Nick Rowe, applauded by such luminaries as Don Boudreaux and Bob Murphy, argues that, contrary to folks like Paul Krugman and yours truly, government debt is too a burden on our grandchildren, unless you believe in Ricardian Equivalence.
I want to explain what that means, and why it’s wrong.
To make sure we’re all talking about the same thing, I’m going to adopt all of Nick’s assumptions, most critically that all taxes are lump sum. I’ll come back at the end and say a little more about why this obviously false assumption is the right assumption to make.
Now: Suppose the government borrows money to finance a tax cut. That makes us feel richer. We therefore buy and consume more stuff, which leaves less stuff for our grandchildren to consume. (Nick tells a very nice detailed story about how this might play out across generations; I applaud that kind of detail, but it’s not important for this response.) Government debt is therefore a burden to our grandchildren.
Unless! If we — the current generation — foresee all this, and care about our grandchildren, we’ll choose to (in effect) undo what the government has done by saving our tax cuts and giving them as gifts to our grandchildren (presumably as part of their inheritance). This restores every generation’s consumption to the original status quo.
Ricardian Equivalence is the economist’s jargon for the assertion that we will foresee all of this, and will care about our grandchildren, and therefore will give them our tax cuts as gifts. Nick Rowe’s claim is that unless you make the very strong assumption that Ricardian equivalence holds, government debt enriches us at the expense of our grandchildren.
Here’s why that’s wrong: There’s no “us” that decides whether to save these tax cuts. Some of us can save them, while others spend them. That’s a failure of Ricardian equivalence, but it’s not a burden on all of the next generation. It’s only a burden on that part of the next generation that had greedy grandparents. If you’re not interested in living well at your grandchildren’s expense, then you won’t — and your grandchildren, therefore, won’t suffer.
Here, then, is the main point: Your grandchildren suffer only if you want them to. Bert wants to live well at his grandchildren’s expense; Ernie doesn’t. Therefore Bert spends his tax cut and thanks God for the public debt, while Ernie saves his tax cut and considers the public debt a matter of indifference. In this story, nobody who is alive today actually objects to the public debt. So Nick cannot use this story as a reason for you, me or anyone to become a deficit hawk.
Three more points:
- This is not to say that government debt won’t affect your grandchildren. If I don’t save my tax cut, my grandchildren will be poorer, which means they’re more likely to turn to your grandchildren to finance their Medicare and Social Security. That’s a real effect—but it’s not the effect Nick is talking about. It can’t be, because he assumed lump-sum taxes (as is standard in these discussions, in order to focus on one issue at a time), which means that he’s ruled out this effect.
We all agree that deficits can matter because they have redistributive effects and incentive effects. But those are not at all the same as the alleged burden-on-the-next-generation effect — and the real effects are typically much smaller than the imagined effect. (The whole point of assuming lump-sum taxes is to make these agreed-upon effects go away, so we can see what the other effects might be.) So deficits do matter, but not for the “usual” reasons, and not nearly as much as is widely imagined. This is exactly what both Krugman and I said earlier this week.
- Note that this all plays out exactly the same way whether the American public debt is held by Americans, or by Chinese, or by Martians. Paul Krugman muddied the waters when he pointed out that American debt held by Chinese is largely offset by Chinese debt held by Americans. That might be true, but it has nothing to do with the fundamental issues.
- There seems to be a widespread assumption (at least among econo-geeks) that Ricardian Equivalence is likely to fail because people misperceive the effects of current tax cuts on future generations. There seems to be a further widespread assumption that all those misperceptions will be in the same direction. But why should that be? Politicians, journalists and bloggers admonish us every day that our grandchildren face disaster because of our government’s fiscal irresponsibility. Some taxpayers will take those warnings too lightly, and therefore undersave; others will take them too seriously and therefore oversave. The grandchildren of the first group will be impoverished by our debt; the grandchildren of the second group will be enriched by it. Who can say which group is larger?