Defici(en)t Thinking

Gerald Seib, in the Wall Street Journal, reports that “There is a cancer eating away at the budget from within, one that steadily drains American wealth, sends much of it overseas and only gets worse over time.”

This is economic illiteracy in spades. The fact is that every single dollar of interest we pay on the national debt comes right back to the pockets of American taxpayers. If you don’t understand that, then you’re not thinking clearly about the national debt.

Suppose the government owes $100 and pays $3 a year in interest. The alternative to paying that interest is to raise current taxes by $100 and pay down the debt. If you do that, taxpayers are going to have $100 less in assets, and will therefore earn less interest on their savings. That costs them (roughly) the same $3 a year.

In other words, the damage was done back when the government spent that $100 in the first place. (Of course, if the $100 was spent wisely, the damage might have been worth doing. Or not.) Once that $100 has been spent, the taxpayers are out $3 a year forever regardless of whether the debt is ever paid off.

That’s why I say that the government’s interest payments come right back to the pockets of American taxpayers. The government pays $3 a year as an alternative to taxing you $100 and paying down the debt. The choice to do that puts an extra $100 in your savings account, which earns you $3 a year. There’s the $3 a year coming right back to you. Notice that it comes back to you regardless of whether the government makes its interest payments to Americans, Chinese or Martians. All of the benefits come back to American taxpayers.

Of course, you might choose not to save that $100 the national debt is saving you. That’s fine. Then presumably you’re spending it on something that you value more than an interest flow of $3 a year. Congratulations. You’re a winner.

Or you might grumble that you have no savings vehicle that will pay you the same rate as the government’s paying on its debt. That’s where you’re wrong. You can save by buying government bonds. That will get you exactly the same rate the government’s paying on its debt.

None of this is to say that government debt is entirely without important economic consequences (though I think that might be true). It is to say that the consequences are nothing at all as Gerald Seib (along with so many others) describes them.

If the government borrows an extra $10 trillion dollars tomorrow in order to cut taxes by $10 trillion, it will have to make, say, an extra $300 billion a year in interest payments (for which we are collectively responsible) and at the same time, we’ll collectively earn an extra $300 billion on our savings portfolios. No favor to the taxpayers, but no harm done either.

It’s important to understand this in order not to be bamboozled by tricksters who try to misdirect every conversation about government spending into a conversation about government debt. It’s spending, not debt, that can impoverish us, and that’s what we should be talking about.


39 Responses to “Defici(en)t Thinking”

  1. 1 1 Harold

    Thanks for a clear description. I would just say that you and Krugman seem to be in agreement about it not being the deficit that is the problem. You both think tricksters are using this argument. He thinks the tricksters are people that want to cut spending instead of increasing taxation. Now, however much you do not agree with raising taxes as a policy, you cannot fault the logic tht *IF* the deficit were the (only) problem, it could be solved by raising taxes as well as cutting spending. You also cannot disagree that there are people (like Sieb you quote above) that are saying we need to cut spending *in order* to reduce the deficit. Krugman is pointing out that some people who want to cut spending are using the deficit as the reason. The trickster is Sieb, not Krugman (in this particular instance).

  2. 2 2 AC

    I agree with your point — I always say it is spending, not the deficit, that is the problem. But the way that you phrase it, it sounds like the government is benefiting the public by making interest payments. It’s true, the alternative is taxes, but that’s like saying I will benefit you if I don’t hit you in the head with a hammer.

  3. 3 3 Dan

    You mention that government debt might or might not have “important economic consequences”. What are they?

  4. 4 4 Alan Gunn

    I don’t disagree at all, but isn’t there a sense in which financing spending sprees by borrowing rather than by raising taxes does harm for exactly the reason you give: economic ignorance? If the government had to raise taxes as soon as it committed itself to spending money, it would be a lot harder for politicians to hide the costs of their programs. Even today, a lot of people who ought to know better keep insisting that the Social Security trust fund “has” trillions of dollars it can use to pay benefits until 2037 or some such, so there’s no need to raise retirement ages, etc., today. If the payroll taxes, or some other tax, were rising as fast as the obligations, those paying them might pay attention.

  5. 5 5 Silas Barta

    Or you might grumble that you have no savings vehicle that will pay you the same rate as the government’s paying on its debt. That’s where you’re wrong. You can save by buying government bonds. That will get you exactly the same rate the government’s paying on its debt.

    Right, as long as you can evade the taxes on that interest income.

  6. 6 6 Cyril Morong

    The one thing we want to avoid in the future is taxes that are too high that harm economic efficiency. It is probably better to have 10 years with an income tax of 10% than 5 years with no income tax and then 5 years with an income tax of 20%. I think the overall deadweight loss to the economy is much greater in the second case. If you double a tax, the deadweight loss quadruples. If you triple a tax, the DWL increases 9 times. So every incremental tax increase harms economic efficience more than the last one. I think Robert Barro wrote an article related to this and said something like “we want to minimize the future discounted value of all deadweight losses.”

    Imagine if the taxes got so high we would not have any economic activity at all. Then we would really see the cost of the huge deficits now. But I agree that, in general, the more important question is what the money is being spent on now.

  7. 7 7 Steve Landsburg

    Silas Barta:

    Right, as long as you can evade the taxes on that interest income.

    I remember making exactly the same mistake! I wrote the following note in penance: . The tone is light-hearted, but the point is serious: Taxpayers are not currently on the hook for all of the interest payments on the national debt. They are on the hook only for those interest payments minus the taxes the govt collects on those interest payments. So to cancel the effects of your share of the debt, you only need to earn the govt bond rate after taxes, not before.

  8. 8 8 nobody.really

    What Alan Gunn said.

    I share Landsburg’s frustration that people can’t speak about debt except in emotional terms: stigmatizing debt, treating it as a form of sin. Yet I sometimes wonder if Landsburg is unduly dismissive of emotional thinking. Perhaps social stigma arises as a tool, albeit a blunt tool, for managing market failure.

    Landsburg regularly remarks that government actors are not subject to many of the same forces that constrain non-government actors from engaging in imprudent/self-indulgent conduct. A prohibition on (or stronger social more against) debt, whatever its other shortcomings, would require government actors that propose to spend to confront the constituents they propose to tax, contemporaneously. This would help mitigate the market failure Landsburg complains of.

    To be sure, actors within private bureaucracies are prone to debt, too – assuming that they believe that they will not bear the full consequences of their actions. We observed over time that various executives would be willing to offer deferred compensation to their employees – often in the form of pensions and retiree benefits – knowing that the executive would be long gone before any of those obligations came to fruition. Congress addressed this market failure in 1974 by passing ERISA, which (roughly) requires firms making commitments today to make payments tomorrow to make payments today to fund those commitments tomorrow.

    To mix threads, I wonder that Landsburg’s aversion to collective bargaining by public employees might not be better addressed if public entities were subject to ERISA-type laws. That is, public unions would be free to negotiate collectively for whatever mix of compensation they find optimal, but public officials would know that they could not get out of any labor disputes simply by offering more deferred compensation; each dollar of additional compensation of whatever kind would require additional revenues to be set aside contemporaneously. This would give officials the appropriate incentive to push back on employee demands, because the officials would know that they’d have to face the voters.

  9. 9 9 Richard

    Of course there is harm done in borrowing 10 trillion. If you don’t raise taxes to pay for the interest payments, you have to print money. That leads to hyperinflation.

    Yes, the money will come back to Americans, but will it be worth anything at that time?

    It’s amazing that an economics professor can be so disingenuous.

  10. 10 10 Harold

    Re important economic consequences. One thing Govts are desparate to avoid is being downgraded by the ratings companies, Moodys etc. This happened to Greece, and means they they must offer above going rate interest to borrow money. So you might be out $6 per year instead of $3 per year. This all depends on the opinions of these companies, who earn their money from (and use the same testing models as) the very people they are assesing. Crazy system, which led in no small part to the meltdown.

  11. 11 11 Ken B

    @Harold: Perhaps in the case you mention (Greece) the real problem is that Greece has too much govt spending already. If govt spending is the problem because it reduces overall output then there is only so much a country can sustain. In any event I think SL’s argument holds for 6 as well as 3. Why precisely does the higher rate vitiate his argument do you think?

  12. 12 12 Harold

    Ken B, I wondered if it made any difference whether the rate was 3 or 6. I am not sure it does, but Govts certainly are afraid of it happening to them. I was thinking that if the govt paid off the debt, it would cost $3, but paying the new interest rate costs $6, but I am not sure if this is right.

  13. 13 13 Silas Barta

    @Steve_Landsburg: None of that contradicts my claim that you are in error to say that the ROR on government bonds is equal to their interest rate. Even with the effect described, you are not earning “exactly the same rate the government’s paying on its debt.”

  14. 14 14 Steve Landsburg

    Silas Barta: After abstracting from many things that might in fact be important (e.g. different people being in different tax brackets etc) you are in fact earning *exactly* the same rate that the govt is effectively paying. If the govt pays 3% interest, but collects half that interest back in taxes, then it is really paying only 1.5%, which is exactly what you can earn (net of taxes) by buying govt bonds.

  15. 15 15 Ken B

    @Steve: In your response to Silas Barta don’t you assume the gov’t won’t default on the bonds? (Mr Landsburg, meet Herr Schacht.) Or are you arguing that is baked into the interest rate?

  16. 16 16 Mike

    It seeems that this does not necessarily hold true if the interest rate is including a risk premium for the possibility of default (or high inflation). In that case you are paying (value of money)+(risk of default) and getting benefits of (value of money).

    I’m not sure how that works out with buying government debt, on average you get equal returns but the average citizen probably has lower risk tolerance than the typical bond buyer.

  17. 17 17 Doc Merlin

    Agreed Steven, government spending is the problem, not taxes. However you slightly (very slightly) misunderstand the role of debt. Due to incentives in financing the debt, it encourages the state to artificially lower interest rates below what they should be. This has a very real dead weight loss both from increasing inflation and from causing mis-pricing in asset markets.

  18. 18 18 Fake Name

    One section from the article jumped out at me –

    “When the government pays for health care for its poor and elderly, a valuable social benefit is delivered. When Americans get a Social Security check, the money by and large stays in circulation in the American economy.

    The same can’t be said for interest payments, which take money out of the private economy, sending much of it to foreign investors who hold American Treasury bonds and provide no services in return.”

    Uh Mr. Seib, the debt allowed us to spend money on things which provide a “valuable social benefit” such as Medicare and Social Security.

  19. 19 19 Scott H.

    The big problem that I see is that NOBODY in the USA knows their portion of the debt and therefore how much any particular spending affects them. Given that void, its difficult to really have a rational conversation about your interests.

    A short list of some considerations important for MY portion of the current debt:

    1.) How long will I live?
    2.) How much will the economy grow until #1?
    3.) What will my income future look like?
    4.) What will happen to tax rates?
    5.) To what extent will debt be monetized? Or, what will inflation look like?
    6.) What will happen to interest rates?

    With our current spending levels I believe there are many, many people who figure they will not be materially participating in either paying interest or principal. Yikes!

  20. 20 20 Will A

    @ Scott H.:

    I wouldn’t say “Yikes!”.

    Apparently the net worth of U.S. households rose to $56.8 trillion in DEC 2010. The U.S. annual income is about $13 trillion. This should be more than enough to cover a $ 14 trillion debt.

    To put this in perspective, this is like a person who has a net worth of $ 1 million and an income of $ 225,000 having an outstanding loan of $ 250,000.

  21. 21 21 Bob Murphy


    I think the idea that “money going abroad stops helping us” is far worse than the idea that “paying interest on the debt makes taxpayers poorer.”

    For example, your point rests on the view that if the government doesn’t pay down the $100 in debt, then it will have to tax by that much. But why couldn’t the government just cut spending elsewhere by $100 to pay off the debt?

    (I realize you are holding other things constant etc. I’m just pointing out that it’s not obvious you have established the true tradeoff at stake here.)

  22. 22 22 Scott H.

    @ Will A

    I agree with the idea that today’s debt load is managable.

    The yikes! comes from current federal spending being 175%+ of current federal revenue — with more of the same for the foreseeable future. At least around my house that gets a Yikes! I’m not sure if the analogy still holds, but usually at that point the breadwinner tries to cut spending.

  23. 23 23 Will A

    Scott H.:

    I think that the 175%+ of revenue is kind of irrelevant for the reasons that Steve points out.

    Apparently the President’s budget request for 2010 totals $3.55 trillion (~30% of Tax Payer Income). We could choose to finance the whole thing and Americans could invest 30% of their incomes to pay future increased tax bills or buy more valuable assets. Or we could collect taxes totalling 30% of Tax Payer Income. (I guess we could even collect more than 30% and give ourselves back a being American bonus).

    It seems to me, the percentage to look at is not government spending as a percent of government revenue.

    The better percentage to look at would be government spending as a percentage American Income. This would seem to really be what our (Americans in total) tax rate will be.

  24. 24 24 Harold

    Ken B: I was not saying that paying higher interest alters Steve’s argument at all. I was adressing the “other consequences” part. I think paying 6% instead of 3% is worse. I also think Greece has massively overspent – I am not pro all Govt. spending, nor anti all Govt. spending. But the downgrading has made a bad situation for the Greeks worse (but may have made it better for others who lend them money).

  25. 25 25 Ken B

    I think I can illustrate Steve’s point with an example.

    The village government decides to put 100 chickens in a blender.
    (Spending 100 chickens to make a vat of puree).
    To avoid borrowing the 100 villagers must all bring in a chicken today.
    (The spending is financed by current taxes.)
    A week later the 100 viallagers are each out 1 chicken and 7 eggs.
    In a second identical village the government instead borrows 100 chickens from
    farmer Bob, with a loan to be repaid in 7 days.
    A week later the government pays off this loan when the 100 villagers bring in a chicken and the 7 eggs it laid.
    Bob is paid back the 100 chickens and 700 eggs.
    (The eggs are interest.)
    Each villager is poorer by 1 chicken and 7 eggs.

    Was it the borrowing or the blender that impoverished them?

  26. 26 26 Ken B

    I should point out my chicken puree example is not entirely fanciful. FDR in the New Deal and Trudeau in Canada in the 70s did pretty much precisely the same thing.

  27. 27 27 Neil

    To me, the deficit Cassandras are simply pointing out the future consequences of government spending that is not financed by current taxes. Nothing wrong with that. In Ken B’s allegory, the villagers go along their merry way while the government borrows chickens from farmer Bob (China) every week. Due to fiscal illusion, none see the fact that their future chicken flocks are being depleted, so a Cassandra is needed to warn them. Of course the government could always screw farmer bob and default. But farmer bob has already factored that into the equation in terms of the number of eggs interest he demands in order to lend them chickens.

  28. 28 28 Will A


    In order to know if future chickens are being depleted you need to know the total number of chickens and the rate at which the chicken population grows.

    If the chicken population grows at a faster rate than the interest being charged, then it would make more sense to borrow chickens.

    If Americans finance $ 14 trillion dollars at 4% for 30 years, but American net worth grows at 5% annually during that time, we wouldn’t be throwing away future dollars by financing the debt.

  29. 29 29 cmprostreet

    @ Richard
    “Of course there is harm done in borrowing 10 trillion. If you don’t raise taxes to pay for the interest payments, you have to print money. That leads to hyperinflation.

    Yes, the money will come back to Americans, but will it be worth anything at that time?”

    We borrow $10 Trillion at (say) 5% interest. All of it is spent immediately on a project we would otherwise have pursued anyway via tax revenues (I assume this is the case since you left out the possibility of using the $10 Trillion to pay off portions of the interest on itself).

    If the US prints money to cover the interest payments rather than raising taxes, then Americans’ savings and assets earn higher (nominal) interest rates to account for that inflation, leaving us no worse off.* However, our interest payments owed to holders of government debt have not nominally increased, so we gain by paying them back with dollars which are worth less than expected.

    *Save for the costs of inflation itself, e.g. shoe leather, menu, and uncertainty costs. However, the likelihood of the US hyper-inflating its way out of its debt due to its refusal to raise taxes, to the detriment of its own taxpayers, and without having been priced into the debt to begin with, seems about as likely as the scenario where all bondholders’ bonds are suddenly lost in a fire and no longer need to be repaid. Oddly, that possibility was not analyzed either.

  30. 30 30 Neil

    Will A,

    A growing stock of chickens allows the villagers to borrow against their future wealth and consume more (or waste more, in Ken B’s example)now, but we are talking about debt growing more rapidly than the stock of chickens. The example simply asssumes a growth rate of chickens equal to zero for simplicity. Nobody would care about the deficit if the economy were growing at 5% and the debt were growing at 4%.

  31. 31 31 Doc Merlin

    @Bob Murphy
    “For example, your point rests on the view that if the government doesn’t pay down the $100 in debt, then it will have to tax by that much. But why couldn’t the government just cut spending elsewhere by $100 to pay off the debt?”

    He makes that point later, sort of.
    ‘It’s spending, not debt, that can impoverish us, and that’s what we should be talking about.’

  32. 32 32 Neil

    Of course, if the villagers are already indebted to farmer bob (china) for X chickens, they could pay that debt off and be no worse off than they were before. Unless, that is, the government-borrowed chickens were pureed. So it is really the fact that the government chickens were pureed that impoverished them. If not, they break even.

  33. 33 33 Harold

    Depends on the value of chicken puree.

  34. 34 34 Bill

    Statements in the Seib article related to payments of interest to Chinese purchasers of U.S. government debt and the assertion that “this represents a giant transfer of American wealth overseas” are bothersome. While I agree that interest on government debt is a burden on taxpayers, I don’t see why interest paid to parties living outside the U.S. is any more of a burden than is interest paid to parties living in this country. First, like dollar payments made to foreign suppliers of goods and services, foreign lenders will be using those dollar interest payments either to purchase U.S. goods and services, to invest in assets in the U.S., or to supply loanable funds to borrowers in this country. So, in this regard, the interest paid to foreigners is no different than is the interest paid to domestic lenders. Secondly, the interest payments made to foreign holders of U.S. debt represent a payment in exchange for the use of borrowed funds, so how can this be thought of as a “transfer of American wealth overseas”? When any of us makes a purchase, whether that be for food, for clothing, or for anything else including interest payments on a loan, we do so in order to acquire something we value more than the money we give up in order to make the purchase. Voluntary exchange is a “positive sum transaction” with both parties to the exchange expecting to benefit. Thus, my discomfort with the notion of “transferring American wealth overseas.”

  35. 35 35 S.V.

    A post about Nuclear energy?

  36. 36 36 Tagore Smith

    Thanks. I have been trying to explain this to people for years. Debt is fine.. excessive spending that does not produce a return is not.

    But I think that people will not get this until it is too late.

  37. 37 37 BestQuest

    Rather than raising taxes by $100, the government could simply default on the debt. The only people who would be hurt are the guilty: The tyrants, the people who fund them (by lending them money), and the greedy recipients of stolen loot (defense contractors, Wall St. welfare queens/kings, labor monopolists, and similar parasites).

  38. 38 38 Lawrence H. White

    “Once that $100 has been spent, the taxpayers are out $3 a year forever regardless of whether the debt is ever paid off.”

    Steve, I get the present-value equivalence of (current taxes avoided by $100 borrowing) with (future taxes entailed by the same $100 borrowing). I agree that the amount the government spends is what matters for the size of the burden it imposes, not whether the taxes come sooner or later.

    But you might want to address the Buchanan-Wagner argument that the amount of spending isn’t independent of the finance method. The taxpayers who would be taxed $100 today are not identical to the group who end up paying $3 a year forever. Borrowing obscures the burden to current taxpayer-voters or allows them at least partially to avoid it (shifts it on to people not currently voting). Some people don’t have heirs or don’t leave them bequests; the taxpaying population grows through immigration. It BW are right, then we invite more (too much) spending by allowing it to be debt-financed.

  39. 39 39 Steve Landsburg

    Lawrence H. White: This is of course an important point and one I’ve written about elsewhere. But I think it would be a considerable stretch to argue that this was what Mr. Seib (in the article to which I was responding) had in mind.

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