Our National Debt Matters

Paul Krugman recently advanced an interesting theory in a piece for the Houston Chronicle. The Nobel economist argued that “Debt matters, but not that much”. The crux of his argument is that in the case of the United States national debt, it is mostly money that America owes to America. Because Americans own the vast majority of outstanding treasury bonds, we will simply be giving money to ourselves when we do eventually get around to repaying. This, Krugman argues, is very different than the debt a family owes on its mortgage. In the case of a family, the money owed is money the family will lose in the future. Whereas the mortgage debt is only a liability for a family, our national debt is both a national liability and a national asset for a the country. The implications of this reasoning for government policy – if correct – would be significant. Rather than obsessing about what programs to cut and whom to tax, we could deploy more money to cure joblessness, improve education, provide healthcare, and maybe even colonize the moon (if you haven't been following the Newt Gingrich campaign, you might be interested to know that the former Congressman says he plans to establish a permanent base on the lunar surface if elected president). Indeed, Krugman says that Washington is excessively focused on “the allegedly urgent issue of reducing the budget deficit.”

I wish Mr. Krugman were correct. Unfortunately, he is mistaken. Our national debt does indeed matter very much and repaying it will involve national hardship, much like that endured by a family repaying an imprudently large mortgage. When the U.S. Government spends more money than it receives in revenues, it sells bonds to raise cash to cover the shortfall. Historically, Americans have purchased the majority of these bonds. Krugman suggests that when the owners of the bonds are also Americans, it follows that America is not really losing anything. Tax revenues will have to be higher in the future to repay this debt, but future Americans will be receiving most of this cash. So America is not losing substantial sums of wealth. True. But this analysis misses the crucial point.

Deficit spending diverts capital from private markets. That can be good or bad. When government deficits are used to increase future productivity, they can actually increase a nation's wealth. Borrowing money to build a strategically placed bridge or a successful research facility, for example, is often profitable for a country because the economy will be more productive in the future. But when the spending does not result in investment that increases economic productivity, the debt created will cause a decrease in future living standards. Borrowing money to fund wars in Iraq and Afghanistan, for example, has done little to improve our economic productivity and has diverted resources from activities that would make us wealthier in the future.

A useful way to illustrate the downside of indebtedness is a stylized comparison. First, consider a country – call it Austerity – with a fiscally conservative government that balances its budget. The people of Austerity collectively save 1 billion per year. Since there are no government bonds to buy in Austerity, families invest savings in stocks and bonds issued by corporations. The 1 billion in capital that the corporations receive each year is used for new factories, research, and training programs to improve employee skills.

Contrast Austerity with its neighbor Stimulus. Stimulus is economically similar to Austerity, except that the government has decided to lower taxes by 500 million and sell 500 million in government bonds to cover the shortfall. Because the people of Stimulus have an extra 500 million in disposable after tax income, they both spend and save more money than their neighbors. Stimulusarians save a total of 1.25 billion per year and spend an extra 250 million. Of the 1.25 billion in savings, 500 million is invested in government bonds. That leaves only 750 billion to invest in corporations. As time goes by, the corporations of Stimulus – which have have less money to spend on improving productivity - become increasingly less productive than corporations in Austerity.

On average, retirees in Austerity are able to build up retirement savings of 500,000. All of theses savings are in corporate bonds and stocks. Because of lower taxes, Stimulusarians are able to save 625,000 for retirement. 375,000 is invested in private markets and 250,000 is in the form of government bonds. But Austerity is really a much wealthier country than Stimulus. In Austerity, retirees leave future generations a nation that can produce more output per person than the economy of Stimulus. That is why the value of corporate investments in Austerians' retirement accounts is 33% higher than the value of private investments in Stimulusarians' accounts. In both countries, retirees will stop working; they will rely on the productive capacity of younger generations to feed, clothe, and take care of them. But because Austerity is able to produce more per worker, younger generations will pay lower taxes and enjoy a higher standard of living.

Amidst the recent roller coaster of booms, bubbles, busts, bailouts and Bernanke press conferences, it is easy to forget that investing is supposed to be about lending capital to help foster innovation and growth. When governments run deficits, they divert capital – and therefore real resources - from private markets. Depending on how the government uses that capital, both superior and inferior economic outcomes can be achieved. Oftentimes, governments use deficits to fund entitlements, military spending, and other activities that do not increase future economic productivity. When this happens, future generations must bear a burden that causes their real living standards to decline.

None of that is to say that deficit spending is inherently bad or that providing a social safety net is not an excellent policy. Rather, when we do run deficits, we must keep in mind that we are diverting capital from private markets and creating a burden on future taxpayers. Only when those costs are outweighed by the benefits of deficit spending should we spend more than we receive in tax revenues. Unfortunately, the United States is currently using deficit spending to pay for wars and underfunded social programs that do little to increase productivity. Contrary to Krugman's assertion, this will indeed matter very much to the future American way of life.