I am seeing a disturbing rise in “free lunch” thinking. One place this increasingly shows up is in the case of “deficits”. People seem to have trouble grasping that deficit spending implies future austerity.
Let’s start with an electric company. Suppose it plans on being in business forever. It decides to issue enough debt so that it’s current stock of debt at any given point in time is equal to 1% of the GDP of the city it serves. If the city it serves is growing over time, the electric company can basically run “deficits” forever, or so it would appear.
In fact, the electric company still faces a budget constraint. It must still service that debt with money earned from customers. The net present value of future interest and principle payments is still equal to the value of the debt issued. The debt continues to be a liability, in any meaningful sense of the terms. Ratepayers should still be concerned about the electric company issuing too much debt, and saddling them with huge future liabilities.
The same reasoning applies to the Federal government. Some might argue that if the growth rate of the economy exceeds the interest on debt, then there is a free lunch. Governments can simply issue more debt to pay interest on existing debt. That may work for a brief period, but beyond some point additional debt will push up interest rates, and the marginal cost of the new debt will exceed the growth rate of the economy. Indeed this may well have happened in the US in recent months, as some people believe that rising fiscal deficits partly explain the recent increase in interest rates on Treasury debt. The marginal cost of borrowing exceeds the average cost, and at some point it exceeds the average growth rate of the economy.
Let’s say $X represents the amount of newly issued debt that a government will issue over a period of N years. (Make X as a big a number as you’d like). In that case, the average annual deficit equals $X/N. A decision to borrow more money in any given year will lead to less borrowing (more austerity) in the other N-1 years. Fiscal policy cannot be continually expansionary, even if the government runs a budget deficit in every single year. That’s because the expansionary impact (on AD) doesn’t come from there being a budget deficit, but rather from the deficit being bigger than the year before.
In the very, very long run, there are no deficits at all. The net present value of taxes from now until the end of time should equal the net present value of government spending from now until the end of time. And the same is true of trade deficits. Other countries will not give us stuff for free, and hence we must eventually pay for all imports with exports. Even the outflow of US currency will eventually be reversed, when the world switches to electronic money.
Interestingly, there’s a certain type of person who is so swayed by recent trends that they think both trade and budget deficits can go on forever. That’s wrong. They also think that this is good news for the budget, but bad news for trade. That’s also wrong. If we could run trade deficits forever, that would be really good news. The outside world would be a big Santa Claus for the USA.
Alas, they will eventually want to be paid. Ironically, that fact (which is bad news for us) would be greeted as good news by many people who regard exports as “good for the economy”.
PS. Measured trade deficits can go on forever, as they do not accurately measure actual trade deficits. Indeed they don’t even come close. It’s not at all clear that the US has run large actual trade deficits in recent decades, properly measured.
Budget deficits are also incorrectly measured, usually quoted in nominal terms rather than real terms. In real terms the US often ran budget surpluses during the 1960s and 1970s. The real budget deficit is the change in the real stock of public debt. If the nominal stock of debt rises more slowly than inflation, the real budget is in surplus.
This post is about actual budget and trade deficits, not measured deficits.
READER COMMENTS
Peter Gerdes
Feb 21 2018 at 5:41pm
I don’t think anyone denies the claim that if you borrow today you can spend less tomorrow. Whatever you think about continual borrowing its clear that any money you borrow today is money you couldn’t borrow tomorrow.
And it is of course possible to continue to borrow indefinitely and the key to that fact is exactly your remark about the NPV of expected future payments being equal to the amount borrowed. Indeed, I don’t think it would be at all hard to construct plausible models on which it is desirable to constantly run a deficit. You just have to assume that investing money today has a sufficiently large boost to future growth.
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What isn’t possible is to constantly borrow enough that the money you borrow more than covers the cost of debt service and I expect this is what you meant.
(Of course, if you are willing to play tricks with the money supply the government can hide some of its taxation to service the debt in inflation)
Thaomas
Feb 21 2018 at 7:20pm
I think we lose sight of how deficits are incurred. If they are incurred to increase current consumption then that increase which is not invested will reduce future income thereby lower consumption in the future. If they are incurred to invest then future income and consumption can be larger. Then, too one needs to take into account that during recessions some of inputs into investments have marginal costs that are less than their market prices so the social NPV of the project will be higher than the nominal NPV; a given deficit reduces current consumption less than it would when all resources are fully employed.
Effem
Feb 21 2018 at 8:10pm
The political “free lunch” will take the form of inflation that will be blamed on external causes, separate from the debt. Inflation will be made to look like the result of supply shocks, acts of trade war, crony capitalism, etc.
By using the interest rate as it’s primary transmission mechanism, the Fed invites larger deficits which will force the country into the position of having to accept future inflation as the only politically feasible outcome…and the Fed will have no choice but to go along.
Iskander
Feb 21 2018 at 8:43pm
Scott, what is the mechanism through which budget deficits boost AD/NGDP?
Larger deficit -> higher interest rates -> higher velocity of money/natural rate of interest?
Are there any other reasons why?
Is there empirical evidence that budget deficits have a large impact on AD, aside from using the printing press to fill the gap?
Thomas Sewell
Feb 21 2018 at 8:53pm
Trying to see if I have this right in my mental framework:
If the coining process printing press is used to pay down debt (inflate) at a rate of 2% of GDP per year, does that imply the nominal deficit can be 2%/year without creating a real deficit?
James
Feb 21 2018 at 9:42pm
Scott,
You are missing that borrowing creates both an asset and a liability.
Say there is a country where you and I are the only taxpayers and we each make $500 per accounting period. The government spends $100 and asks us each to pay $50. In this scenario there is no deficit and private sector dispisable income has been reduced by $100.
Now suppose I want to spend all $500 this period so I borrow from you to pay my taxes. You lend me $50 and pay $50 yourself so there is still no government budget deficit. Private sector disposable income is still $900 ($500 for me nad $400 for you), same as above. If I pay you back in the next period, then I have to spend less but you get to spend more by the same amount.
Now suppose the government decides to act as an intermediary between people who want to borrow to pay their taxes and people who want to make loans to those people who want to delay paying their taxes. Once again private spending is reduced by the amount the government spends, no more and no less, in the period that the government spends it.
The spending matters but the mode of financing does not.
Philo
Feb 21 2018 at 11:05pm
If there will be an end of the world, and everybody knows when it will occur, then you are right: as the end approaches people will get more and more reluctant to lend money (to the government or to anyone else). If there will be an end of the world but it will come unexpectedly, then deficits can go on till that final moment, when default will occur–the debt will not be paid off. If the world will go on literally forever–to infinity–then you are definitely wrong: deficits can go on forever.
Of course, none of this has any relevance to the question whether the government’s plans for deficit spending over the next two years constitute good public policy.
DougT
Feb 22 2018 at 5:38am
This analysis ignores demographics and investment in human capital. If a country spends the proceeds of its borrowing on developing human capital so that productivity (and potential GDP growth) is markedly higher, then the net present value of the assets will exceed that of the debt and positive economic value is created.
This is similar to the utility example, where the utility issues debt to build a generation facility. Such activity, if executed well, creates economic value for the residual beneficiaries, i.e. the shareholders.
Note: this is not a “free lunch.” Spending much be controlled, activities must be managed, and outcomes must be monitored to be sure that economic value is created. But prudent borrowing is typically an important part of a diversified capital structure, and is a crucial management tool.
David S
Feb 22 2018 at 9:30am
I think there may be a bit of a free lunch here – “if someone offers you a loan at <3%, take it!”
Basically, it can be viewed as the citizens of the United States being given the option to borrow money to pay their taxes at (essentially) the risk free rate. Most choose to do that, the other can buy treasuries and offset any future debt payments.
That said, another issue with deficit spending is that it allows the government to command a larger portion of the current economy. The government competes with the private sector for resources. By loaning themselves money they are able to outcompete the private sector while providing less value than the private sector would create given the same inputs.
Jerry Brown
Feb 22 2018 at 10:16am
To the extent that foreigners desire to net- save in US currency, a trade deficit is sustainable. And this isn’t just about putting $100 bills in a safety deposit box. Foreign government economic development strategies and the desire of foreign central banks to hold large reserves in US Dollars also would allow a trade deficit to be sustained. Of course, those savings desires or the policies may change in the future.
Similarly, the desire to save in the currency would allow the government to deficit spend without inflationary effects, and to issue debt denominated in its currency if law requires deficit spending to be matched with debt issuance.
Of course, currency issuing governments have an option not available to an electric company- they can create the currency used to repay the debt, or they can have their central bank purchase that debt from the debt holders and hold it. This option could be inflationary in some situations (a full employment situation), but not necessarily in all.
Andrew_FL
Feb 22 2018 at 10:38am
This would then make whether the budget is in surplus or deficit heavily dependent on how one measures inflation in at least some cases, and we can’t very well have that, now can we?
Gary former UofC
Feb 22 2018 at 11:44am
The mistake here is using private debt as a model for reserve currency debt of a sovereign giant nation. Debt of the US govt has never and likely never will require repayment. The dollar wealth of citizens and foreign entities is the same as the debt of the US government. Subject to the savings/ consumption preference of non-federal entities, inflation and future tax obligations will NOT increase with increased federal debt, but instead will add to wealth. Many people and governments desire wealth. Overall wealth can only increase if federal indebtedness increases. That is why the assumption in this article that increased indebtedness now must be balanced by repayment later is not appropriate. So the type of person portrayed in the last paragraph is NOT wrong. The person who criticizes him is wrong.
Gary former UofC
Feb 22 2018 at 11:51am
The mistake here is using private debt as a model for reserve currency debt of a sovereign giant nation. Debt of the US govt has never and likely never will require repayment. The dollar wealth of citizens and foreign entities is the same as the debt of the US government. Subject to the savings/ consumption preference of non-federal entities, inflation and future tax obligations will NOT increase with increased federal debt, but instead will add to wealth. Many people and governments desire wealth. Overall wealth can only increase if federal indebtedness increases. That is why the assumption in this article that increased indebtedness now must be balanced by repayment later is not appropriate. That assumption is not the whole picture. US government debt is valuable to the world and to US citizens. They desire it. They will continue to desire it as long as we have a stable dollar and a large growing economy. So stop worrying.
Mark
Feb 22 2018 at 1:48pm
Minor quibble: “If the nominal stock of debt rises more slowly than inflation, the real budget is in surplus.”
For it it be a surplus, wouldn’t the nominal stock need to rise slower than the rate of inflation*(1 – the fraction of debt that is inflation protected)? Or something like that.
Lorenzo from Oz
Feb 22 2018 at 8:23pm
The public debt of the British crown after the end of the Napoleonic wars in 1815 was probably well over 200% of GDP.
Of course, then the Industrial Revolution really took off from 1820s with massive expansion of productive capacity.
But there was also a paying debt but not incurring new debt …
Andrew_FL
Feb 22 2018 at 11:43pm
@Lorenzo from Oz
Actually, peaks at just under 200% in 1822, but pretty close!
Don Boudreaux
Feb 23 2018 at 2:40pm
A friendly objection: I believe it to be misleading to call “repayment” all of that which foreigners expect to gain from their transactions that generate trade (or current-account) deficits in the home country.
E. Harding
Feb 23 2018 at 5:18pm
Agreed, Sumner. An underappreciated point is that the biggest contributor to U.S. Federal debt is recessions. The burden of which can be softened by NGDP level targeting.
“If we could run trade deficits forever, that would be really good news. The outside world would be a big Santa Claus for the USA.”
Basically true. In the real world, though, it would be much better for the U.S. if imports became much cheaper.
Mark Bahner
Feb 23 2018 at 8:37pm
But interest on the debt will require payment, right?
Derek
Feb 23 2018 at 10:49pm
In recent chatter about new tax bill, I would like someone to say:
There has been no tax cut, there has been a tax deferral. Gov’t spending = Taxes. QED
Gary
Feb 24 2018 at 3:52pm
Federal spending does not cause taxes. Other than transfer payment, government spending = income to the recipients. A portion then goes back to government in taxes. The Treasury does not collect taxes before it spends. Spending leads to income which allows us to pay taxes. The extreme example is to pay off all the federal debt. This will result in eliminating all the bonds, notes, other federal liabilities, which are the net financial wealth of people, other than the money we owe to each other in private debt, which also balances to zero. The ability of the federal government to credit interest payment to the bank accounts of bond holders is not constrained. The important thing is rising rGDP in proportion to debt service liability. Certainly we don’t want runaway money supply growth. But we are nowhere near any risk of that. We are not Venezuela. Venezuela got in trouble by socializing and destroying private businesses. Cutting corporate taxes in America is the opposite.
Mark Bahner
Feb 25 2018 at 11:35pm
But we’re not in that situation for the next foreseeable years, are we…even if interest rates don’t rise?
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