Debt: More Than Something We “Owe to Ourselves”

Paul Krugman points out that debt is something that we “owe to ourselves”. He’s emphasizing the idea that today’s debt doesn’t necessarily represent something that puts a burden on future generations. And he’s right to a certain degree, but there’s more to the story than he explains because when debt is used in the wrong way it can most certainly be a burden in the future.

At face value, the net worth of the entire financial asset world is zero. In fact, net worth = nonfinancial assets. Balance sheets balance so at face value the aggregate financial world has no financial asset net worth. Of course, we don’t value financial assets at face value. We value them at market value. And when you add market value into the equation then the economy has a massively positive net worth because the market values of many financial assets are well above their face value. So, Krugman is basically saying that assets and liabilities balance. That’s just a macroeconomic truism.

In the long-term, we should expect that assets and liabilities will both expand. That is, as the economy expands and output grows our real and financial net worths should be able to support some degree of added balance sheet expansion.  This is a good thing. And it only reverses course in unusual circumstances. So, the idea that debt gets “paid back” in the aggregate is misleading. You pay back your debt in the short-term, but in the long-term the expansion of the debtor pool is more than offsetting your debt reduction. Debt doesn’t get paid back over the long-term. It should expand assuming the economy is healthy and net worths expand.

But this doesn’t mean that debt can’t create a burden for future generations. This isn’t a question of whether debt gets “paid back”. Yes, the people who are arguing that debt is some financial constraint on a government that can print its own debt and currency, are totally wrong (see here for more detail).  The debate here is really a question of whether debt is used for productive purposes or not. For instance, when people borrow gobs of money to speculate on an unsustainable housing boom then you tend to get a disaggregation of credit where a credit boom fuels a housing boom and when the underlying asset price appreciation fails to support the debt boom then the debt bubble collapses and results in the type of highly unusual environment that we’ve seen over the course of the last 5 years.  We “owed that debt to ourselves” in the sense that private sector actors had both an asset and a liability as a result of the credit expansion.  But this also put quite a hefty burden on the economy in the ensuing years as it fueled an unsustainable debt binge that ultimately led to the current malaise.

The same basic fact is true of the aggregate government. Government debt generally doesn’t get “paid back”.  In a healthy economy we should expect that the government would grow in some proportion with the overall economy as more roads, firefighters, policemen ,etc are needed to accommodate the growing needs of the private sector. But this doesn’t mean that government debt can’t be used for things that result in a disaggregation of credit.  And it certainly doesn’t mean that more government debt is a good thing just because we “owe it to ourselves”.

Interestingly, in a productive de-leveraging economy more government debt can actually be the solution to a private sector debt deleveraging because it increases incomes as well as the quantity of safe financial assets. But this isn’t necessarily true in all environments. Americans sometimes seem to forget that we experience a certain degree of “exorbitant privilege” thanks to our highly productive economy and status as a reserve currency issuer. The point is, while more government debt has been the exact right thing to do in recent years, this might not always be true.  And in the wrong environment more government debt most certainly could become a burden on future generations in that it could result in a sort of “watering down” of overall output thereby leading to high inflation and lower average living standards.

So yes, we owe the debt to ourselves. But the story is much more complex than that and we should be careful implying that government debt or private sector debt is never a burden on future generations.