Pundits, inside and outside of government, make a big deal out of the problems of national debt. Before you understand the problem of national debt you must understand the truth behind what they say about national debt.
Having the federal government borrow money to finance its operation does not really amount to the large problem some people believe. The real problem consists of the misallocation of resources caused by government “spending.” Government borrowing simply provides another way of financing the misallocation. The real risk from government debt comes from the effect that it has on financial markets, not the impact that it has on the economy.
Who Really Pays
Many people claim that national debt creates a burden for “our children.” As long as we have a progressive tax system, “our children” will never bear a large portion of the current tax burden nor will they bear the burden of government debt.
When the time comes to pay national debt — if that ever occurs — it will be the children of rich people, or new rich people, who bear that burden. We can’t understand how big a problem national debt will cause until we understand exactly who pays it and what happens to the money in the interim.
Occasionally a person will claim that government debt does not represent a problem because we “owe the money to ourselves.” The problem, as I mentioned in my opening, does not consist of who owes money to whom but the deleterious effect of resource allocation through government “spending.”
Government finance consists of a very complex subject. A person can never achieve a real understanding of the problems and its ramifications.
Walk with me through three diagrams that I hope will give you a handle on why government debt by itself does not represent a large problem.
Government Finance Without Borrowing
The diagram below represents a very simple model of how government finance should work. In order to pay for its outlays government must collect taxes. In this example, they collect an equal amount from Taxpayers A and B, and they collect next to nothing from Taxpayers C. Those taxes represent the bulk of government receipts with which it pays its outlays. (To simplify this model, I have left out other forms of government revenue — park fees, license fees, etc.)
Also, forgive me for using the word “outlays” instead of the commonly used word “spending.” For me the word “spending” connotes exchanging something for value. Most of what government calls “spending” consists of redistribution; so, it doesn’t deserve to be described as “spending.”
You can see from this very simple example that government taxes finance all government outlays. For the purpose of these examples, I make no argument about the validity or you effectiveness of the government outlays.
In the next model I will show how government uses borrowing to finance some of its outlays.
Government Finance Including Borrowing
Government must always receive enough money to equal its outlays. When it doesn’t receive enough in tax revenues, it must borrow the balance. The diagram below depicts that process in a relatively simple form.
As in the previous diagram Taxpayers A and B split nearly the entire tax burden between the two groups, and Taxpayers C contribute next to nothing. In this case, however, Taxpayers A and B play different roles. Taxpayers A, mostly entrepreneurs, invest most of their income into various investments. Taxpayers B invest most of their money in government bonds.
Thus, Taxpayers B provide all the money the government borrows. This allows Taxpayers A to delay their tax burden for an undetermined time. Because of this tax deferral, Taxpayers A have more money to reinvest than they would have if government had collected enough tax revenue from A and B to cover its outlays.
This process has the effect of temporarily transferring the liability of Taxpayers A to Taxpayers B. Does this mean that the children of Taxpayers A face an additional tax burden in the future? Yes. But, some benefits accrue to the errors of Taxpayers A. Government acts, in effect, as an intermediary for a low interest loan from B to A.
I will attempt to demonstrate this in hypothetical example below.
The Real Effects of Government Borrowing
The diagram below represents a hypothetical situation in which, instead of lending money to the government, Taxpayers be lend the same amount of money directly to Taxpayers A — with a guarantee from the government.
This diagram, of course, does not represent how government financing actually works, but it does represent the real effects of government borrowing.
[I think you can see that I could’ve made a simpler diagram. I left this diagram in the same format as the previous diagram so you could see the effects of simply substituting “Taxpayers A Borrow” for “Government Borrows.”]
In this case, Taxpayers A receive what amounts to a low interest loan from the Taxpayers B, at a preferred interest rate. Of course, Taxpayers A will eventually need to repay the debt, but, in the interim, they receive a return on the money they don’t pay in taxes and can invest.
If the financing arrangement were done according to this hypothetical example, no one would complain about the burden imposed on future generations. People see a big problem, however, if when government achieves the same results by doing the borrowing itself.
I have not discussed the influence of foreign lenders to our government. That process can become very complicated depending on how foreign banks deal with that money. If, for example, they expand their own money supply in order to acquire US dollars, that will hold down the price of US imports giving a benefit to US consumers, and causing inflation in their own country.
So, why should we consider government debt a problem?
The biggest risk of massive government debt arises in the financial markets. When government debt rises to the point where investors doubt that the government can raise enough tax revenue, the price of those bonds will decline significantly causing disruption to financial markets. That disruption can feedback into the “real” economy.
I have attempted to explain a very complex issue with a few words and diagrams. But, above all else, I want you to comprehend that complexity.
When someone tells you that the rising federal debt represents a huge problem, and a huge burden for “our children,” remember the complexity of the process. Don’t consider the results all good, all bad, are all benign. You need to know who’s paying the taxes, who’s getting a tax deferral as a result of government borrowing, what they’re doing with that deferred tax revenue, and what effects it has outside this simple example.
The real problems arise from the redistribution resulting from government “spending.”