Debt and Future Generations

As the national debt approaches $16.4 trillion, it is worth reminding ourselves why that debt should give us cause for concern. Government spending itself can be harmful because it crowds out private investment, redirecting resources to projects that are designed more for political than economic benefit. But the debt itself -- outlays in excess of receipts -- has consequences beyond that of even a "responsible" level of spending, since it represents payments that future generations will have to make. By racking up debt today, we are imposing a burden on our children.

Keynesian economists object and say that debt does not hurt future generations, provided that "we owe it to ourselves." Dean Baker writes that "As a country we cannot impose huge debt burdens on our children [since] the ownership of our debt will be passed on to our children. If we have some huge thousand trillion dollar debt that is owed to our children, then how have we imposed a burden on them?"

The reasoning seems valid. Even if our children have to pay off our debt at a future time, they will only be paying it to other Americans. Thus, that generation will, on net, be no poorer because of the debt created by their parents. The debt merely causes a transfer of resources from taxpayers to bondholders.

A large debt could make, the Keynesians acknowledge, for an unequal and inequitable society, by creating a discrepancy between the taxpayers and the bondholders to whom they are indebted. But though the debt could reduce social welfare, its net effect on the generation's total wealth is zero.

Of course, it is inaccurate to say that we owe the debt only to ourselves; much of our debt is owed to foreign governments, such as China and Japan. But even putting aside the issue of whether our creditors will get antsy and interest rates will climb (Keynesians say there's nothing to worry about), if the entirety of our debt were held by fellow Americans, it would still reduce the net wealth of future generations.

The subtle mistake made in the "we owe it to ourselves" argument is that it unwittingly presumes that the future bondholders will get their bonds redeemed for free -- i.e., that the money they will receive from taxpayers is clear profit, not offset by any cost. The net gain to the bondholders of the future generation, however, would be much less than the net loss to the future taxpayers.

Suppose that the national debt is zero, and the government decides to borrow, rather than tax, $100 million of its citizens' money in order to finance another stimulus project, or to throw a block party on the Capitol's East Lawn. In 2013, investors collectively give up $100 million and receive government bonds in return, which state that eventually the government will redeem them at their present value, plus 3% interest compounded annually. Consequently, the national debt rises to $100 million.

Some years later, taxation is still unpopular, so Congress has made no effort to pay off the debt. The aging bondholders, realizing that the government isn't going to redeem their investments any time soon, begin to make other plans. Some decide to keep their bonds, to be passed on to their children. But others trade the bonds to other private individuals for cash, which they use for their present consumption. As generations come and go, the individual bonds change hands again and again -- sometimes they are given away for free; other times they are sold for a price.

In the year 2091, the original $100 million debt, over the course of 78 years at 3% interest, has increased to $1 billion. The government decides now is a good time to tax the current group of taxpayers to redeem the bonds it issued years before and pay off the current group of bondholders.

After a Debt Tax has been levied, taxpayers cough up a total of $1 billion, which is paid to the bondholders. Does this mean that the debt had no net effect on the Americans of 2091? No -- while the bondholders do collectively gain the full value of their bonds plus interest, a total of $1 billion, they did not get the bonds themselves for free. They had to buy them. So the $1 billion represents a gross, not a net gain, for the bondholders.

The net gain for bondholders depends on the length of time they have held their bonds. Suppose the government originally issued one million bonds in 2013, each worth $100. By the year 2080 -- eleven years before Pay Day -- each of the $100 bonds has matured at 3% interest to $725. Suppose that at this price, a bond is sold from an old guy to a young guy. Both of them gain from the trade: the old guy is selling his bond because he thinks the government won't redeem it in his lifetime, and the young guy is buying the bond because he thinks the 3% interest rate is better than any alternative rate of return he can get from his money.

Eleven years later in 2091, the individual bond is now worth $1,000 -- but that is not a net gain for the bondholder. After all, he paid $725 to get the bond in the first place. Thus, whereas a group of taxpayers had to surrender $1,000 to redeem that individual bond, the bondholder himself only made a profit of $275. And after taking into account the opportunity costs of purchasing bonds -- the profit that could have been made by investing in other enterprises -- the bondholders' net gain is even smaller, and thus the net loss to the Americans of 2091 even greater.

If the bondholders had gotten the bonds for free, as would be the case if they inherited them from their benevolent parents, then the future generation would have suffered no net loss. But because the prior generations of bondholders did not bear the cost burden themselves, a future generation will indeed have less wealth when the government finally unloads its debt. Debt doesn't simply disappear if we wait long enough.

Yes, the projects that the present generation's government chooses to finance, even while racking up a debt, might have a lasting value that compensates future generations by providing them with the fruits of a long-term investment they could not otherwise have, such as infrastructure or domestic oil production. But the guardian angels of the state are not very adept at selecting such services, even less so when decisions are made with the resources but without the consent of the unborn.

Borrowing, then, remains the most politically feasible option for the government to finance its spending. Taxation will always be unpopular, and inflation makes its presence felt eventually. Borrowing the money, however, conveniently passes the bill to future generations -- who will never realize that they have been cheated and robbed if we keep repeating the meaningless myth that we owe the debt to ourselves. 

As the national debt approaches $16.4 trillion, it is worth reminding ourselves why that debt should give us cause for concern. Government spending itself can be harmful because it crowds out private investment, redirecting resources to projects that are designed more for political than economic benefit. But the debt itself -- outlays in excess of receipts -- has consequences beyond that of even a "responsible" level of spending, since it represents payments that future generations will have to make. By racking up debt today, we are imposing a burden on our children.

Keynesian economists object and say that debt does not hurt future generations, provided that "we owe it to ourselves." Dean Baker writes that "As a country we cannot impose huge debt burdens on our children [since] the ownership of our debt will be passed on to our children. If we have some huge thousand trillion dollar debt that is owed to our children, then how have we imposed a burden on them?"

The reasoning seems valid. Even if our children have to pay off our debt at a future time, they will only be paying it to other Americans. Thus, that generation will, on net, be no poorer because of the debt created by their parents. The debt merely causes a transfer of resources from taxpayers to bondholders.

A large debt could make, the Keynesians acknowledge, for an unequal and inequitable society, by creating a discrepancy between the taxpayers and the bondholders to whom they are indebted. But though the debt could reduce social welfare, its net effect on the generation's total wealth is zero.

Of course, it is inaccurate to say that we owe the debt only to ourselves; much of our debt is owed to foreign governments, such as China and Japan. But even putting aside the issue of whether our creditors will get antsy and interest rates will climb (Keynesians say there's nothing to worry about), if the entirety of our debt were held by fellow Americans, it would still reduce the net wealth of future generations.

The subtle mistake made in the "we owe it to ourselves" argument is that it unwittingly presumes that the future bondholders will get their bonds redeemed for free -- i.e., that the money they will receive from taxpayers is clear profit, not offset by any cost. The net gain to the bondholders of the future generation, however, would be much less than the net loss to the future taxpayers.

Suppose that the national debt is zero, and the government decides to borrow, rather than tax, $100 million of its citizens' money in order to finance another stimulus project, or to throw a block party on the Capitol's East Lawn. In 2013, investors collectively give up $100 million and receive government bonds in return, which state that eventually the government will redeem them at their present value, plus 3% interest compounded annually. Consequently, the national debt rises to $100 million.

Some years later, taxation is still unpopular, so Congress has made no effort to pay off the debt. The aging bondholders, realizing that the government isn't going to redeem their investments any time soon, begin to make other plans. Some decide to keep their bonds, to be passed on to their children. But others trade the bonds to other private individuals for cash, which they use for their present consumption. As generations come and go, the individual bonds change hands again and again -- sometimes they are given away for free; other times they are sold for a price.

In the year 2091, the original $100 million debt, over the course of 78 years at 3% interest, has increased to $1 billion. The government decides now is a good time to tax the current group of taxpayers to redeem the bonds it issued years before and pay off the current group of bondholders.

After a Debt Tax has been levied, taxpayers cough up a total of $1 billion, which is paid to the bondholders. Does this mean that the debt had no net effect on the Americans of 2091? No -- while the bondholders do collectively gain the full value of their bonds plus interest, a total of $1 billion, they did not get the bonds themselves for free. They had to buy them. So the $1 billion represents a gross, not a net gain, for the bondholders.

The net gain for bondholders depends on the length of time they have held their bonds. Suppose the government originally issued one million bonds in 2013, each worth $100. By the year 2080 -- eleven years before Pay Day -- each of the $100 bonds has matured at 3% interest to $725. Suppose that at this price, a bond is sold from an old guy to a young guy. Both of them gain from the trade: the old guy is selling his bond because he thinks the government won't redeem it in his lifetime, and the young guy is buying the bond because he thinks the 3% interest rate is better than any alternative rate of return he can get from his money.

Eleven years later in 2091, the individual bond is now worth $1,000 -- but that is not a net gain for the bondholder. After all, he paid $725 to get the bond in the first place. Thus, whereas a group of taxpayers had to surrender $1,000 to redeem that individual bond, the bondholder himself only made a profit of $275. And after taking into account the opportunity costs of purchasing bonds -- the profit that could have been made by investing in other enterprises -- the bondholders' net gain is even smaller, and thus the net loss to the Americans of 2091 even greater.

If the bondholders had gotten the bonds for free, as would be the case if they inherited them from their benevolent parents, then the future generation would have suffered no net loss. But because the prior generations of bondholders did not bear the cost burden themselves, a future generation will indeed have less wealth when the government finally unloads its debt. Debt doesn't simply disappear if we wait long enough.

Yes, the projects that the present generation's government chooses to finance, even while racking up a debt, might have a lasting value that compensates future generations by providing them with the fruits of a long-term investment they could not otherwise have, such as infrastructure or domestic oil production. But the guardian angels of the state are not very adept at selecting such services, even less so when decisions are made with the resources but without the consent of the unborn.

Borrowing, then, remains the most politically feasible option for the government to finance its spending. Taxation will always be unpopular, and inflation makes its presence felt eventually. Borrowing the money, however, conveniently passes the bill to future generations -- who will never realize that they have been cheated and robbed if we keep repeating the meaningless myth that we owe the debt to ourselves.