Some popular misconceptions about the debt and deficit.

Scott Wolla and Kaitlyn Frerking, two St Louis Fed authors, try to enlighten us on the deficit and debt. They make some valid points, but also a few mistakes, which I’ll deal with in the paragraphs below. Their article is entitled “Making Sense of the National Debt”.

The first mistake, which appears in the first two paragraphs, is the idea that government, can increase everyone’s consumption by borrowing, just like a household can temporarily bring about a increase in its consumption by borrowing to go on a world cruise or buy an expensive new car, and do that via borrowing. The authors say:

We live in a world of scarcity—which means that our wants exceed the resources required to fulfill them. For many of us, a household budget constrains how many goods and services we can buy. But, what if we want to consume more goods and services than our budget allows? We can borrow against future income to fulfill our wants now. This type of spending—when your spending exceeds your income—is called deficit spending. The downside of borrowing money, of course, is that you must“ repay it with interest, so you will have less money to buy goods and services in the future. Governments face the same dilemma. They too can run a deficit, or borrow against future income, to fulfill more of their citizens' wants now.”

Unfortunately the world of macroeconomics (e.g. the world of government and the economy as a whole) is very different from microeconomics (which is concerned with individual products, households, firms, etc).

Assuming the economy is at capacity, if government spending is $X more than income, excess inflation will ensue unless there’s an $X CUT in spending elsewhere. Unfortunately borrowing $X won't cut spending all that much. In fact it might not cut it at all. Reason is that it’s the rich who lend to government, and the rich don’t change their weekly spending much in reaction to a change in their stock of cash. In fact, given that they won’t lend to government unless they think they’ll make a profit in the long term, they may actually spend that profit before it crystalizes, i.e. raise their weekly spending!!

Thus in the later “borrow and spend” scenario, government and/or central bank has to find some way of supressing demand to balance the increase in demand coming from the “borrow and spend” exercise. Most commonly the central bank, as soon as it spots the above deficit will raise interest rates. Or it may wait till the above mentioned excess demand and inflation actually materialises before raising interest rates. But the exact timing is not of importance to the basic point being made here.

Thus it just isn't possible, in the words of the St Louis Fed article, for government to arrange for the country as a whole to   “consume more goods and services than our budget allows”. For example, in the case of the above interest rate rise, that will dissuade people from buying new or bigger houses, which of course amounts to consuming FEWER goods.


 Borrowing from abroad.

Having said all that, there is one slight reservation that should be made, which is that if a government borrows from abroad rather than from its own citizens, that will enable the relevant country to consume more than it produces for a while. E.g. if China supplies the US with goods, while the US abstains from paying cash on the nail, and borrows from China instead, that will give the US a temporary increase in living standards.

But only a minority of most countries national debt is funded from abroad, so that point is of limited relevance.


Interest on the debt is an opportunity cost?

The authors’ second error is in the passage starting “However, this does not mean that debt is without cost. It is important to understand that debt has an opportunity cost.”

In fact interest on the debt is simply a transfer from one lot of people to another: it’s a transfer from taxpayers (who fund the interest) to holders of government debt. Now why would that have any influence on government’s ability to “finance other projects”?

Clearly the money grabbed off taxpayers is an opportunity cost in the sense that it then becomes more difficult to grab yet more money off those taxpayers. On the other hand, debt holders are better off in that they’ve received the money grabbed of taxpayers, so it is then easier to milk those relatively well off people. All in all, I suggest there is not much of an “opportunity cost” there.

Put another way if government grabbed $Xbn a year off males and gave the money to females (or vice versa), GDP would remain much the same, and hence government’s ability to “finance other projects” would remain much the same.


Growth in the debt is unsustainable.

Next, the St Louis Fed authors trott out a common concern about the debt, namely that if it’s growing faster than GDP in real terms, that is clearly not sustainable in the very long term, which (allegedly) is a problem.

Well now an accelerating car is an “unsustainable” system: it cannot  go on accelerating indefinitely. That’s first because of speed limits on roads, and second, there’s a physical limit to the speed of any car (determined by its engine size and other factors.)

So are accelerating cars a problem? Well clearly not, because there are (to repeat) natural limits to the speed of a car.

And much the same applies to the debt. That is, while the amount of debt that the private sector wants to hold my rise steadily over a period of years or even decades, there must be some sort of limit that the average household wants to hold (either directly or via pension funds and similar).

To illustrate, if someone on average wages discovered they had ten million dollars of government debt, would they just carry on accumulating it, or would they cash it in at the earliest possible opportunity and go on a bit of a spending spree? I think I know the answer to that.

Conclusion: there are natural limits to the amount of debt the private sector will want to hold.

 
Default.

Under the heading “Debt Risks”, the St Louis Fed  authors then worry about the possibility of a government defaulting on its debt when the debt gets sufficiently large and the private sector starts to doubt government’s intention to repay its debt, with the result that debt holders then start demanding a much higher rate of interest for holding debt.

Well the solution to that problem is easy. If interest demand does rise significantly, government can just tell debt holders to get lost when their existing debt matures. In effect, that equals QE.

Of course that would result in former debt holders having a larger stock of cash than previously, which might result in excess inflation (although the actual effect of QE in recent years does not seem to have been inflationary). But if excess inflation does loom, all government has to do is raise taxes. That will produce a deflationary effect to counter the above mentioned inflationary effect.

Nothing difficult in principle there.