Tuesday, April 30, 2013

Guest post: And here's how the debt gets paid off!

Guest post by MNE reader, Ben Strubel.

“Perhaps the issue that causes the most confusion is the mechanism by which deficit spending now is “paid for” in the future.

Most people assume you “pay for” deficit spending the same way you do in your personal life. For instance when I go to the gas station and fill up my vehicle I always pay by credit card. The bank that issues the credit card effectively loans me money which I then use to pay the owner of the gas station.
So I just deficit spent $60. When the end of the month comes around I always pay off my bill in full so I’ll need to pay back the $60 the bank loaned to me via the credit card. If I go in debt now by $60 I will eventually need to pay it off and I will be using either money I have saved up or taking money from my future income.

If I decide not to pay my bill, that will work for awhile. I can transfer balances between cards. I can just make minimum payments. But, at some point in the future my charade will collapse and if I don’t pay up I’ll end up in bankruptcy court with the sheriff showing up to auction off my assets. Not a good outcome.

Most people assume that the government functions the same way. If the government “spends money it doesn’t have” to build a new bridge people will assume that the government will either need to raise taxes in the future or cut other spending to eventually pay for the bridge. Or they can just “kick the can down the road” (this phrase needs to banned from Washington). If they don’t eventually cut spending or raise taxes than conventional wisdom says that at some indefinite point there will be some sort of collapse.

It’s important to notice how no one is ever able to explicitly explain what exactly is going to happen. It’s always vague and uncertain threats. It could be hyperinflation. It could be bankruptcy (this is my personal favorite, where pray tell is the bankruptcy court for countries that issue their own currency?). It could be worrying the job creators enough that they go on strike and don’t hire anyone (also my favorite, I know of very few businesses that would voluntarily turn down sales). It could just be a “burden for our grandchildren” or a “millstone around the neck of future generations”.

Fortunately this is false. The government does not pay off debt by raising taxes or cutting spending. The government debt is “paid off” by the economy growing. Here is how this works.

The Springfield Model 1861 rifle was the most widely used weapon during the American Civil War. It cost $20 in 1861 or $528 in today’s dollars. In 1861 the US economy’s GDP was $5.7B or $150.7B in today’s dollars. Suppose you wanted to equip a million man army and deficit spent to buy a million Model 1861 rifles [note this is not a historical example, I have no idea how many rifles were used in the Civil War]. That would cost the government $528M and would mean a deficit of .35% of GDP ($528M in deficit spending for rifles divided by $150.7B size of economy).

It might seem small but .35% of GDP is huge. For instance in 2012 the government spent only approximately .061% of GDP in providing cash payments to needy families via the TANF program (colloquially “welfare”).

So how does that .35% of GDP get paid off? Well fast forward to today. The debt is still “here” except that something has happened in the intervening century plus. The economy is much larger. It’s no longer $150.7B, its $15.8 TRILLION. The debt from the civil war rifles is now only .0033% of GDP. It went from being six times the size of the federal government welfare program to being 1/18th the size!
That is how the deficit spending and the debt is “paid off”. It is not paid off by raising taxes or cutting spending, it is paid off by economic growth. The larger the economy, the smaller the portion of the debt will be in relation to the economy. Eventually the debt becomes infinitesimally small and ceases to matter.

Also notice how we adjusted for inflation. Although the debt can be “paid off” by inflation it does not need to be and there is no reason for the government to pursue higher than average inflation strategies to do so.

Ben Strubel website.


Ralph Musgrave said...

Ben’s explanation does not cater for the scenario where government incurs a VERY LARGE amount of debt with a view to imparting stimulus. I.e. his example involves debt amounting to 0.35% of GDP, whereas some governments over the last 5 years have expanded their national debts by 50% of GDP or so: a different kettle of fish.

The answer to the latter “50% of GDP” so called problem is that if the private sector wants a permanently expanded stock of net financial assets (NFA) in order to induce it to spend at a rate that brings full employment, then the new and larger debt can just stay in place. As to interest, the US, UK, Japan and numerous countries pay zero interest on their debt on inflation adjusted terms.

But to the extent that the private sector decides it doesn’t need its expanded stock of NFA, it will attempt to spend it away, which will be inflationary, which will mean government will have to damp down the economy by raising taxes relaltive to public spending (i.e. run a surplus). In short, government reduces the debt by simply confiscating it.

Notice also, that the above explanation caters for where there is no economic growth, whereas Ben’s explanation does not.

Unknown said...

Interesting information.