Krugman is right — public debt is good!

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Lars Pålsson Syll
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Krugman is right — public debt is good!

The U.S. economy has, on the whole, done pretty well these past 180 years, suggesting that having the government owe the private sector money might not be all that bad a thing. The British government, by the way, has been in debt for more than three centuries, an era spanning the Industrial Revolution, victory over Napoleon, and more.

But is the point simply that public debt isn’t as bad as legend has it? Or can government debt actually be a good thing?

Believe it or not, many economists argue that the economy needs a sufficient amount of public debt out there to function well. And how much is sufficient? Maybe more than we currently have. That is, there’s a reasonable argument to be made that part of what ails the world economy right now is that governments aren’t deep enough in debt.

Paul Krugman

Indeed.

Krugman is absolutely right.

Why?

Through history public debts have gone up and down, often expanding in periods of war or large changes in basic infrastructure and technologies, and then going down in periods when things have settled down.

The pros and cons of public debt have been put forward for as long as the phenomenon itself has existed, but it has, notwithstanding that, not been possible to reach anything close to consensus on the issue — at least not in a long time-horizon perspective. One has as a rule not even been able to agree on whether public debt is a problem, and if — when it is or how to best tackle it. Some of the more prominent reasons for this non-consensus are the complexity of the issue, the mingling of vested interests, ideology, psychological fears, the uncertainty of calculating ad estimating inter-generational effects, etc., etc.

In classical economics — following in the footsteps of David Hume – especially Adam Smith, David Ricardo, and Jean-Baptiste Say put forward views on public debt that was as a rule negative. The good budget was a balanced budget. If government borrowed money to finance its activities, it would only give birth to “crowding out” private enterprise and investments. The state was generally considered incapable if paying its debts, and the real burden would therefor essentially fall on the taxpayers that ultimately had to pay for the irresponsibility of government. The moral character of the argumentation was a salient feature — according to Hume, “either the nation must destroy public credit, or the public credit will destroy the nation.”

Later on in the 20th century economists like John Maynard Keynes, Abba Lerner and Alvin Hansen would hold a more positive view on public debt. Public debt was normally nothing to fear, especially if it was financed within the country itself (but even foreign loans could be beneficient for the economy if invested in the right way). Some members of society would hold bonds and earn interest on them, while others would have to pay the taxes that ultimately paid the interest on the debt. But the debt was not considered a net burden for society as a whole, since the debt cancelled itself out between the two groups. If the state could issue bonds at a low interest rate, unemployment could be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden was no real burden according to this group of economists, since — if used in a suitable way — the debt would, through its effects on investments and employment, actually be net winners. There could, of course, be unwanted negative distributional side effects, for the future generation, but that was mostly considered a minor problem since, as  Lerner put it,“if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else.”

Central to the Keynesian influenced view is the fundamental difference between private and public debt. Conflating the one with the other is an example of the atomistic fallacy, which is basically a variation on Keynes’ savings paradox. If an individual tries to save and cut down on debts, that may be fine and rational, but if everyone tries to do it, the result would be lower aggregate demand and increasing unemployment for the economy as a whole.

An individual always have to pay his debts. But a government can always pay back old debts with new, through the issue of new bonds. The state is not like an individual. Public debt is not like private debt. Government debt is essentially a debt to itself, its citizens. Interest paid on the debt is paid by the taxpayers on the one hand, but on the other hand, interest on the bonds that finance the debts goes to those who lend out the money.

To both Keynes and Lerner it was evident that the state had the ability to promote full employment and a stable price level – and that it should use its powers to do so. If that meant that it had to take on a debt and (more or less temporarily) underbalance its budget – so let it be! Public debt is neither good nor bad. It is a means to achieving two over-arching macroeconomic goals – full employment and price stability. What is sacred is not to have a balanced budget or running down public debt per se, regardless of the effects on the macroeconomic goals. If “sound finance”, austerity and a balanced budgets means increased unemployment and destabilizing prices, they have to be abandoned.

Now against this reasoning, exponents of the thesis of Ricardian equivalence, have maintained that whether the public sector finances its expenditures through taxes or by issuing bonds is inconsequential, since bonds must sooner or later be repaid by raising taxes in the future.

In the 1970s Robert Barro attempted to give the proposition a firm theoretical foundation, arguing that the substitution of a budget deficit for current taxes has no impact on aggregate demand and so budget deficits and taxation have equivalent effects on the economy.

The Ricardo-Barro hypothesis, with its view of public debt incurring a burden for future generations, is the dominant view among mainstream economists and politicians today. The rational people making up the actors in the model are assumed to know that today’s debts are tomorrow’s taxes. But — one of the main problems with this standard neoclassical theory is, however, that it doesn’t fit the facts.

From a more theoretical point of view, one may also strongly criticize the Ricardo-Barro model and its concomitant crowding out assumption, since perfect capital markets do not exist and repayments of public debt can take place far into the future and it’s dubious if we really care for generations 300 years from now.

Today there seems to be a rather widespread consensus of public debt being acceptable as long as it doesn’t increase too much and too fast. If the public debt-GDP ratio becomes higher than X % the likelihood of debt crisis and/or lower growth increases.

But in discussing within which margins public debt is feasible, the focus, however, is solely on the upper limit of indebtedness, and very few asks the question if maybe there is also a problem if public debt becomes too low.

The government’s ability to conduct an “optimal” public debt policy may be negatively affected if public debt becomes too small. To guarantee a well-functioning secondary market in bonds it is essential that the government has access to a functioning market. If turnover and liquidity in the secondary market becomes too small, increased volatility and uncertainty will in the long run lead to an increase in borrowing costs. Ultimately there’s even a risk that market makers would disappear, leaving bond market trading to be operated solely through brokered deals. As a kind of precautionary measure against this eventuality it may be argued – especially in times of financial turmoil and crises — that it is necessary to increase government borrowing and debt to ensure – in a longer run – good borrowing preparedness and a sustained (government) bond market.

The question if public debt is good and that we may actually have to little of it is one of our time’s biggest questions. Giving the wrong answer to it — as Krugman notices — will be costly:

The great debt panic that warped the U.S. political scene from 2010 to 2012, and still dominates economic discussion in Britain and the eurozone, was even more wrongheaded than those of us in the anti-austerity camp realized.

Not only were governments that listened to the fiscal scolds kicking the economy when it was down, prolonging the slump; not only were they slashing public investment at the very moment bond investors were practically pleading with them to spend more; they may have been setting us up for future crises.

And the ironic thing is that these foolish policies, and all the human suffering they created, were sold with appeals to prudence and fiscal responsibility.