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Lenders and Spenders: Confronting the Political Reality of Debt

Tuesday, November 20, 2012

Is federal debt really nothing more than money ‘we owe to ourselves’? No. It frays the political fabric, and we are feeling its effects already.

“The debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources,” Paul Krugman wrote recently in “Debt Is (Mostly) Money We Owe to Ourselves.”

“That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood.... talking about leaving a burden to our children is especially nonsensical; what we are leaving behind is promises that some of our children will pay money to other children, which is a very different kettle of fish,” he added.

If this little lullaby (“the debt is something we owe to ourselves”) helps you sleep, then you may be in for a rude awakening. Government debt frays the political fabric, and we are feeling its effects already.

Think of a simple economy, where the only product is corn. There is no foreign sector, and there are no financial claims more complicated than IOUs.

There are two types of people in our economy: Lenders and Spenders. Sammy Spender and Lois Lender each grow two bushels of corn per year. However, Sammy wants to eat three bushels this year. There are three ways that this can happen.

Private loan: In a purely private transaction, Sammy borrows one bushel of corn from Lois this year and pays her back one bushel of corn next year.

One-time redistribution: The government redistributes corn by taxing one bushel of corn away from Lois and giving it to Sammy.

Government borrowing: The government borrows one bushel of corn from Lois this year and gives it to Sammy. It then pays Lois back out of taxes next year.

In each case, Sammy can consume three bushels of corn this year — the two he produces, plus the additional bushel from Lois. Conversely, Lois consumes one bushel of corn this year — the two she produces, minus the bushel that Sammy gets.

Next year (year two) is where the three cases differ. With the private loan, when Sammy pays Lois back next year, she is the one who will have three bushels of corn and he will be the one with only one bushel.

In the one-time redistribution case, assuming no further redistribution, then next year Sammy and Lois will revert to consuming what they produce — two bushels of corn each.

Every year, the debt creates more and more political division and antagonism.

With government borrowing, the outcome is decided in year two. Suppose that the government pays back the debt at that time. It owes Lois one bushel of corn. If it obtains that bushel of corn by taxing Sammy, then the result is the same as the private loan. If it obtains the bushel of corn by taxing Lois, then the result is the same as the one-time redistribution. If the government gets half of its tax revenues from each, then Lois will have 2.5 bushels of corn to eat (two bushels she produces plus one bushel repayment, minus 0.5 bushels of tax). Sammy will have 1.5 bushels to eat (two bushels he produces minus 0.5 bushels of tax).

In the first year, when the government borrows the money, nobody is unhappy. Sammy gets to eat an extra bushel of corn, and Lois willingly defers consuming one bushel of corn with the expectation of getting it back next year.

However, this sets the political system up for conflict and strife in year two, when the burden of paying the debt has to be apportioned. As we have seen, it could be divided any number of ways. However, consider this: Lois is expecting three bushels of corn, based on what she produces and her expectation of having her loan repaid. Meanwhile, Sammy is expecting two bushels of corn, based on what he produces. There are only four bushels of corn available, and there will be a political battle over who gets disappointed the most.

It gets worse.

In fact, in year two, the government will not want to resolve the issue of distributing the cost of the debt. Paying off the debt requires incurring political cost. The easiest thing to do is instead to roll over the debt. Moreover, Sammy is used to eating three bushels of corn, and the government does not want to have him face austerity. So it goes to Larry and Lena Lender for a loan of two bushels of corn. The government pays back Lois with one bushel and gives the other bushel to Sammy. It goes into year three with a debt of two bushels of corn.

As you can see, the political incentive for the government is to go deeper and deeper in debt. This in turn raises the stakes in the political conflict over who will bear the burden of tax increases and spending reductions. Every year, the debt creates more and more political division and antagonism.

It gets worse.

As the debt spirals out of control, governments of failing states resort to what economists call inflationary finance. They cannot find enough Lenders to continue to pay off the Spenders. So they borrow from their central bank. The central bank in turn can only expand its lending by creating more money.

In 2011, the Federal Reserve bought 77 percent of new debt issued by our government. We are already resorting to inflationary finance.

At the moment, there is little inflation taking place and there appears to be very little on the horizon. However, the Federal Reserve balance sheet is like a pile of kindling soaked in gasoline. So far, no match has been lit. What happens if a fire does start — if inflation rises to 4 or 5 percent?

Many of the securities that the Fed has acquired are long-term bonds and mortgages. As inflation and interest rates increase, the value of these securities plummets.

Once inflation reaches those levels, the Federal Reserve will want to reduce inflation, or at least to contain it. To do so, it will need to sell government securities, probably in record amounts. This will put more pressure on the government to borrow from private Lenders. It will make it much harder to balance the budget. The Fed is going to be caught between a rock and a hard place. If it fights inflation, the political system will be stressed by the challenge of allocating budgetary pain. If it fails to fight inflation, it risks hyperinflation.

It gets worse.

Many of the securities that the Fed has acquired are long-term bonds and mortgages. As inflation and interest rates increase, the value of these securities plummets. (A bond that pays 2.5 percent interest loses roughly half its value when market rates rise to 5 percent.) In this scenario, the Fed will be incurring losses, which will require a subsidy from the government budget. Thus, the challenge with balancing the budget gets even more difficult.

Another term that economists have coined in the context of government debt is “sudden stop.” What that means is that when all other sources of lending have dried up and the public's tolerance for hyperinflation has been exhausted, the government must suddenly balance its budget. That is how government debt crises typically end. At that point, the irreconcilable expectations of Lenders and Spenders are resolved, one way or another. 

The political conflict created by the debt in the United States is as large as it is in Greece. I believe that Americans will not be as prone to violent demonstrations, but the underlying anger will be there nonetheless.

The burden of the debt is that we create an ever-deeper conflict of interest between Lenders and Spenders. Yes, if you think of Lenders and Spenders collectively, you can say that “we owe the debt to ourselves.” But that is a dangerously vacuous way of looking at it. Large government debt is a recipe for a bitter political stew.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for econlog, part of the Library of Economics and Liberty.

FURTHER READING: Kling also writes “Reforming the Housing Transaction,” “Who Needs Home Ownership?” and “How to Think about QE3.” Steve Conover asks “What Does ‘Fiscal Responsibility’ Mean?” Kevin A. Hassett describes how the country is “Crushed by Debt.” Aspen Gorry and Matthew H. Jensen offer “A Simple Measure of the Distributional Burden of Debt Accumulation.”

Image by Darren Wamboldt / Bergman Group