Thursday, October 18, 2012

One More Rumination on the Burden of Fiscal Deficits

You would think that everything that needs to be said about this topic has been put on the table in the past few weeks.  (I will skip the links; these posts have already been linked to death.)  And you might be right, but I’ll offer a different take anyway.

The debate has been cast in an aggregative framework in which the set of welfare-relevant individuals includes both those who pay taxes tomorrow to repay today’s deficits and those who hold the bonds and receive payments.  Fine, but let’s consider a narrower question, one that most economists apparently think is beneath discussion: what it is the purely fiscal burden of public debt?

Well it’s obvious, isn’t it?  Either you pay off the debt in the future or you roll it over and pay more interest.  Either way you bear a fiscal burden, and they are the same in present value terms.

Well, try this.  In thinking about the fiscal burden, it may help to imagine a country with two types of citizens.  One type pays taxes but owns no financial assets; the other owns financial assets but pays no taxes.  (We’re getting there....)  The government runs a fiscal deficit in period 1.  In subsequent periods will there have to be offsetting transfers from the taxpayers to the bondholders?

First step: I rule out the scenario in which any significant portion of the debt is paid down.  This is not a deduction from theory, just an empirical observation.  Fiscal surpluses are few and far between.  Tomorrow’s taxpayers will no more be paying off the public debt incurred by the current generation than today’s taxpayers are paying off the debt bequeathed to us by our parents and grandparents.

So let’s get to step 2 and consider interest payments on the debt.  Here the critical move is to regard the burden not as a sum of money but a fraction of income, the debt service to GDP ratio.  This goes up if and only if the percentage increase in debt exceeds the corresponding percentage increase in income, given a constant interest rate.  (I abstract from the issue of real versus nominal incomes and interest rates.)

Now, why would anyone think that the incremental effect of a fiscal deficit on future income growth would be positive?  Two reasons.  First, if the deficit finances public investment, and if this investment is more productive than the use to which the money would have otherwise been put, income will grow commensurately.  Second, if the deficit reduces an otherwise stubborn income gap, hysteresis effects are likely to boost potential income in future periods.  The extent to which income growth attributable to deficits offsets debt service obligations and therefore raises or lowers the future fiscal burden is uncertain.

But that’s the point.  I would say it is an open question whether any particular deficit will be burdensome in the most restricted meaning of that term.  The answer is likely to vary from one macroeconomic context to another, from one program of public spending to another, according to the extent of the deficit, and so on.  The bottom line, however, is that, even if all the government bonds are owned by Martians so that taxpayers and bondholders are completely different species and transfers from the first to the second constitute a pure welfare loss, there is still no determinate relationship between more deficits today and more burden tomorrow.


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Don Levit said...

It seems that you place much more emphasis on the payback of interest, rather than that of principal, due to the recurrent budget deficits.
Typically, interest on debt held by the public IS paid by general revenues, is a current budget expense, and increases the deficit.
However, since we are running deficits, interest is "paid" by issuing additional debt held by the public.
So, in effect, interest is paid off by increasing the principal.
With recurring deficits,there is a difference between paying off interest and rolling over principal. The first scenario adds to debt principal; the second scenario simply swaps one debt principal amount for a similar debt principal amopunt.
It is obvious that the U.S. Government has little interest in paying off our debts, principal or interest. If they made that abundantly clear, that the principal of the debt would increase each year, I wonder how the markets would respond?
Don Levit

TheTrucker said...

The amount of the debt is the primary
amount of US fiat money there is in the
world. Most of the "money" is interest bearing, non liquid, "money"
(bonds) that is easily convertible
into liquid, spendable money that does
not bear interest. When the FED
engages in "quantitative easing" it is
converting non liquid interest bearing
money into liquid, non interest bearing
money. The Republicans use the "debt
limit" to stop the FED from doing its
job (See NAIRU). So the FED then buys
other assets such as MBS's so as to
cause the inflation necessary to
restore the value of labor. Those
purchases do not bump up against the
debt limit. The FED should be buying
used cars.

Nick Rowe said...

" Fiscal surpluses are few and far between."

Not in my experience. Canada ran surpluses from 1997 to 2007.

And if you adjust for inflation, (subtract the inflation rate times the debt from the deficit, to find the change in the real debt), you will find that surpluses are more common than you think they are.

Yes, if you borrow to finance an investment that pays a higher rate of return than the interest rate on the debt, it makes you richer. That is true for a family, and true for a nation.

And if you borrow to use fiscal policy to prevent or end a recession, why not use monetary policy instead?

rjs said...

what if the central bank simply cancels the bonds they hold, as Lord Turner has proposed to do at the Bank of ENgland?

Peter Dorman said...

Nick, I gather from the tone of your comments that you are not inclined to minimize the negatives of fiscal deficits. Anyway:

1. The valuation effects (reduction in the real value of the debt due to inflation) should, in my opinion, be distinguished from paying down principle through budget surpluses. There is no direct burden on taxpayers of inflation (assuming indexed brackets), while there is with surpluses.

2. Yes, Canada ran surpluses for many years. These were controversial, as you know, and in any case they are striking as an exception to the general rule. Most countries don't do this. (Certainly not your profligate neighbor to the south...)

3. The hysteresis argument for reduced (or no) burden beginning in a state of underemployment is strictly macro and does not apply to a family.

4. Whether fiscal or monetary policy (or some of each) is more appropriate is a far larger and more complex issue, which I leave to the side. My point is very narrow: even the "slam-dunk" case for a future burden on taxpayers (and not even the population as a whole or in all its economic roles) is unclear.

Incidentally, I restricted my post to the two best understood transmission mechanisms from fiscal deficits to future increases in potential income. In reality, I suspect the web of causation that encompasses current fiscal policy, economic interdependences, private as well as public investment choices, political responses to economic events, and subsequent economic growth further clouds the relationship between today's fiscal deficits and tomorrow's relative tax burden. There is an unavoidable role for qualitative decision-making about economic policy that takes all these factors into account in a way that can't simply be algorithmic.

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