Debt Is (Mostly) Money We Owe to Ourselves

Source: Paul Krugman

I want to expand a bit on something Dean Baker said yesterday:

As a country we cannot impose huge debt burdens on our children. It is impossible, at least if we are referring to government debt. The reason is simple: at one point we will all be dead. That means that the ownership of our debt will be passed on to our children. If we have some huge thousand trillion dollar debt that is owed to our children, then how have we imposed a burden on them? There is a distributional issue — Bill Gates’ children may own all the debt — but that is within generations, not between generations. As a group, our children’s well-being will be determined by the productivity of the economy (which Brooks complained about earlier), the state of the physical and social infrastructure and the environment.

One can make the point that much of the debt is owned by foreigners, but this is a result of our trade deficit, which is in turn caused by the over-valued dollar.

I think it’s worth looking at some numbers here.

Below are two series, both expressed as percentages of GDP: total domestic nonfinancial debt (public plus private), and U.S. net foreign debt, as measured by the negative of the net international investment position:

What you can see here is that there has been a big rise in debt, with a much smaller move into net debtor status for America as a whole; for the most part, the extra debt is money we owe to ourselves.

And here are the same numbers, measured as changes from 1980, so that you can see that the great bulk of the rise in debt was not financed by foreign borrowing.

People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. And as Dean says, talking about leaving a burden to our children is especially nonsensical; what we are leaving behind is promises that some of our children will pay money to other children, which is a very different kettle of fish.

Let me give you a thought experiment that may help clarify matters.

Suppose that for some reason the nation temporarily ends up being ruled by a guy who is driven mad by power, and decrees that
everyone will have to wear their underwear on the outside
(sorry, Woody Allen reference) everyone will receive a large allotment of newly printed government bonds, adding up to 500 percent of GDP.

The government is now deeply in debt — but the nation has not directly gotten any poorer: the public, in its role as taxpayers, now owes 500 percent of GDP, but the public, in its role as investors, now owns new assets equal to 500 percent of GDP. It’s a wash.

So where’s the problem? Well, to pay interest on that debt, the government will have to raise a lot more revenue. Again, this is a wash — the extra revenue is matched by the extra income people receive as bondholders. But tax rates will have to go way up; and because lump-sum taxes don’t exist in the real world, this means that marginal tax rates will have to go way up.

And you don’t have to be a right-winger to acknowledge that yes, very high marginal tax rates act as a disincentive to productive activity. So real GDP may well fall significantly.

This is what I mean when I say that the burden of debt is about incentives, not about having to deliver resources to other people.

Private debt, by the way, creates a different kind of problem: again, it doesn’t directly make us poorer, but it increases our macroeconomic vulnerability.

The general point is that the analogy with a family that owes too much is all wrong. Unfortunately, this dumb analogy dominates our national discourse.

Here’s another example, together with some data that people may not be aware of.

First, instead of a hypothetical example, let’s talk about a real case: US debt after World War II. The government emerged from the war with debt exceeding 100 percent of GDP; because there was almost no international capital movement at the time, essentially all that debt was owned by domestic residents, with a sizable fraction consisting of savings bonds bought by individuals.

Now, here’s the question: did that debt directly make America poorer? More specifically, did it force America as a whole to spend less than it would have if the debt hadn’t existed?

The answer, clearly, is no. Yes, American taxpayers had to pay the interest on that debt. But who received that interest? American taxpayers. Not exactly the same people, of course — although savings bonds were held pretty widely. But America was not like a home buyer who has to scrimp to find enough money to make his mortgage payments; America was both the borrower and the lender, and was essentially paying money to itself.

Today, of course, we live in a more complicated world, in which American financial markets are intertwined with other nations, and in which a substantial part of our debt is indeed owned by foreigners.

But what a lot of people apparently don’t know is that while foreigners have a lot of claims on America, America also has a lot of claims on foreigners. Here’s the way the national balance sheet vis-a-vis the rest of the world has evolved:

So the big rise in US debt hasn’t been accompanied by an equally big rise in our net obligations to foreigners. And in the past few years, as the budget deficit has exploded, the trade deficit has actually been lower than pre-crisis – which says that the big recent rise in debt is very much a rise in the amount Americans owe other Americans, not a matter of selling IOUs to foreigners.

Again, I’m not saying that debt is never a problem. But it’s not the kind of problem people imagine.

I’ve been arguing that the nature of US debt now is not, despite appearances, all that different from debt post-World War 2, when we pretty much entirely owed the money to ourselves. Now, of course, some of the money is owed to foreigners; but as I pointed out, America has large assets abroad, not too much less than its liabilities.

But wait, there’s more. American assets. often taking the form of foreign subsidiaries of US corporations, earn a higher rate of return than US liabilities — especially now, when there’s a lot of foreign money parked in Treasuries, but this was true even before the crisis. As a result, income from US-owned assets abroad — the blue line below — consistently exceeds payments on foreign-owned assets in the United States, the red line:

Again, if your image is that we’re deeply in hock to foreigners, that our extravagance has condemned us to a future of debt peonage, you’re wrong.

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About James Crist

How do we stop America's decline? The country is in trouble and we can all feel it. Where did we go wrong? How do we fix it? We now have an auction-based government, for sale to the highest bidder. Politicians have become nothing more than corporate whores and pawns for the rich. If we want our representatives to represent us, let them get their campaign money from us, their constituents. We have to amend the constitution to get the big money out of politics.
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