Do We Owe Our Debt to Ourselves?

Tuesday, 3 Jan 2012 | 1:59 PM ET

Beneath a great many debates about politics and economics is a question of how we are to pay for the costs of being social animals.

Or, as Lenin put it: who, whom?

This comes up in debates about government debt. Some people worry that we are burdening future generations with the costs of our current projects because we are promising that they will pay for them. Others say that there is no burden because, well, we owe it to ourselves.

Paul Krugman of the New York Times recently argued for the latter view:

People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

He includes this chart graph to show that, despite what you might hear about China financing our deficits, most of our debt is lent by domestic institutions and individuals:

Nick Rowe, an economist at Carleton University in Ottawa, Canada, says Krugman has it wrong.

“Sorry, but that's just plain wrong. The economically illiterate rube who thinks that the national debt is a burden on our children or grandchildren is basically right,” Rowe writes over at his blog, Worthwhile Canadian Initiative.

Rowe uses a simple example of a government that “makes a transfer of 100 apples to the current cohort, financed by borrowing.” Does this create a future burden? Rowe says it does.

Here’s a long quote with his explanation:

My argument is obvious. At least, it's obvious to anyone who has thought about overlapping generations models. And it's equally obvious to the unsophisticated uneducated rube who has never thought about overlapping generations models.

The government borrows 100 apples from each of cohort A, then gives each person in cohort A a transfer payment of 100 apples. It is exactly as if the government had simply given each person in cohort A an IOU for 100 apples. That IOU is a bond.

So far there is no change in cohort A's consumption of apples.

Cohort A then sells the bonds to the younger members of cohort B. So each person in cohort A gets an extra 110 apples (assume 10% interest per generation), which he eats. Cohort A then dies.

Cohort A is better off. Each member of cohort A eats an extra 110 apples. In present value terms, those extra 110 apples are worth 100 apples at the time the transfer payment is made.

Cohort B eats 110 fewer apples when young, but 121 extra apples when old, and they sell their bonds to cohort C. Although cohort B eats 11 more apples in their lifetimes, the present value of their total consumption of apples is the same. The rate of interest must be high enough to persuade them to eat fewer apples when young and more apples when old, otherwise they wouldn't have bought the bonds from cohort A.

So cohort B is not worse off.

But (given my assumption) the debt is rising faster than GDP. The government knows this is unsustainable. It cannot rollover the debt forever, because eventually the next cohort will be unable to buy the bonds from the older cohort. So the government decides to pay off the debt by imposing a tax of 121 apples on each young person in cohort C, which it uses to buy back the bonds from cohort C.

Each member of cohort C eats 121 fewer apples.

Cohort A eats more apples, and cohort C eats fewer apples. It is exactly as if apples traveled back in time, out of the mouths of cohort C into the mouths of cohort A. (With interest subtracted as they travel back in time through the time machine.) Yes, the national debt is a burden on future generations.

Where I think Rowe goes wrong is by writing as if there were anything special about financing the transfer of apples with debt. There’s not.

Regardless of whether the government raises taxes now to fund the purchase of apples, shifts spending toward apples away from other expenditures, prints new money to fund the purchase, or borrows debt, the burden of paying for the apples is always shifted to someone else.

Some other “cohort” pays for the cohort of apple consumers to receive the apple.

To put it slightly differently: Government spending always imposes a cost on someone — and that someone is not typically the beneficiary. The cost can be higher taxes, loss of government benefits, loss of purchasing power of the money, or an obligation to repay bonds.

Is there something special about intergenerational burden transfer that I’m missing?

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