The Right Kind of Spending Can Fuel Real Growth
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The Fiscal Times
February 1, 2011

As Congress turns its attention to deficit reduction, one argument we’ll hear again and again from those in favor of large cuts in spending is that our children and grandchildren should not be asked to pay the bills of this generation. The deficit will reach a record $1.5 trillion this year before declining, according to the Congressional Budget Office. However, deficits are not always harmful to future generations, and it would be a mistake to cut the deficit on behalf of our children and grandchildren and end up making them worse off in the process.

When the government incurs debt, the important factor to consider is what the government does with the money relative to what the private sector would have done with it. If the money would have been used for consumption goods or remained idle in bank accounts, and the government uses it to purchase needed infrastructure instead, then this is better from the perspective of future generations since it enhances the productive capacity that they will inherit. If the private sector would have invested the money instead of consuming it, then from the perspective of future generations it depends upon which type of investment – government or private sector – leads to higher productive capacity for the types of goods and services that they desire. With government goods such as bridges, roads, water systems and so on, the high return to both present and future generations is easy to see and people accept that such spending is both necessary and useful.

Many of us have forgotten what it was like before … Social
Security and Medicare existed, and a comparison of the two
eras makes it clear just how valuable these services are.

With other goods and services provided by the government, like social insurance, the benefits are harder to measure, and there is more disagreement over how large the benefits are. But many of us have forgotten what it was like before programs such as Social Security and Medicare existed, and a comparison of the two eras makes it clear just how valuable these services are to individuals and to society.

Future generations benefit greatly from having social services infrastructure in place, and in many ways this type of infrastructure is harder to construct than physical infrastructure. Without the efforts of previous generations to build upon, present and future generations would be forced to construct a social services system from the ground up, a costly and timely undertaking, or go without the high value that these services provide.

So far, not much has been said about which generation is asked to pay for the government spending. Doesn’t that matter as well?

When the borrowing is from people within the US, it affects the distribution of income within each generation, and that can produce undesirable changes. But it does not substantially alter the intergenerational effects on productive capacity. To see why, think about the case where the government borrows money today to build badly needed roads and bridges, and then pays it back a generation later. In the current generation, money that would have been used to purchase consumption or investment goods, thereby increasing the sellers’ incomes, is diverted to government expenditures on transportation infrastructure. Thus, this redistributes income to people in the road and bridge construction business.

When the government bonds become due a generation later, there is another redistribution of income as taxes are increased to pay off the debt and money is transferred from taxpayers to the people who inherited the maturing bonds from their parents.

However, the situation is different when the borrowing is partly from the foreign sector. In this case, the first generation will get more income than was borrowed domestically, since some of the new spending is financed from abroad. But the second generation will see some if its income flow out of the country as taxes are raised to pay foreign debt holders. In this case, for the world as a whole it is still a redistribution of income within each generation, but the net result within the U.S.is a transfer of income across generations.

Thirty years ago, only between 10 and 15 percent of the debt was held by the foreign sector, so the redistribution across generations was relatively small. But presently nearly half of our $14 trillion debt is held outside the US, and practically all of the new debt is financed by the foreign sector, so the intergenerational transfer is larger. However, even though the costs to future generations are higher, it’s still quite possible for spending on, say, social or physical infrastructure to provide them with net benefits.

Deficits can impose costs in addition to the intra- and intergenerational effects discussed here, and the costs of deficits can increase rapidly once the debt load crosses the critical threshold where confidence the debt will be repaid begins to fall. For this reason, we do need to get our long-run budget under control. There are places to cut, of course, but we are far behind in our infrastructure needs, and the payoff to both present and future generations is very high for these projects. In addition, our long-run debt problem is mainly a health care cost problem, and this is the problem that deficit reduction must address. It would be a mistake to cut government spending that provides large present and future benefits based upon the false notion that it somehow helps to solve the long-run budget problem, or worse, based upon the fear that such spending will impose significant costs on future generations.

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.