety net created by the government spending is lost.
Another example comes from taxes on labor. It could be good in the short term to cut everyone’s taxes, because then they’ll be more incentivized to work. We’ll have a more efficient economy for a bit. If, in the future, the government has to pay off its debts from less taxes now with higher taxes on labor, we’ll have a less efficient economy in the future.
Because generally government spending is efficiency-creating and taxation is generally inefficiency creating, “paying money back” will create inefficiencies. Hence, Schwarz’s argument about governments merely “recollecting” money underestimates the cost of future deficit-reduction.
But Schwarz is right to show some skepticism towards this line of argument. I’ll explain why. It is not always the case that a government needs to “pay back” its debts: A government could borrow some money to spend more or tax less now and cover the additional interest cost with more borrowing. If the rates of inflation and growth are high enough relative to the interest costs of extra debt, the government could grow its way out of the debt. The extra debt, even as it accumulates through interest, could decline relative to the GDP. So, let's just grant Schwarz that the government can currently borrow a lot of money for some spending programs, or tax cuts and never pay that debt off. Surely he is correct that, in that case, deficits don't leave a burden for our children, right?
Wrong. In fact, the primary argument economists use to warn about the national debt is not financial. The idea is that there are resource constraints. Higher debts and deficits apportion resources to certain things (like personal consumption spending or higher quality healthcare now). Those resources could alternatively been used to increase our standard of living in the future (through investment or net foreign lending). Even if deficits are sustainable financially, they still come with costs, because we have limited resources.
The way that resource limitations operate in a market economy is through inflation. If the demand for goods and services made in America exceeds a certain point, the unemployment rate as well as the level of unused land and machinery falls low and prices start to rise. Fluctuations in demand can create expansions or recessions in our economy.
However, demand cannot be elevated above a certain point in perpetuity (or fall below in perpetuity) without creating a serious inflationary (or deflationary) problem. For example, the mid 60s to mid 70s were a period of strong demand which kept unemployment low for most of the time period. This drove inflation high and in the late 70s to early 80s a massive double-dip recession was intentionally caused by the government to control inflation.
The main ways demand is increased (or decreased) is through government decisions which increase (or decrease) the deficit; or through FED decisions which decrease (or increase) interest rates. A higher non-foreign held level of government debt also would stimulate more demand as whoever holds onto the debt has more wealth and feels more free to spend money.
Hence, a higher level of deficits/debt can create more of an inflationary problem (and less of a deflationary problem) by raising demand. Whether or not this is macroeconomically justified at any point, raising demand now will mean a weaker demand in the future. This is because stronger demand means a stronger economy, lower unemployment and less unused land or capital machinery. Higher demand for goods and services combined with a tight market for inputs to production will cause prices to rise higher relative to expected inflation. Of course, inflation cannot under or overshoot expectations in perpetuity so demand cannot be too strong or too weak forever.
Fortunately, higher deficits usually do not create inflationary problems for the next generation. This is because the FED intervenes to raise interest rates slightly when the government stimulates the economy. The higher interest rates will reduce demand and cancel out the inflationary impact of government spending. This means that while actions which increase the deficit do not often create a burden in terms of inflationary pressures, they do leave a burden through higher interest rates. Higher interest rates reduce investment spending and attract foreign lending into the US. By investment spending I mean actual purchases of goods which are used to make other goods (like a farm buying a new tractor). The less of these goods there are, the less productive the economy will be in the future. Similarly, when foreigners have lent Americans more money, future generations will have to pay them back.
So debt, through creating an unsustainably higher demand, or through raising interest rates seems to always create a burden for the next generation.
Does this mean deficits always leave a net burden for our children? Well, perhaps not. Of course a higher deficit created by certain programs designed to invest in the future may increase the standard of living of the next generation. Still, I would say that most forms of government spending hikes and essentially all forms of tax cuts will leave a net burden for our children.
I return now to the piece written by Schwarz. He responded to concern of foreign ownership of the US debt. His argument is that the more treasury bonds foreigners buy, the less American stocks they will buy and he argues that, because government bonds pay out a lower rate of return than stocks, that this is saving America money on net.
This argument is wrong for three reasons. First, he argues that foreigners will buy more US debt just because there's more of it. This is not true. When the US debt goes up, foreigners will likely buy more of it, only because likely there will be higher interest rates on US debt. Second, he does not consider the implications of less stock market investment in the US economy. Wouldn't that also leave a burden to the next generation? Some companies, especially startups, use equity markets to finance investment spending. Third, in the long run, a higher deficit and debt will mean a higher interest rate on every type of asset in America, which in turn will attract more foreign ownership of American stocks, contrary to what Schwarz predicts.
Finally, Schwarz needs to address the real propaganda. I’ll point out two types.
First, his article used, unquestioningly, the term "deficit spending." The term is one pushed heavily by conservatives to frame the debate. While tax hikes are tools to cut the deficit, conservatives want you to connect in your mind spending and deficits. You need to resist this manipulation and understand they are different things.
Another piece of conservative propaganda is the assumption that borrowing against our children’s future is necessarily bad. We all know this isn’t true. Imagine a newlywed couple who intend to raise children in the future. If that couple takes a honeymoon trip now, they are using up money that could otherwise be invested and later given to the children they will one day raise. Obviously, this newlywed couple is borrowing against their children to live a good life today. That’s entirely appropriate. What is key is a broader question of how to strike the right balance. It is entirely appropriate to borrow against the next generation’s futures as long as there's not a high return on saved wealth today and the next generation can be reasonably expected to end up better off than us. Unless we are forgoing truly fruitful investments in the future, we shouldn’t really be too concerned about people who are going to be wealthier than we are.
When it comes to borrowing against our children’s future, the real cost we should worry about leaving them comes from destroying all the natural beauty we currently enjoy. We are at risk of doing that by polluting the planet, raising global temperatures and cutting down forests.