Deficits don't have to mortgage the future

(breakingviews.com) -- Huge government deficits have many people worried. But why are they harmful? One popular answer to that question is that issuing floods of debt to finance them creates a mortgage on a nation's future. But it's not as burdensome -- or as simple -- as that analogy suggests.

If nations worked like individual families, the frightening argument would hold. Suppose the old parents take out a mortgage. They will have more money to spend now, but the mortgage payments mean the children will have less when they inherit the house.

But government borrowing doesn't actually shift money through time. It moves funds now from one group to another and promises different movements later.

Start with the present. A government has three ways to get the money it spends. First, there's printing money. That can easily lead to an inflationary mess. Second, there are taxes. That's money that the government confiscates, quite legally, from the nation's available financial resources.

Finally, there is borrowing. Like taxation, this involves the government collecting money from the nation's available financial resources. Unlike taxes, the contributions aren't compulsory and they are compensated with future interest payments and eventual repayment.

The money a population has available to spend today is reduced equally whether its members make tax payments or buy bonds of the same value (and a government has the same amount to spend in each case, too). The government may believe that selling bonds is better for the economy than raising taxes -- because deficits are supposed to stimulate more economic activity than balanced budgets -- but the basic financial equation is identical.

Fast forward a few years. Any government that borrowed in the past will need to raise a bit more money than it would if the books had been balanced, because it has to make interest and principal payments on past debts.

Suppose the heavily indebted government chooses to raise the additional funds through taxes. Those are the payments on the supposed national mortgage. But tax revenues don't get sent backwards in time, so they don't change the situation today.

The future debt-payment taxes do, of course, take money out of the economy when they are levied. But that money, in theory at least, flows right back into the economy as holders of government debt reinvest the interest and principal payments they receive. There is really no mortgage at all: just present transfers to the government to finance deficit spending and future transfers from the government to pay interest on and redeem those bonds, in turn financing spending by bondholders.

Even though there is no mortgage, there are still at least two problems.

First, the U.S. and U.K. governments, in particular, sell much of their debt to foreigners. For a globally minded economist, that doesn't change the picture. But anyone thinking in national terms is right to see something like a mortgage. Locals get to consume now, thanks to foreign-financed deficits. But foreigners will get to consume more later, as those deficits come due. Governments issuing swathes of debt can head this problem off to some extent by trying to sell more of their bonds to patriotic locals.

Second, higher borrowing now does mean governments, as opposed to their citizens as a group, will eventually have to cut spending or collect more taxes. That can disproportionately affect the poorest layers of society.

But the additional burden doesn't have to be huge. The National Institute of Economic and Social Research, a British group, expects the U.K. will need an additional £25 billion of annual tax revenues four years hence to meet additional interest expense from the crisis period. That's about 1.8% of GDP, less than half the 4% of GDP the government added to its tax take -- raising its share from 38% to 42% -- between 1997 and 2008.

Even if some of the incremental taxes leave the country to pay foreign lenders, the debt adjustments to taxes wouldn't create a big problem in a well run country. Many countries, including the U.S. and the U.K., have paid down much higher debt burdens, generally incurred during wars.

Assuming a disciplined government, when repayment time comes around some combination of economic growth, controlled inflation and perhaps some government surpluses gradually reduce the share of GDP dedicated to interest payments. In the meantime, clever tax policy can ensure that the rich, who typically own bonds, don't profit too much at the expense of the poor, who typically don't and therefore lose when the government has to pay lenders.

But perhaps a country governed well enough to achieve those things would not allow gigantic foreign-financed credit booms and busts in the first place. Or try to test what the future effects of massive government borrowing really are.

--The above comment reflects the personal view of Edward Hadas, editor at Breakingviews.com