Government deficits through fiscal policy and inter-generational justice

Recently, a lot of warnings have been given that after the crisis the future generations will be heavily indebted (see Huffington Post). Future generations would pay for our sins today – that would be unfair. Here is the FT from yesterday:

The next decade was always going to be difficult. As retirement beckons for the middle-aged “bulge” in many national populations, governments have been facing an expensive demographic transformation. Now, the economic crisis makes the outlook only worse.

Once the recession passes, countries will need to work on closing their gaping fiscal deficits without triggering further collapses in output. They will also need to service bloated national debts. The International Monetary Fund estimates that among the Group of 20 nations whose leaders meet in London this week, the industrialised members will have increased their national debts by an average equivalent to nearly 25 per cent of gross domestic product between 2007 and 2014.

Since most people, economists included, do not think clearly neither about credit nor about debt, let us go through this slowly.

First of all, credit is always connected to debt. That means that expansionary monetary policy and low interest rates always increases the amount of both credit and debt. A credit to somebody must end up as a debt to somebody else. For instance, if I save money by keeping it in my savings account, I accumulate a credit. Since the bank loans the funds to somebody else in order to gain money by way of interest rate spread (I get less for my savings than somebody pays for her loan), somebody must end up with debt. So, each credit creates the same amount of debt, and each debt must create the same amount of debt. It sounds simple, but many people don’t think that way.

So, in the last few years we have seen low interest rates creating new credit and debt in the world economy. Financial institutions borrowed heavily (think of Iceland, or the German Landesbanken), and lent heavily. So did consumers in countries like the US, the UK, Ireland or Spain. During this period, a lot of debt (and created) was created. Apparently, nobody said anything about inter-generational justice during that time.

Now, if governments increase the amount of their government debt, why is the reaction so different? Before, you bought an I-owe-you (IOU) because you believed in some asset being worth a certain amount of money. The asset happened to be from the private sector, most of the times. Now, we have the same story, but the asset (creating credit and debt) is issued by the government. Where is the difference?

Government debt, just like private debt, can lose its worth by default or risk of default. If we expect that a government cannot honor its obligations, the price of government bonds will fall. The same happens to private companies, like Ford, GM and Chrysler. While with private firm debt the firm has to pay, government debt is backed by a whole nation. However, the nation can decide through its political institutions to default on its debt, just like private firms can move into bankruptcy and renegotiate their debt. This has happened many times over the last decades and centuries (see here for Reinhart and Rogoff paper (pdf)).

Why then, if government and private sector debt are both very similar, is an increase in government debt robbing future generations, while an increase in debt in the private sector is not? Of course, we cannot physically take money from unborn children nor directly borrow against them. So, how does the inter-generational effect play out?

For each government bond, which is the instrument to increase debt for a nation, issued, there will be both a credit (the government holds the money) and a debt – somebody who holds the government bond. In the future, the government, which is us, has to repay the bondholder. This is a purely distributional effect. Wealth is shifted from us to the holders of government bonds. This, of course, increases inequality in incomes. However, since today people with money buy the government bonds, there is less inequality in economic wealth today: some probably rich people give their money to the government, which can spend it however it wishes.

The net effect then depends on many things: the interest rate for government bonds, the risk of default, the interest rate and risk for alternative investments. This net effect can be strong and result in more income inequality in a nation. However, this cannot be taken for granted. If stocks offer higher interest rates than bonds that overcompensate the extra risk, those that invested in government bonds might be relatively worth off than the rest.

Let me summarize: an increase in government debt does not take away money from future generations. It changes the future income distribution in a way that is quite complex and impossible to predict because we don’t know the interest rates and risks of different asset types of the future. An increase in government debt can have strong effects, but I cannot come up with an exploration of this here. Anything on this topic should make clear that the assumptions are driving the results and that those assumptions describe unknown future developments.

In the last years, private sector debt has increased and a lot of money was wasted, as the stock market valuations can tell us. This had big distributional consequences, for groups like retired US-Americans. Nobody cried that future generations were robbed. Actually, they were, since we wasted our resources and our children inherit less capital, both human and physical. Now I wonder whether the government can invest our money more wisely than private firms in the last few years. Stabilizing our global economy should have extraordinary returns to capital and huge spillovers to private sector debt.