Tuesday, September 6, 2011

Is US government debt a burden on our grand children

You hear this a lot these days from deficit hawks.  Our current government deficit spending, will result in a higher future tax burden.  So better cut back on the debt now,  for the sake of our grandchildren.  It is as if these people forget how fractions work - Debt/GDP.  Debt by itself means nothing, it only has meaning as a percentage of income.  Remember that, US GDP equals all gross domestic income made in the US, given that someone's spending is someone else's income. Thus US debt/US GDP is the relevant figure here.  It is as if the hawks assume the denominator (income) will be static forever.  Only if GDP is static.  What is really static over time is the numerator - debt principal and interest payments.  As GDP and inflation grows over time, the original debt remains the same, that is a certainty.  So what happens when GDP is higher, income will also be higher (since GDP is income) and thus tax payments will also be higher, all without any new tax increases[1].  So even by their misguided logic, you will have more taxes to cover the same debt (which never changes over time), plus more for new debt issuance. Is there a need for an increased tax burden, in this scenario? 

US Debt/GDP history

Take a look at the experience of the US after WWII (1946-1981).  Debt/GDP ratio was 121% in 1946, but by 1981 it was just 32%.  You would think the Government paid down a lot of its debt.  In reality not one cent was paid off. It quadrupled from $271B to $994B. Its not like the government stopped issuing debt after 1946.  But yet the debt/GDP ratio went down, because GDP growth far outstripped debt growth. Yet during the same period, the tax burden remained roughly the same, averaging around 17-18% of income (GDP). This idea that the US government is just like a household has to be jettisoned for good. The government does not need to ever repay its debt, it outgrows it. It has only been paid back once (in 1837), but then a depression followed and the government has been in debt ever since.  How many households can do that and still function?  Does it really matter (even by conventional logic) that the government debt is $100T  30 years from now, when GDP is $200T?

US Debt as % of GDP (zfacts.com)

Austerity hurts

You know what really  hurts your grand children. Its not US debt, it is austerity (lack of GDP growth, due to government budget cuts).  Generally a recession happens when consumer spending (C) and private investment (I) falls due to loss of confidence in the economy, in this case due to the collapse of the housing bubble. As C and I are components of GDP, GDP falls, and income falls as as a consequence. Less income among the same number of people, and guess what, some people finds themselves out of work[2]. Government spending (G), which is also a component of GDP should rise  to prevent a collapse in GDP. Thus, government debt will also rise. Some of this increased spending happens automatically, as social safety net spending increases (unemployment insurance, social security etc:).  This may not be enough, ideally the increase should compensate for the loss in C and I[3].  Yes the numerator (debt) increases rapidly for sometime, but GDP growth catches up far faster than if we had chosen the austerity path.  Austerity is a double whammy.  When the government cuts spending (G) in a recession, not only does GDP fall, but ironically the debt also rises .  Why, because GDP is income, and when income falls, taxes fall, unemployment insurance payments rise, thus actually increasing the government debt. The experience of countries like Ireland who embraced austerity early on should show that trying to cut government debt in a recession actually increases the debt. Looks like the US is slowly heading in the Irish direction.

So far I explored this with mainstream logic.  The mainstream assumption is that taxes fund government spending.  In the case of a state government yes, in the case of a national government under the Euro regime, yes. But for a sovereign issuer of currency, under a floating exchange regime, no.  Why does the issuer of dollars, who can create them at will, need to acquire dollars to make payments in dollars?  In this type of government (US, Japan, Canada etc:) taxes are a form of inflation control[4], not government income.  Yes currently there are restrictions on how the government spends, but they are a self imposed political straight jacket, they are certainly not economic in nature. They should be repealed so we can unleash the full potential of our economy.  The title claim makes even less sense, when you take this into context. The only real economic restriction on government spending is inflation.[5]  Plus lets us not forget that a liability (government debt), is in an asset to some one else.  69% of US government debt is owned by American households and institutions.  If you own treasuries they are your assets not your debt. So if anything your grand children are inheriting interest paying assets not debt.


1. I made things a little simpler so it is easy to follow.  See the Question 5 section here for more detail, on why government budget surpluses are not needed to reduce the debt ratio.
2. Again I simplified things slightly.  For more detail on recessions see here.
3. Not all government spending is created equal.  Some spending is very inefficient, such as tax cuts for rich, or giving tax cuts to business and hope they hire people.  On the other hand direct government spending on creating jobs is far more efficient.  While the modest US stimulus of 2009 did help in GDP growth when it was still active, it didn't help as much (it still helped) in lowering the unemployment situation.  It was far too small and contained too much inefficient spending.  Direct government spending on jobs has not been tried since the 1930s when it was highly successful.  The GDP growth rate then, averaged 10% and employment growth was 750k jobs/month (population adjusted).
4. In this example I am referring to possible inflation due to government deficit spending. There are different types of inflation.  For example supply issues, caused by real shortages or speculation.  The latter type of inflation is what is occurring now in the energy and food markets.
5. There is a range beyond which government spending will cause more than the desired inflation. This range is much wider in recessionary times, while it is much narrower at times of full employment.  But in no way is the money supply proportional to price inflation.  It maybe during times of full employment, but otherwise unlikely.