In an earlier post, I looked at how we might think about the ‘cost’ of additional public debt, if that debt financed public investment, and our concern was intergenerational equity. Here I want to examine the question of how great the burden of extra debt is on future generations, if that debt financed not investment, but consumption spending or tax cuts that had only current period benefits.
Our initial instinct would be that this burden is bound to be positive. The current generation gets the benefit of additional spending, or a tax cut, but future generations pay the cost in terms of finding the money to pay the interest on the debt. However, if the additional debt is never paid off, and remains a constant share of GDP, then there is a situation in which it is not a burden, which I discussed in that earlier post. Let the ‘growth corrected real interest rate’ be r-g. Suppose r-g=0. In that case the interest on the outstanding debt each year could be entirely paid for by issuing new debt such that the total debt to GDP ratio remained unchanged. The debt is only a burden on the final generation, but there is no final generation.
Normally r>g, so taxes do have to rise (or government spending has to fall) to pay part of the interest on the debt. Debt is a burden on that account. There is a trap that we can fall into here, which is the following. Suppose all the debt is owned domestically. What the government does is raise taxes to pay interest on the debt, so this is a transfer from tax payers to debt owners. The government is just taking with one hand and giving back with the other. If society is just paying itself, how can debt be a burden?
It’s an easy mistake to make – I should know, because I made it in an earlier post, which Nick Rowe pointed out in a comment. Incidentally, Nick has two excellent posts on these issues, here and here. The argument above is wrong because it can still involve a transfer between generations. This becomes very clear if we consider an unfunded pension scheme, which I will do in a later post. Someone who just gets interest on their wealth is clearly better off than someone who also has to pay tax increases to get that interest.
If you are still not convinced, think of the following. Suppose the current generation gets a debt financed tax cut, but in a fit of conscience it decides to put it all into a trust fund to compensate future generations. (This is what happens under Ricardian Equivalence.) Suppose also that there is a final generation when all the extra debt is repaid, and it gets the complete trust fund. In real terms the size of the debt will cumulate up at the rate g, as each year a bit of new debt is issued to keep its total a constant proportion of GDP. However the trust fund cumulates with the real interest rate r. If r>g, the trust fund will exceed the amount of debt to be repaid, and so the final generation will be better off. As all this just involves intertemporal transfers, the final generation being better off must mean that the generations in between should have got some of the trust fund – they were losing out too.
If there is a final generation (when the debt is paid off), then the answer to the question ‘is debt a burden’ is obvious. It is only if we think about never paying the debt off that we need to worry about the r>g condition. The argument I made in one of the earlier posts, and want to repeat now, is that there should normally be a final generation – the debt should be paid off eventually. This argument has nothing to do with intergenerational equity.
Creating additional debt has two negative consequences aside from any intergenerational equity concerns. First, increasing taxes to pay the interest adds to the scale of tax distortions in the economy. Second, it seems likely that additional government debt will to some extent crowd out investment in productive capital, and this is a cost if, as also seems likely, we currently have less than the optimum amount of productive capital. (Economists will know that I am here assuming we do not have complete Ricardian Equivalence, and that the economy is not dynamically inefficient.) For both reasons, even if we ignored issues of equity, we should not be indifferent to the level of debt.
So these arguments suggest we should aim to bring debt back to some target level. Those economists familiar with this area will know that there is one special, but frequently used, case where that is not true, and this paragraph is for them. As a consequence of Barro’s famous tax smoothing hypothesis, the short term costs of bringing debt back to some target can outweigh the long term benefits of doing so, if the real rate of interest is not greater than impatience (the rate of time preference). My own view is that this is a ‘knife edge’ result which really tells something different, which is that any adjustment towards a debt target should be very gradual. For more on this see another earlier post of mine.
What the ideal level of debt should be is a complex question. But once we accept that in theory there is some ideal level of debt, this means that doing thought experiments where we forever depart from it are just that: thought experiments rather than practical policy. To put the same point more topically, if we accept that current levels of government debt are too high, we must have in mind some lower target for debt. If debt rises above this target, it should fall back towards it. In effect, that means there will be a final generation: any additional debt will eventually have to be repaid.
So the burden of additional government debt for future generations involves the debt itself, and not just the growth corrected interest on that debt. However, the practical importance of this point for any particular generation is not great, because adjustment towards a debt target should be slow. Getting debt right is likely to be a cost for our children’s children as well as those generations currently alive.