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February 16, 2015

Perhaps Krugman’s Grandson Will Understand Government Debt

By Robert P. Murphy, Free Advise via Econintersect  

Oh boy here we go again... In two recent posts, Paul Krugman has once again hoisted up a fallacy in his attempt to educate the masses on the proper way to analyze government debt. This is particularly frustrating since a bunch of economists in the blogosphere-ranging the political spectrum-grappled with this issue three years ago, the last time Krugman (prompted by Dean Baker) started wagging his finger at everyone on the topic. In this post I'll summarize the key issues and provide links for the true wonk.

The Central Non Sequitur: "We Owe It to Ourselves"

As he demonstrates by making it the title of his recent initial post, Krugman thinks the regular Joe who worries about today's government deficits being "paid for by future generations" is talking nonsense, to the extent that the government bonds are held by Americans. In other words, Krugman thinks it is impossible for the people alive today to in any way consume at the expense of their grandkids through the use of deficit finance, so long as the people lending the money to the government are Americans.

Now it turns out that this is a very subtle topic. I myself used to agree with the way Krugman is analyzing the issue. However, after reading Nick Rowe three years ago the last time this debate flared up, I realized I was wrong. (I admitted it quite explicitly at the time. I wonder if Krugman will do the same?) So to be clear, I can understand why Krugman has fallen into this trap, because it's seductive. Nonetheless, it is Krugman who doesn't understand government debt; the layman's intuition is right.

Let me first explain how Krugman is looking at things: When the government runs a deficit today, it issues bonds and borrows money from lenders. Those lenders must be reducing their (potential) consumption TODAY in order to finance the deficit. There is no question of a time machine; some people in the current generation are reducing consumption in order to allow the government to live beyond its means.

Now in 100 years, it's true that the existence of those extra government bonds will mean that future generations of citizens are taxed to pay the interest on the bonds. But that doesn't in any way mean that real resources get sucked out of the future and into the present. No, the government in 100 years will be taxing citizens at that time, in order to make interest payments on the government debt to bondholders AT THAT TIME.

Thus, Krugman thinks it is blindingly obvious that running a government deficit today cannot possibly mean that the current generation is selfishly living at the expense of our unborn grandkids, so long as the government's bonds are continually held by Americans. To see why "we owe it to ourselves" is so important, consider: If today's Americans borrowed money from Chinese lenders, and then in 100 years the U.S. government taxed our grandkids in order to pay off the debt to the grandkids in China, THEN it would make sense to say today's Americans lived above their means and passed the bill on down the line.

However, Krugman insists, so long as the U.S. government finances its deficits by selling bonds to American lenders, then there is no possibility of people alive today living at the expense of unborn future generations. It is physically impossible.

Explaining the Fallacy

To repeat, the above reasoning is totally wrong. I am very familiar with how Krugman is analyzing the situation, and I can quite clearly recognize the fallacy he has been making for three years and counting. (To reiterate, I know it so well because I used to think this way myself.) To show that this isn't merely my anti-Krugman bias, here is market monetarist Nick Rowe complaining about Krugman being wrong on debt after all these years, here is the iconoclastic Roger Farmer doing the same, and here is Keynesian (and frequent Krugman ally) Simon Wren-Lewis doing it too (though Wren-Lewis tactfully doesn't mention that he is blowing up Krugman's recent posts).

The central problem with focusing on "we owe it to ourselves" is that it overlooks the possibility of overlapping generations. Specifically, old people today can benefit from a government transfer program financed by borrowing money from young workers today. This clearly helps the old people today, but it also helps the young people today because they voluntarily agreed to lend their money. No coercion was involved TODAY.

In 50 years, the government then taxes the new crop of young workers, who weren't even born when the initial spending decision was made. The government uses the tax revenue to retire the bonds held by the people who have now matured into senior citizens. Thus, when you step back and look at the entire process, what clearly happened is that the government conferred benefits on the first and second generations, while imposing nothing but harms on the third generation. This occurs, even though in this example the government debt was held domestically, and no time machines were used.

Is Debt Really the Problem Here?

Now some economists (such as Steve Landsburg and Gene Callahan) understood the subtle nuances of the overlapping generations approach, but nonetheless thought Krugman had been right all along. After all, it wasn't really the debt per se that hurt the unborn grandkids in my example above. Rather, it was the government's decision to make particular spending and tax decisions that, over the lifetimes of the three generations, helped the first two (on net) and harmed the third. We could have achieved the exact same outcome without the use of debt financing.

Now Landsburg and Callahan are right insofar as their analysis goes. However, I find it baffling that they think Krugman should be congratulated. He clearly is not exonerating government debt the way they are. The smoking gun proof of this is that Krugman-to this very day-titles his post, "We Owe It to Ourselves," which is completely irrelevant to the way Landsburg and Callahan try to handle the issue.

To illustrate the situation, permit me a silly analogy. Imagine you saw the following debate among economists:

KRUGMAN: People are always yelping about the dangers of guns, but so long as people wear bulletproof vests, they can't possible be hurt by gunfire.

ROWE and MURPHY: What the heck is he talking about?! Imagine a guy wearing a bulletproof vest, and someone else walks up and shoots him in the head. Uh, try again Krugman.

LANDSBURG and CALLAHAN: Well Krugman is right, if you think about it. A gunshot to the head doesn't necessarily harm someone; we can imagine a guy with a scorpion on his head, and the bullet just nicks him while taking out the scorpion. Furthermore, we can achieve the same result of killing a man with head trauma by, say, smacking his temple with a hammer. So Rowe and Murphy are wrong to think that gunfire per se causes death from head injury.

KRUGMAN: Like I've been saying for years, nobody understands guns. Let me say it slowly, everyone: If you're wearing a bulletproof vest, a bullet can't hurt you.

LANDSBURG and CALLAHAN. Beautiful, Paul. Preach it brother.

Again, I realize the above is a bit silly, but then again I can't believe Krugman is still getting away with titling posts, "We Owe It to Ourselves."

Links for Further Reading

If I've intrigued you with this post and you want more, here's a Freeman article I did which spells everything out more carefully, while avoiding technical assumptions. But if you're a true wonk, in this One Act play I satirized and provided hyperlinks to all of the major participants in the Great Debt Debate of 2012 after it went down. In particular, I came up with a simple model of an "apple economy" in the middle of that post that provides a numerical example showing how the first five generations can live at the expense of the next five generations, even in a world where there is no physical investment, no deadweight loss from taxation, and all debt is held domestically. In my humble opinion, if you take the time to figure out what I'm doing in that Excel table, you will spare yourself hours of reading and frustration. You will instantly "see" what Krugman to this day is missing.

So remember, kids (and grandkids): Even if we owe it to ourselves, government debt still allows the present to live at the expense of future generations.

Courtesy Robert P. Murphy at Free Advice, posted previously at Mises Canada 12 February 2015, via Global Economic Intersection  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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