Wednesday, 5 November 2003

Shall We Borrow from the Children?

Tax and spend” is the usual charge levied against democratic governments seeking popular support by dipping into the pork barrel. “Spend and tax” would be more accurate. The typical pattern is for expenditure on worthy and less worthy programs to rise first, with revenue seldom if ever catching up. The money never runs out, for unlike households, the government can always borrow whatever it needs to cover the deficit, almost regardless of how large it is. It owns a sort of widow’s curse whose magic lies in the state’s power to raise the taxes in the future that it has no stomach to raise in the present. The day of reckoning need never come, for old borrowing is always refinanced from new borrowing. The debt-to-income ratio must not get out of hand, but in actual fact the markets tolerate high ratios for unsecured government borrowing whilst they would demand individual debtors to put up some security.

In the 19th century, with Victorian probity permeating both ethics and economics, public deficits were felt to be perilous, and running them systematically a short route to ruin. Modern public finance theory has reduced these fears to the status of a superstition, knocking down one barrier to the steady rise in the share of the national income absorbed by state spending. Perhaps enlightenment is not always the unmixed blessing that we unthinkingly take it to be.

However, there subsists in the public mind a faint unease about budget deficits. While no longer believing that a state that gets ever deeper into debt will finish by going bankrupt, may sensible people are worried about the propriety of the government doing something on behalf of its citizens that it would be imprudent if not downright wrong for the citizens to do for themselves. It is worth looking more closely at the mainsprings of this unease.

For believers in the freedom of contract, there is no objection in principle to willing borrowers selling bonds to willing lenders; any transaction between consenting adults deserves the presumption of being an improvement in well-being. Good reasons must be advanced to show that this is not the case.

What effectively shatters this presumption is that public borrowing that is never repaid, but is constantly rolled over and keeps swelling in volume, is not a transaction between consenting adults. With only a mild recourse to metaphor, we could represent it as a transaction in which consenting adults borrow from their children and their children’s children who do not consent and could not do so, especially if they are not yet born.

While this undoubtedly deprives deficit financing of liberal credentials, there is no need for moral alarm bells to ring too shrilly about it. It is not the only, nor the gravest, instance of the present generation mortgaging the interests of their descendants. In this particular instance, though, it is doing so not out of sheer selfishness or carelessness, but as the somewhat incoherent, self-contradictory act of a split personality. Its public persona is doing one thing, its private one the opposite.

The great majority of private individuals achieve some positive saving over their lifetime, the ratio of saving to personal income averaging from 2-3 per cent to near 20 per cent from country to country and year to year. The ratio is highest for individuals near the peak of their earning power and declines in old age, but it seems to be a near-universal aspiration, not confined to people who have children, to leave more at the end of one’s life than one was given at its start. Dissaving via cumulative budget deficits runs counter to this objective. It consumes resources now which would otherwise have been available for future consumption. To add insult to injury, this pre-emptive move is not costless. Its cost, the debt interest which reflects the present generation’s time preference, will be paid mostly by our descendants through the indefinite future.

Governments buy support by spending money, not by siphoning it away in taxes. Spending now and deferring the matching taxes to an indefinite future is dictated by the most elementary political know how and it should not surprise nor shock anyone to see it happen again and again, especially when elections approach and politicians start getting desperate. They are not wicked, they are just playing by the democratic rules. That the electorate is quite content with these rules, or at least does not try to alter them, is perhaps more difficult to explain.1 It may be that the bulk of the electorate just does not see the connection and cannot be bothered to think about it. Public choice theory has several other, less simple explanations for the contrast between collective and private behaviour. Whatever the reason, they are mutually contradictory and the economic and social consequences are fairly weighty.

The deficit and public debt problem shows up to varying degrees in the USA, most European countries and very acutely in Japan. The US has tried to stem it by placing a ceiling on the federal debt, a measure whose only effect is to oblige the Congress to raise the debt ceiling every time the rising debt catches up with it. Japan has so far not done anything systematic to control the debt. In Europe, fiscal histories and outlooks differ widely between countries. The twelve states that have adopted the euro have understood that a common currency combined with widely divergent fiscal regimes could give rise to dangerous and unfair free riding.2 To forestall this, in the Maastricht treaty founding the currency union they accepted the obligation to keep the national debt under 60 per cent and the budget deficit under 3 per cent of national income (GNP).

As was obvious from the outset, the treaty obligation is proving unenforceable. France showed no embarrassment in declaring, almost in so many words, that it will reduce its deficit to the Maastricht limit when it will find it convenient to do so. Less arrogantly, Germany is following much the same course. Only poor little Portugal is scrambling to obey the treaty, for what will not be enforced against big states may be enforced against small ones.

However, it is instructive to see what would happen if eurozone countries were strictly to stick to the 3 per cent limit year in, year out, not deviating from it in either direction. Let us suppose, counter-factually, that they all start with a national debt at 60 per cent of GNP. (This limit is in the treaty but carries no sanction).

What happens under this hypothesis as we move over time depends primarily on the average rate of growth of GNP. Assuming that the zone as a whole achieves growth at 2 per cent a year looks optimistic from the perspective of the dismal present, but should be feasible with only reasonable luck. Consider a ten-year time span,-not a long time for a currency union. At the end of Year 1, GNP rises from 100 to 102 and the national debt from 60 to 63. At the end of Year 10, GNP is at 122. The national debt rises to 93, which amounts to 76.4 per cent of GNP. The longer the period considered, the more glaring becomes the effect of the growth of the debt being faster than the growth of national income.

It would seem, then, that unless economic growth were much faster than we can realistically expect in a zone of welfare states, even durable obedience to some such self-denying ordinance as the Maastricht treaty cannot guarantee long-run equilibrium. Regardless of questions of morality, economic realities alone tell us that “borrowing from the children” had better not become a steady habit.

Anthony de Jasay

This article first appeared on The Library of Economics and Liberty.


1 A well-known theory (R. Barro, “Is Government Debt Net Wealth?”) asserts that households knowingly compensate a rise in government debt by increased saving, because they anticipate a rise in future taxes they (or their descendants) will have to meet. The theory would seem to reconcile the apparent contradiction between public borrowing and private saving. This theory, first described by David Ricardo, is further discussed in “Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence,” Morgan Rose, Library of Economics and Liberty, September 24, 2001.

2 Cf. “Free-Riding on the Euro”, Anthony de Jasay, Library of Economics and Liberty, September 17, 2003.