Edward Prescott, the Nobel prizewinning crusader for Real Business Cycle theory, published a piece called Five Macroeconomic Myths in last week's Wall Street Journal.  The last two will probably cause the most political distress, particularly among the centrist DLC-type Democrats who have been leaning heavily in their battles (both intra- and inter-party) on fiscal responsibility:

Myth No. 4: The U.S. government debt is big. The key measure here is privately held interest-bearing federal government debt, which includes debt held by foreign central banks, and does not include debt held by the Fed or government debt held by the government. So let's turn to the historical data once again.

Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. This debt level was not alarming then, and it is not alarming now. From a historical perspective, the current U.S. government debt is not large.


 It is true:  the current level of debt is not high by historical standards, even after six years of the dreaded Bush tax cuts.  Interest payments are hardly crippling, at roughly 1.6% of GDP.  But America's debt is over four trillion dollars.  That's 4,000,000,000,000 trips to the local Dollar Store.  When the notes come due, America's grandchildren will have to fork all that over to the lenders.  How can this not be a problem?

For starters, because American grandchildren don't have to pay it off.  They can just roll the debt over.  For a modest 1.5% of their annual income, or so, they need never put up a dime of principle.  Of course, that leaves them vulnerable to adverse interest rate swings. 

But there are two other reasons that America's future generations will not be crippled by the debts the current generation has amassed:  growth, and inflation. 

Assuming that America grows at, conservatively, about 2% a year, and that inflation is a low 2% annually, that debt becomes 4% easier to pay off every year. 

Say all that debt comes due in about ten years*.  At that time, America will owe upwards of $4,000,000,000,000 in principal.  As things stand now, that's about 35% of America's 2006 GDP, as projected by the Congressional Budget Office; Americans would have to cinch their belts pretty tight to pay that off. 

In ten years, however, inflation and economic growth will have brought America's nominal GDP to at least $19.5 trillion, meaning that if Americans wanted to pay all their federal debt off in one blow, it would take them less than 25% of national income.  Merely by waiting ten years, Americans have knocked 1/3rd off the cost of reducing their debt!  If you assume higher rates of growth and/or inflation, the resulting reduction is even greater. 

And obviously, the longer you wait, the more inflation and economic growth eat away at the principle.  In thirty years' time, when George Bush's hypothetical grandchildren start paying taxes, the $1.4 trillion worth of debt that has accumulated over his presidency would cost less than 3% of national income to pay off.  But why should they bother?  The interest paid on the debt will undoubtedly total something less than two tenths of one percent of the national income.

Of course, the government will have borrowed money since then.   It is a somewhat ironic problem:  except in exceptional circumstances, it is never the money your great grandparents borrowed that causes the trouble; it is always the money you yourself borrowed five years ago that costs the most.  That means that those who are truly worried about their grandchildrens' future should not focus their energy on the money they have already borrowed, or even what they are borrowing now, but rather, on anything they might be doing to open up spending or depress tax revenues in the future.  That is why so many conservative economists are saying that Mr Bush's tax cuts are irrelevant (especially since they now seem doomed to expire in 2010); it is entitlement spending, including his own prescription drug benefit for Medicare, that is truly leaving a problem for future generations.

The best way to put it is that the current government should avoid doing anything that makes committments on behalf of future generations that the future generations cannot easily renege upon. 

In my estimation, governments around the world have found it much easier to fiddle with their tax structures than to meaningfully cut spending.  Good government types should thus worry more about new spending than new tax cuts.  Especial care should also be used in enacting policies that cause the citizenry to make irrevocable committments of their own.  Social Security and Medicare, in America, and similar schemes around the world, cause people to save less than they otherwise would, on the assumption that a basic pension and other needs will be provided in retirement.  No humane society can make such promises and then go back on them when the old and vulnerable try to collect.  But if finances deteriorate far enough, governments around the world could conceivably be forced to do so, no matter how inhumane the resulting suffering. 

Those worried about their government's long term fiscal position should be looking not at what the government is doing now, but at what it is causing its citizens to do, now and in the future.  In most countries, the picture is not pretty.

*most US debt is issued in the form of treasury notes, which have 2, 5 or 10 year maturities