Does more government help or hurt?

4 January, 2016 at 09:44 | Posted in Economics | 7 Comments


Through history public debts have gone up and down, often expanding in periods of war or large changes in basic infrastructure and technologies, and then going down in periods when things have settled down.

The pros and cons of public debt have been put forward for as long as the phenomenon itself has existed, but it has, notwithstanding that, not been possible to reach anything close to consensus on the issue — at least not in a long time-horizon perspective. One has as a rule not even been able to agree on whether public debt is a problem, and if — when it is or how to best tackle it. Some of the more prominent reasons for this non-consensus are the complexity of the issue, the mingling of vested interests, ideology, psychological fears, the uncertainty of calculating ad estimating inter-generational effects, etc., etc.

In classical economics — following in the footsteps of David Hume – especially Adam Smith, David Ricardo, and Jean-Baptiste Say put forward views on public debt that was as a rule negative. The good budget was a balanced budget. If government borrowed money to finance its activities, it would only give birth to “crowding out” private enterprise and investments. The state was generally considered incapable if paying its debts, and the real burden would therefor essentially fall on the taxpayers that ultimately had to pay for the irresponsibility of government. The moral character of the argumentation was a salient feature — according to Hume, “either the nation must destroy public credit, or the public credit will destroy the nation.”

Later on in the 20th century economists like John Maynard Keynes, Abba Lerner and Alvin Hansen would hold a more positive view on public debt. Public debt was normally nothing to fear, especially if it was financed within the country itself (but even foreign loans could be beneficient for the economy if invested in the right way). Some members of society would hold bonds and earn interest on them, while others would have to pay the taxes that ultimately paid the interest on the debt. But the debt was not considered a net burden for society as a whole, since the debt cancelled itself out between the two groups. If the state could issue bonds at a low interest rate, unemployment could be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden was no real burden according to this group of economists, since — if used in a suitable way — the debt would, through its effects on investments and employment, actually be net winners. There could, of course, be unwanted negative distributional side effects, for the future generation, but that was mostly considered a minor problem since, as  Lerner put it,“if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else.”

Central to the Keynesian influenced view is the fundamental difference between private and public debt. Conflating the one with the other is an example of the atomistic fallacy, which is basically a variation on Keynes’ savings paradox. If an individual tries to save and cut down on debts, that may be fine and rational, but if everyone tries to do it, the result would be lower aggregate demand and increasing unemployment for the economy as a whole.

An individual always have to pay his debts. But a government can always pay back old debts with new, through the issue of new bonds. The state is not like an individual. Public debt is not like private debt. Government debt is essentially a debt to itself, its citizens. Interest paid on the debt is paid by the taxpayers on the one hand, but on the other hand, interest on the bonds that finance the debts goes to those who lend out the money.

To both Keynes and Lerner it was evident that the state had the ability to promote full employment and a stable price level – and that it should use its powers to do so. If that meant that it had to take on a debt and (more or less temporarily) underbalance its budget – so let it be! Public debt is neither good nor bad. It is a means to achieving two over-arching macroeconomic goals – full employment and price stability. What is sacred is not to have a balanced budget or running down public debt per se, regardless of the effects on the macroeconomic goals. If “sound finance”, austerity and a balanced budgets means increased unemployment and destabilizing prices, they have to be abandoned.

Now against this reasoning, exponents of the thesis of Ricardian equivalence, have maintained that whether the public sector finances its expenditures through taxes or by issuing bonds is inconsequential, since bonds must sooner or later be repaid by raising taxes in the future.

In the 1970s Robert Barro attempted to give the proposition a firm theoretical foundation, arguing that the substitution of a budget deficit for current taxes has no impact on aggregate demand and so budget deficits and taxation have equivalent effects on the economy.

The Ricardo-Barro hypothesis, with its view of public debt incurring a burden for future generations, is the dominant view among mainstream economists and politicians today. The rational people making up the actors in the model are assumed to know that today’s debts are tomorrow’s taxes. But — one of the main problems with this standard neoclassical theory is, however, that it doesn’t fit the facts.

From a more theoretical point of view, one may also strongly criticize the Ricardo-Barro model and its concomitant crowding out assumption, since perfect capital markets do not exist and repayments of public debt can take place far into the future and it’s dubious if we really care for generations 300 years from now.

Today there seems to be a rather widespread consensus of public debt being acceptable as long as it doesn’t increase too much and too fast. If the public debt-GDP ratio becomes higher than X % the likelihood of debt crisis and/or lower growth increases.

But in discussing within which margins public debt is feasible, the focus, however, is solely on the upper limit of indebtedness, and very few asks the question if maybe there is also a problem if public debt becomes too low.

The government’s ability to conduct an “optimal” public debt policy may be negatively affected if public debt becomes too small. To guarantee a well-functioning secondary market in bonds it is essential that the government has access to a functioning market. If turnover and liquidity in the secondary market becomes too small, increased volatility and uncertainty will in the long run lead to an increase in borrowing costs. Ultimately there’s even a risk that market makers would disappear, leaving bond market trading to be operated solely through brokered deals. As a kind of precautionary measure against this eventuality it may be argued – especially in times of financial turmoil and crises — that it is necessary to increase government borrowing and debt to ensure – in a longer run – good borrowing preparedness and a sustained (government) bond market.

The question if public debt is good and that we may actually have to little of it is one of our time’s biggest questions. Giving the wrong answer to it will be costly.



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  1. “… as Lerner put it,“if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else.”

    MMT likes Lerner, with good reason, but that particular phraseology is actually an interesting logical contradiction to the standard MMT analysis. The point is not that that the payments are made within existing cohorts at the time, but that so-called “net financial assets” are destroyed when the debt is repaid with budget surpluses. To that extent, in that situation, debt ironically does become somewhat like the stereotypical “burden” on future generations – IF it is repaid with future surpluses.

    • JKH, first, for your many, many, many great comments that I have learned so much from on many different blogs, I thank you. That being said, I don’t see any contradiction with MMT analysis in the quote from Lerner. MMT does not say government should never ever run a surplus, just that the budget outcome should be a result of maintaining full employment and price stability. The destruction of net financial assets that a “MMT approved surplus” would entail would be a necessary burden on that current generation at that time of the surplus- regardless of previous government debt from previous generations. Meaning that the point of having a government surplus would be to constrain demand rather than to pay down government debt.

      • thanks Jerry

        I’m aware that MMT does not necessarily disapprove of a surplus in all cases and that Lerner’s functional finance is broadly intelligent in that regard

        But I’m looking at some very specific language from Lerner in this case that I find surprising

        And I’m nit-picking in a way, but just consider the oceans of ink that have been spilled in trying to get to the heart of the logic around this subject in general

        I’m going to transpose something I just wrote in response to somebody else, who had the same kind of question. Here it is, slightly edited:

        “My point is that you can’t use Lerner’s quoted language to illustrate anything about the effect of debt on future generations.

        The reason for that is that exactly the same language applies to the creation of a deficit and debt. When a deficit is created, the current cohorts within the population “pay it” to themselves. The bond buyer’s payment goes to the current recipient of the deficit expenditure. Yet obviously MMT (and others) argue that the creation of a deficit provides a net benefit to the private sector IN AGGREGATE in the form of a net financial asset, which is represented by the bond in that case (the fact of the payment from the bond buyer to the deficit dollar recipient is merely an operational characteristic underlying the fact of the creation of the bond, which is the important aspect in the NFA sense).

        So in the case of NFA, and debt, the “pay it to ourselves” characteristic results in a net benefit according to MMT and others.

        So you can’t argue that “pay it to ourselves” at the other end when a budget surplus is used to pay down the debt is a sufficient characteristic to result in a neutral effect – which is what Lerner’s language directly claims – because that very same characteristic applies to the other end of the transaction where MMT argues that there is a net benefit. The language alone can’t mean one thing in one case and one thing in another case if it is claimed as sufficient proof of a particular effect in either case. So that particular characteristic – which is captured in Lerner’s language – can’t logically prove neutrality when debt is paid down – because it certainly doesn’t prove anything of the sort when when NFA is created. That’s the logical contradiction I refer to.

        (I’m not generalizing to anything/everything else Lerner may have said on the subject. If that particular quote is accurate, it just seems wrong as a point of logic about deficits and debt.) “

      • more from the same source:

        ” Lerner’s language is that debt is not a burden to future generations because when we pay down debt, “we pay it to ourselves”. So he’s saying that the “pay it to ourselves” characteristic neutralizes what some might otherwise consider to be a burden on future generations. Mosler in effect says something similar when he invokes “no grandchildren involved”. So no burden because we pay it to ourselves. The situation is claimed to be net neutral because of this.

        At the other end, when debt is created, the situation in fact also includes “pay it to ourselves”. It’s just that the role of payer and payee are reversed in debt creation versus debt destruction.

        Yet MMT argues that the creation of debt is not net neutral – because it creates NFA as a net benefit.

        Then the inconsistency becomes evident from two perspectives:

        a) If NFA is a net benefit when created, how can it not be a net cost (i.e. “burden”) when destroyed? Private sector wealth has declined.

        b) Conversely, if “we pay it to ourselves” neutralizes the cost of debt destruction (according to the Lerner quote), how can it not neutralize the benefit of debt creation?

        Now you can argue that there are good reasons for the timing of both debt creation (deficits) and debt destruction (primary surpluses), but the logic of “we pay it to ourselves” (and the logic of Mosler’s grandchildren) is not the way to do it. “

  2. Thanks JKH for your reply. As soon as I hit the post comment button I started thinking that explaining MMT to JKH was almost as presumptuous as me telling Stephanie Kelton what MMT is all about would be. Next time I will tell you about National Accounting and that whole I=S thing. Shoot me if I ever try that please.

    As to my new understanding (hopefully) of your original comment – you are saying that MMT and Lerner want to have their cake and eat it too? That they shouldn’t claim that creating government debt is a good thing in the first place (because it creates NFA) and at the same time claim retiring that debt isn’t a bad thing just because the payments would be made to people within the economy at that time it was repaid?

    But, I just don’t see that MMT actually claims that the “Debt” part of government deficit spending has anything to do with the positive aspects of the deficit spending when deficit spending is called for. Doesn’t MMT say that the creation of Net Financial Assets for the private sector is due to the actual spending by government- not the selling of bonds that might happen afterwards? The exchange of previously accumulated NFAs for a new bond is all that happens when the government borrows money in its own currency?

    • Thanks again.

      Yes – your understanding is correct regarding my take on the Lerner quote specifically.

      Yes – NFA is created by deficit spending.

      Yes – NFA can take different asset forms, depending on institutional arrangements, real or imagined. For example, the full bore William Mitchell proposed system would create NFA in the form of bank deposits created directly from deficit spending without bond issuance. If you assume that as the first step in a two-step process of bond issuance, then your characterization is fair. I’m just using bonds as the standard NFA form that results when governments issue bonds to fund deficits. There’s nothing special about it other than it tends to be the way things work in prevailing institutional arrangements. My point doesn’t depend on the form of NFA, whether its bonds or bank deposits or anything else. The salient point is that private sector wealth increases with new NFA (other things equal), whatever its financial form. And surpluses reduce wealth and NFA, whatever the financial form of the latter.

    • Jerry, look at it this way. Before deficit spending, the private sector has say 100$. Afterwards it has 100$ + say 100$ worth of bonds for wich it had to render 100$ worth of goods to society. Now, MMT says that bond is worth 100$ in wealth because people do not expect to have to pay it back with taxes. So, in MMT world, financial wealth has increased by 100$ due to deficit spending. Paying back the debt is the opposite operation. Government taxes everybody to pay back Paul the bond holder 100$ in (tax) money and retire the bond. After that operation the private sector has 100$ in money and 0$ in bonds. According to MMT that is a reduction in wealth. Acording to the Lerner quote, nothing has changed.

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