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In the Nation's Interest

Does Krugman Understand Debt?

Joseph Kennedy
President of Kennedy Research, LLC

Economic complacency has risen rapidly over the last few months, backed by falling energy prices, rising GDP estimates and above normal monthly job reports. And there is certainly much good news. The threats, if they exist, lie mainly in overseas events over which the United States has limited control and any hidden structural weaknesses that have escaped regulators’ attention despite the complexity of the Dodd-Frank reforms.

Yet this belated return to near normalcy has not stopped a determined minority of economists from advocating for greater fiscal stimulus. Paul Krugman made another plea for it with a recent editorial “Nobody Understands Debt.” Given his reputation, I think he really believes that. His point, especially applied to global debt levels, is that net global debt must always be zero. In his words: “Because debt is money we owe to ourselves, it does not directly make the economy poorer (and paying it off doesn’t make us richer).” This makes a certain amount of sense. And if debt does not matter, then issuing another trillion dollars of it to boost near-term economic activity seems like a no-brainer. So, does debt matter?

It does. A lot. And it matters especially now because most of the debt that exists is the worst kind of debt. There are three basic kinds of debt. The differences among them depend upon what the proceeds of the debt are used for and how people behave in the presence of debt. The first type of debt occurs when someone borrows money to invest in a project that generates a rate of return higher than the interest on the loan. In this case value is being created. The project generates benefits that are greater than the opportunity cost of the money, which is reflected in the interest rate. Although the borrower is taking on risk, if he is correct in his calculations, he will emerge richer than he started. The lender will make a nice rate of return.

The second type of debt is created when the borrower takes out a loan in order to consume now. Since the consumption does not generate a rate of return, the borrower is simply transferring pleasure from the future to the present. His current welfare rises, but it comes at a cost. His future welfare will be forever diminished until the loan is repaid. Whether this makes him better off depends upon his discount rate and the rate of interest. If the borrower escapes this constraint by defaulting on the loan, the reduction in future welfare is simply transferred to the creditor. If the United States had spent another trillion dollars in fiscal stimulus in 2009, growth undoubtedly would have been greater in 2009 and 2010. But that would have come at a perpetual cost of roughly $20 to $40 billion every year in interest payments. Whether the economy in 2015 would be any different is a debatable point.

If we ignore liquidity constraints, one can argue that whether debt is repaid or not does not matter on the global scale. As Krugman says, “debt is money that we owe to ourselves.” But that is not necessarily true. In some cases it is possible for debt to fundamentally change how people behave. The worst type of debt exists when the borrower lives like he has no intention to repay the debt and the creditor lives as if the debt were good. In this case reality must inevitably intrude by lowering the standard of living of one or both parties. If the debtor ultimately has to repay the debt, as Greece is having to do, then its standard of living must fall from the level that existed before. And if the debt is defaulted on, as it was in Detroit, then the creditors suddenly see their asset values fall.

In much of the world today, borrowers are not acting as if they intend to repay their loans. And yet creditors have not fully discounted the loans either. Someone is going to be poorer than they think. And the uncertainty over how this is going to play out imposes its own cost. Debt does not have to be explicit for this to happen. The federal, state and local governments have made long-term commitments to retirees, veterans, and others that are much greater in magnitude than their formal debt. For the most part, the recipients of these promises are acting as if they will be paid on time. They are not increasing their savings or reducing their present consumption in anticipation of harder times to come. Yet the government has done little to put aside the necessary funds. As a result, the living standards of one or both groups will inevitably be lower than people expect. Faster productivity growth can counteract this, which is why pro-growth policies are so important.

Krugman would assure us that governments can always either raise taxes or print money. Well, they can until they can’t. Even ignoring the dead-weight economic loss that additional taxes impose, raising taxes is a political decision, not an economic one. There is no assurance that future majorities will decide to honor past commitments. Ask Detroit and Argentina. Printing money also is not a solution. Even if inflation is not rampant, it gradually reduces the purchasing power of all citizens, making them poorer than they anticipated being. Finally, when debt is sold abroad, it raises the exchange rate, again imposing a tiny tax on a broad section of the country.

Debt also matters in a different way. Without debt, all spending must compete for priority within a fixed income. This tends to favor higher-priority items over others. In a balanced budget F-15 fighters would have to compete with other things such as Medicaid expansion, research tax credits, and veterans’ benefits. Debt does not remove this constraint, but it lessens it dramatically. It becomes possible to believe that these things don’t compete against each other; that you can have them all and not really pay for it except in the far distant future when we will all be richer anyway.

It is important to emphasize these points because of the increasingly popular argument that the United States is in a prolonged period of secular stagnation. According to this theory, economic growth is likely to remain far below its potential for some time, not because government regulations unnecessarily increase business and consumer costs or because political uncertainty deters investors from committing their funds. Rather, it is because we are all in a sort of funk. According to this theory, in this situation deficit spending can do more than simply shift future income to today. By jumpstarting an otherwise stagnant economy, it can increase long-term economic growth above what it would otherwise be. The problem is that this prescription is backed by very little other than theory. It assumes an underperforming economy and then discounts any alternative explanations. It ignores the political influences governing how the money gets spent. And it encourages Americans to believe that prosperity can come without a cost.

The Bible has a very definite position about money. It reflects thousands of years of experience in which creditors always did better than debtors. Even in the case of sovereigns, who were often able to default without immediate penalty, debt eventually eroded their strength. This history has not suddenly been overturned by modern finance theory and economic modeling.

Joseph Kennedy is President of Kennedy Research, LLC, which consults on a wide variety of policy issues. He is also a Senior Fellow at the Information Technology and Innovation Foundation.

Guest blogs are the views of the individual and not the official policy of CED.