Debt Mythology

Paul Krugman implies that deficit spending is necessary to jumpstart a floundering economy, and in the process repeats the well-known “we owe it to ourselves” fallacy about public debt in his latest piece.

The implication of the “we owe the debt to ourselves” fallacy is that debt isn’t all that harmful or distortionary because, after all, we’ll simply repay ourselves in the end.   We now examine this and a handful of other popular myths about the national debt…

Myth 1: We Owe it to Ourselves

Unfortunately, the “we” and “ourselves” are simply not the same set of individuals.  Economic analysis should always focus on individual actors, and this simplistic catchphrase obscures exactly which individuals are involved in the debt process.  In reality, certain individuals always owe certain other individuals.  It is paramount to identify the “we” and “ourselves.”  Otherwise, we might as well argue that taxation is harmless because we simply owe it ourselves.  After all, taxes are extracted and later spent on other individuals.  But no one argues that taxation is not onerous simply because we “owe it to ourselves.”  Some will be net beneficiaries of the taxation process, and others will be net losers.

Myth 2: Debt is Less Distortionary than Taxation Because Debt is Voluntary

Economists often point out that debt directs resources away from consumer preferences and into lines of bureaucratic preference.  Other economists will respond that this is not true because while taxation is an involuntary process, debt is financed voluntarily (through the purchase of government bonds).  “See,” say these economists, “this is what (some) consumers prefer.”  However, the involuntary nature of public debt is simply more concealed than the outright coercive nature of taxation.  How does government repay its debt?  Through the taxation which it must levy in the future.  The coercive element is intertemporal, and often ignored.

Armed with the ability to practically guarantee its ability to pay back, the government will be able to divert funds from savers at a lower rate than market participants (because the risk element of the interest rate is reduced).

Debt may also be more pernicious than straightforward taxation because the former targets saving and investment.  Taxation reduces both consumption and investment.  Debt’s exclusive focus on saving/investment shrinks the capital structure, and the ultimate effect is a lower societal standard of living.

Myth 3: Future Generations Must Shoulder the Burden of Debt

In examining the burden of any debt or taxation scheme, the critical issue is how many real resources have been diverted from private use and into bureaucratic use.  Private use of resources is subject to economic calculation—profit/loss statements and asset/liability calculations.  This ensures that societal resources are used for satisfying consumer preferences, and that scarce resources are not wasted.  Bureaucratic decision-making lacks this critical calculation scheme—the use of resources is not constrained by profit-loss because revenues are extracted coercively and benefits are received passively.  Incidentally, this analysis shows us that the best tax scheme is whatever minimizes the transfer of revenue to the state.

This allows us to see that the burden of debt is always in the present.  The state uses its newly acquired funds to purchase resources in the present.  When it later taxes the populace to repay the bondholders, all that it occurs is a redistribution of wealth.  This process is detrimental to some individuals, and beneficial to others, but the net effect is absolutely neutral.  The real transfer of resources, and thus the real debt burden, has already happened in the past (when the government spent the revenue it acquired though sale of its bonds).

Myth 4: The State Can’t Go Bankrupt, So Debt’s Ok!

The argument here is that the state cannot issue “too much” debt because it always has the power to tax or inflate away the debt.  The recent repudiation of 50% of the debt in Greece should disavow us of this notion.  The state can only tax so much before it threatens to crush production altogether; it can only inflate so much before hyperinflation threatens.

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2 Responses to Debt Mythology

  1. krlatham January 1, 2012 at 4:36 pm #

    http://cafehayek.com/2011/12/open-letter-to-paul-krugman-3.html
    A great post dealing with the same issue

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  1. Romer Takes the Economy’s Temperature « Hans Economics - January 6, 2012

    […] any difference in the absence of a profit and loss system.  For more on this fallacy, see here, here, and here. Share this:TwitterFacebookLike this:LikeBe the first to like this post. « […]

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