Wednesday, February 10, 2010

Is the National Debt a burden on future generations?

Most of the national debt is NOT a burden on future generations. Reasons are thus.

Suppose government borrows $X to build a highway, and assume for the moment that all the money is borrowed from natives, not foreigners. Assume also that the economy is working at capacity, i.e. that the relevant economy enjoys full employment. I’ll relax these assumptions later.

Creating a capital investment, like a highway, requires a sacrifice of current consumption. That is, the highway needs steel. So people will have to consume fewer cars and other products made of steel. Highways also need concrete. So people will have to consume less concrete in for example house foundations.

(To be more accurate, steel consumption for cars for example COULD be left unaffected if resources can be transferred from the rest of the economy to boost steel production. But in this case the country just sacrifices consumption of whatever is produced in “the rest of the economy”.)


Apart from steel and concrete, labour is required to build highways. And this labour will have to cease producing stuff for current consumption, and instead, help build highways.

Now where does this labour come from? Well it’s a bit difficult for the future generation to supply the labour. To illustrate, having new-born babies build highways might pose a few problems. As for having those due to be born in 2020 build highways in 2010, the problems are just insurmountable.

And where does the steel and concrete come from? Well you cannot consume steel in 2010 that is produced in 2030 ! In short, the “burden” involved in building the highway absolutely has to come from the current generation.

Debts and financial assets ARE passed on to the next generation.

Having established that the REAL BURDEN involved in building the highway is born by the current generation, it is nevertheless true that SOMETHING passes on to the next generation. To be more accurate, two things are passed on. First and most obviously when government borrows to build the highway, extra government debt is created (e.g.Treasuries in the U.S.). And the owners of these Treasuries pass them on to their children (or to a cats’ home, or to whoever they like).

But also, EVERYONE inherits a liability, namely the obligation to pay interest and eventually return the capital sum to the owners of the Treasuries. Alternatively they might inherit the obligation to pay a toll for using the highway.

But the important point is that IN THE AGGREGATE, nothing passes to future generations apart from the highway.

Borrowing to fund current spending.

Sometimes governments borrow to fund current spending as opposed to capital spending, like highways. In this case, obviously no physical asset passes to the next generation. All that passes (as above) are a set of financial assets and liabilities. I.e. in the aggregate, NOTHING passes to future generations.

Having future generations pay would be fair.

Given that future generations will use highways, it would certainly be fair to make them contribute. Unfortunately this is just not possible, ASSUMING natives rather than foreigners fund the highway.

Of course, if the money is borrowed from abroad, then foreigners (at least to some extent) sacrifice current consumption to finance the highway. And likewise, a genuine or real sacrifice in living standards may be made by future generations in the country with the new highway when they repay foreigners. (Coincidentally a namesake of mine made more or less this point in a paper in the American Economic Review seventy years ago.*)

But whether a standard of living hit is involved depends on exactly what form the above “repayment” takes. For example if foreign holders of government debt are given cash in exchange for such debt (e.g. on maturity of the debt), and this cash is deposited in a bank in the country with the new highway, then there is virtually no effect on living standards. After all cash (at least nominally) is a liability of a government – central bank machine, and government debt is much the same in nature.

In contrast, if the above cash is exchanged for another currency and taken out of the country, then the country’s currency declines relative to other currencies. That means a standard of living hit for the country’s citizens. This is what might be called “genuine debt repayment”.

Another example of genuine debt repayment would occur if say China wanted to halve its holding of U.S.Treasuries, and use the money concerned to buy U.S. products for consumption in China. In this case real and valuable goods move from the U.S. to China and U.S. citizens have to forgo current consumption to make such goods.

Having shown that borrowing from foreigners to fund infrastructure investments enables a country to force future generations to pay their fair share of the cost of such investments, does prove that there is any point in doing this? Probably not: after all if every country engages in this policy, it turns into a zero sum game!

Relaxing the full employment assumption.

Of course economies are not always at capacity or, put another way, at full employment. That is given an economy with excess unemployment, the highway could be financed by boosting aggregate demand. But likewise, this boost in AD could be used to fund consumption. Thus in this scenario, the country concerned is still sacrificing consumption to fund the highway.

* Richard A Musgrave, (1939). The Nature of Budgetary Balance and the Case for the Capital Budget. The American Economic Review, 29 (2): 260-271. As Richard Musgrave (no relation) put it, “collection of funds from out- side the tax jurisdiction and gradual repayment out of tax revenues will permit a spreading of the burden.”

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