The balanced budget paradox

18 Jul, 2017 at 18:44 | Posted in Economics | 10 Comments

The balanced budget paradox is probably one of the most devastating phenomena haunting our economies. The harder politicians — usually on the advise of establishment economists — try to achieve balanced budgets for the public sector, the less likely they are to succeed in their endeavour. And the more the citizens have to pay for the concomitant austerity policies these wrong-headed politicians and economists recommend as “the sole solution.”

national debt5One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. But this does not hold for national debt which is owed by the nation to citizens of the same nation. There is no external creditor. We owe it to ourselves.

A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the repayments than they will be enriched by receiving them.

Abba Lerner The Burden of the National Debt (1948)

Few issues in politics and economics are nowadays more discussed – and less understood – than public debt. Many raise their voices to urge for reducing the debt, but few explain why and in what way reducing the debt would be conducive to a better economy or a fairer society. And there are no limits to all the – especially macroeconomic –calamities and evils a large public debt is supposed to result in – unemployment, inflation, higher interest rates, lower productivity growth, increased burdens for subsequent generations, etc., etc.

People usually care a lot about public sector budget deficits and debts, and are as a rule worried and negative. Drawing analogies from their own household’s economy, debt is seen as a sign of an imminent risk of default and hence a source of reprobation. But although no one can doubt the political and economic significance of public debt, there’s however no unanimity whatsoever among economists as to whether debt matters, and if so, why and in what way. And even less – one doesn’t know what is the “optimal” size of public debt.

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 more 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 — “either the nation must destroy public credit, or the public credit will destroy the nation” (Hume 1752)

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 (Lerner 1948) “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.

Abba Lerner’s essay Functional Finance and the Federal Debt set out guiding principles for governments to adopt in their efforts to use economic – especially fiscal – policies in trying to maintain full employment and prosperity in economies struggling with chronic problems with maintaining a high enough aggregate demand.

Because of this inherent deficiency, modern states tended to have structural and long-lasting problems of maintaining full employment. According to Lerner’s Functional Finance principles, the private sector has a tendency not to generate enough demand on its own, and so the government has to take on the responsibility to make sure that full employment was attained. The main instrument in doing this is open market operations – especially selling and buying interest-bearing government bonds.

Although Lerner seems to have had the view that the ideas embedded in Functional Finance was in principle applicable in all kinds of economies, he also recognized the importance of the institutional arrangements in shaping the feasibility and practical implementation of it.

Functional Finance critically depends on nation states being able to tax its citizens, have a currency — and bonds — of its own. As has become transparently clear during the Great Recession, EMU has not been able to impose those structures, since as Hayek noted already back in 1939, “government by agreement is only possible provided that we do not require the government to act in fields other than those in which we can obtain true agreement.” The monetary institutional structure of EMU makes it highly unlikely – not to say impossible — that this will ever become a “system” in which Functional Finance is adapted.

To Functional Finance the choices made by governments to finance the public deficits — and concomitant debts — was important, since bond-based financing was considered more expansionary than using taxes also. According to Lerner, the purpose of public debt is to achieve a rate of interest that results in investments making full employment feasible. In the short run this could result in deficits, but he firmly maintained that there was no reason to assume that the application of Functional Finance to maintain full employment implied that the government had to always borrow money and increase the public debt. An application of Functional Finance would have a tendency to balance the budget in the long run since basically the guarantee of permanent full employment will make private investment much more attractive and a fortiori the greater private investment will diminish the need for deficit spending.

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.

Robert Barro (1974) 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.

If the public sector runs extra spending through deficits, taxpayers will according to the hypothesis anticipate that they will have to pay higher taxes in future — and therefore increase their savings and reduce their current consumption to be able to do so, the consequence being that aggregate demand would not be different to what would happen if taxes were raised today.

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

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.

At times when economic theories have been in favour of public debt one gets the feeling that the more or less explicit assumption is that public expenditures are useful and good for the economy, since they work as an important — and often necessary — injection to the economy, creating wealth and employment. At times when economic theories have been against public debt, the basic assumption seems to be that public expenditures are useless and only crowd out private initiatives and has no positive net effect on the economy.

Wolfgang Streeck argues in Buying Time: The Delayed Crisis of Democratic Capitalism (2014) for an interpretation of the more or less steady increase in public debt since the 1970s as a sign of a transformation of the tax state (Schumpeter) into a debt state. In his perspective public debt is both an indicator and a causal factor in the relationship between political and economic systems. The ultimate cause behind the increased public debt is the long run decline in economic growth, resulting in a doubling of the average public debt in OECD countries for the last 40 years. This has put strong pressures on modern capitalist states, and parallel to this, income inequality has increased in most countries. This is according to Streeck one manifestation of a neoliberal revolution – with its emphasis on supply side politics, austerity policies and financial deregulation — that has taken place and where democratic-redistributive intervention has become ineffectual.

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 failure of successive administrations in most developed countries to embark on any vigorous policy aimed at bringing down unconscionably high levels of unemployment has been due in no small measure to a ‘viewing with alarm’ of the size of the national debts, often alleged to be already excessive, or at least threatening to become so, and  by ideologically urged striving toward ‘balanced’ government budgets without any consideration of whether such debts and deficits are or threaten to become excessive in terms of some determinable impact on the real general welfare. darling-let-s-get-deeply-into-debtIf they are examined in the light of their impact on welfare, however, they can usually be shown to be well below their optimum levels, let alone at levels that could have dire consequences.

To view government debts in terms of the ‘functional finance’ concept introduced by Abba Lerner, is to consider their role in the macroeconomic balance of the economy. In simple, bare bones terms, the function of government debts that is significant for the macroeconomic health of an economy is that they provide the assets into which individuals can put whatever accumulated savings they attempt to set aside in excess of what can be wisely invested in privately owned real assets. A debt that is smaller than this will cause the attempted excess savings, by being reflected in a reduced level of consumption outlays, to be lost in reduced real income and increased unemployment.

William Vickrey


  1. So many comments! Clearly a hot topic.
    I wish my own comment above was less . . . poetic.
    The critical thing is uncertainty. In a certain (or probabilistically predictable) world, debt is a vehicle for making income transfers. This is where most conventional economic analysis focuses. A certain world. Transfers between savers and investors, between taxpayers and rentiers, between generations. And this focus is a distraction, a magician’s trick in the hands of right-wing ideologues.
    Uncertainty is what makes money and finance and debt so complicated and so very, very useful.
    A marketable national debt in a sovereign’s currency managed by a competent central bank and a treasury (representing the fiscal capacity to control expenditure and collect taxes on economic rents), and including the administrative capacity to regulate the payments system, banking, financial markets and adjudicate bankruptcy — such a complex system makes possible a money economy with all its attendant deal-making, insuring against loss and investment in the future. It enables governments to govern, which is to say, to respond when mistakes are made and the consequences of those mistakes become unexpectedly manifest.
    We keep being asked to not-understand or appreciate this complex response to uncertainty and to substitute some simpler heuristic, like Hume’s moral hectoring or Barro’s rational expectations and ricardian equivalence. The damn Euro was designed without people of good will appreciating the game of jenga they were playing, building a financial system stiff in its joints and without the governors to respond creatively to the unfolding of disappointed expectations, fraud and conflict, and which “must” visit immense suffering on people who work for a living, because “expert” economists have left the politicians with no alternatives.
    A very important post.

  2. Ricardo seems odd to me. It seems reasonable that people or companies might review their budgets so as to take account of future taxes. But ‘saving’ seems too narrow a term. Might they not invest in their own potential, which might involve ‘consumption’ of a kind?

    For example, in a crisis one might well hunker down, seeking to weather the storm. But if the government has a credible recovery plan one might carry on as normal or even seek to capture the market share of those less optimistic.

    More generally, the Ricardoian argument seems inevitably an equilibrium argument, and so its conclusions should be questioned when we are out of equilibrium. In my view we are currently in an undesirable equilibrium. More debt could be justified if it were part of a plan to kick us into a more favourable one. Mainstream economics seems to be about exploiting a ‘given’ equilibrium. But is that what we want?

  3. Delighted to see the word “optimum” in the above article. The concept “optimum” is too difficult for most economists and economic commentators in my experience.

    As to what the optimum level of debt is, I suggest MMTers have the answer to that (or at least Warren Mosler, founder of MMT has the answer). It’s thus.

    First, debt and base money are the same thing. Second, they are assets as viewed by the private sector, thus the more “debt plus base” we have, the more the private sector will spend. Thus the optimum amount of both (i.e. the sum of debt and base) is whatever induces the private sector to spend at a rate that brings full employment and at a zero rate of interest. (Warren Mosler and Milton Friedman argued for a permanent zero rate).

    Alternatively a rate below inflation would do, I think: that amounts to a sub-zero REAL (i.e. inflation adjusted) rate.

  4. Another absurd aspect of Ricardian equivalence is that national debts just aren’t repaid for the most part. For example according to Roger Farmer the UK’s debt declined from over 200% of GDP in 1945 to about 50% in 1990 without any debt being repaid at all: the decline was all down to inflation and rising GDP.

  5. The response from the left to the Ricardo-Barro hypothesis of equivalence between debt and taxes has always struck me as curiously weak, involving as it does mumbling about imperfect capital markets, the cognitive incapacity of economic actors and the like.
    Of course, people save in anticipation of future taxes and no they do not need to have perfect rational expectations to do so. When people lend money to the government, they receive a bond promising interest and the repayment of principal; shocking as it may be to the mathematically sophisticated, that bond is exactly equivalent to the future taxes that will finance the payment of interest and principal. The act of buying the bond *is* the act of saving now exactly an amount equivalent to those anticipated taxes.
    The sleight of hand in Barro’s argument is the implicitly assumed neutrality of money. At base, the claim of monetary neutrality is the rather trivial observation, made famously if not originally, by Hume to the effect that the magnitude of the unit of account is arbitrary and trivial. But, Barro is slipping rather more past; Barro wants neutrality of money to have force, to impart a kind elasticity to the “natural” equilibrium of the economy, so that the government spending more now entails the government spending less in the future (when the debt must be repaid).
    Barro wants it to be the case that the government borrowing money now to buy widgets made now will somehow entail a constraint on economic activity in the future. Somehow, he wants it to be the case that fewer widgets can be produced in the future, because more were made now; somehow, paying taxes to finance the payment of interest and principal in the future will depress activity.
    But, notice please that the means of paying interest and principal are already in hand and have been in hand from the first day the government sold bonds: it is the bonds themselves. Extinguishing the debt can done by extinguishing the bonds and vice versa with no necessary effect one way or another on rates of productive economic activity in the future. Future activity will be determined in the future. The elasticity of a neutral money is not going to snap like a rubber band, pulling future widget production down because past widget was driven up by deficit spending; the money debt of the bond and the money taxes to finance the bond require money, not widgets, and, conveniently they exactly cancel each other out.
    The truth is we always only have as resource the present moment; we use it for the production of goods or lose it. The trade-off with an uncertain future is a fiction written in the language of money and finance. It is fortunate that we have to complement the certainty of eventual death the proximate certainty of taxes. The marketable government bond is useful in its own right as an extension of a circulating currency. (Or perhaps the currency is a extension of the national debt?) It anchors numerous hedged bets in finance, commerce and industry and provides ballast to keep the banking and payments systems from capsizing. It is the usefulness to private finance of a public “zero-risk” instrument that justifies regarding marketable public debt as a source and foundation for wealth even though it seems only to be a vehicle of transfers. In a certain world, it would only represent transfers. In an uncertain world, it is a means, a mechanism for making deals.

    • I think that observing that people just do not behave in the way Ricardian Equivalence says they do is more than enough to challenge a theory that really is based on understanding how people will behave. So I wouldn’t call it a weak response, I would call the Barro hypothesis weak to begin with.

      But you do make a lot of good points and I especially like how you show that Barro is depending on some super neutrality of money concept.

  6. Missing from this discussion about debt and the supposed paradox of balanced budgets is the fiscal impact on the government of the debt service charges whether or not there is a balanced budget. There is interest that has to be paid and that comes from tax payers ultimately. If that payment is so large that other services needed by the citizens of the country are limited or crowded out, then the debt has become a problem. If it becomes a means of transferring tax dollars to the well-off of that country does it not then contribute to inequality — especially if they are able to avoid taxes on it?

    Mind you it can also be a positive force if a national pension scheme holds some of the debt thus receiving some of the interest payments but it is my hunch that those paying the taxes are not those benefiting from the interest payments on the debt. So it becomes a transfer from tax payers to the well-off often able to avoid taxes.

    Now Insurance companies and banks also are looking for safe investments and are receiving huge amounts of cash daily so the government bonds and T-bills can be a safe albeit temporary investment but again the return on those bonds or T-bills may become payouts to customers of the insurance company and banks but are more likely ultimately to be transferred to the investors in the company who may be able to evade taxes and thus the policy may contribute to income inequality.

    So the big piece of this puzzle that is missing is WHO HOLDS THE DEBT? If the country’s central bank has the government as its only shareholder and the central bank holds all or part of the debt, then the debt service charges or interest payments do not impact fiscally on the government’s budget since the interest is returned to the government in large measure. But if that debt is held by the private sector in whole or largely, then it can impact on the government’s budget to the detriment of society as a whole.

    When a country’s debt is held outside of the country that becomes a bigger issue contributing to the problems of the people of Greece for example. And I have not gotten into the subject of the central banks’ powers to adjust interest rates in the pursuit of (often mythical) inflation control for the country and the further impacts on both government fiscal policies. Worse it often has an uneven impact on citizens.

    Finally, using the debt to GDP ratio as an indicator obscures these impacts and becomes a smokescreen and can be a political football.

    So balanced budgets and their desirability is not the paradox here. Who holds the debt may be a bigger paradox.

    • Te problem you describe is easily solved: don’t issue debt(credit bank reserves instead of issuing debt) or run ZIRP policy.

    • Re: “There is interest that has to be paid and that comes from tax payers ultimately.”

      I think you missed the entire point of the article. Taxpayers don’t finance anything if the government is the currency issuer.

  7. I meet a econometrician doctoral student, he had not read Keynes, Abba Lerner had he not heard of, not even Vickrey the Nobelprizewinner. Sorry state of mind.

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