A Swollen River of Indebtedness

The first book that Nobel-laureate economist James Buchanan wrote is titled Public Principles of Public Debt. Published in 1958, at the zenith of Keynesianism’s ascendancy among economists, this book exposed the elementary Keynesian fallacy that fueled the notion that internally held government debt is no burden for domestic citizens. Unfortunately, Buchanan’s point is easy to miss and, thus, the myth that debt that “we owe to ourselves” is no burden remains dominant today.

A summary version of Buchanan’s point is that public debt allows today’s citizens-taxpayers to consume at the expense of tomorrow’s citizens-taxpayers. Public debt – at least if its issuance is unconstrained by sound constitutional rules – thus is a source of negative externalities. With the cost of current government programs paid for at least in part by future citizens-taxpayers who have no say in today’s fiscal decision-making, today’s citizens-taxpayers will free-ride on tomorrow’s citizens-taxpayers, leading to excessive consumption through government today.

The reasoning here is fully analogous to that which is used to explain more-familiar cases of negative externalities, such as water pollution. If a river is open-access – that is, if it is unowned and, hence, uncontrolled by anyone – a factory located on the banks of the river will treat the river as if it’s a free resource. But if homes and businesses exist downstream from the factory, then the factory’s use of the river as a disposal site inflicts negative consequences on unwilling third parties.

From the perspective of the factory’s owner, dumping his effluents into an open-access river is free, but not from the perspective of society. Other individuals must absorb – pay – part of the cost of the factory’s operation. Able to off-load – to “externalize” – onto individuals downstream part of the costs of his factory’s operation by dumping effluents into the river free of charge, the factory owner dumps into the river too many effluents.

The above description is of a classic negative externality. Economists have spilled rivers (!) of ink debating the best ways that such externalities can be “internalized.” It’s not my purpose here to join that debate, except to note that economists agree that if persons downstream from the factory have enforceable property rights in their interests in the river, then the externality problem disappears and the amount of pollution in the river won’t be excessive. I wish in this essay instead to explain why Buchanan was wise to warn of unconstrained deficit financing. I do so by explaining that such financing is a source of negative externalities identical in all essential respects to the negative externalities that arise when a factory owner can ignore the consequences of his actions on persons down river from him.

Contaminating the Community

Suppose that the property-rights system ensures that everyone with an interest in a river can, legally and practically, prevent others from polluting his or her portion of the river. In this case, if factory-owner Jones wants to use the river to dispose of his factory’s wastes, he must purchase permission to do so from the river’s owners. As a practical matter, the more each river owner is paid, the greater is the amount of pollution each owner will permit.

If Jones purchases permission to pollute the river using his own money, there arises no negative externality. Each person downstream, by obliging Jones to pay to use the river, internalizes on Jones the full costs of using the river to dispose of his factory’s effluents. The amount of effluents dumped into the river is socially optimal.

Now, however, consider a different scenario. Suppose that, as before, each person downstream from the factory has in his or her portion of the river an enforceable property right. That is, as before, each person along the river can successfully demand that his or her portion of the river be free of pollutants, but may agree to let his or her portion of the river be polluted with some mutually agreed-upon amount of factory wastes.

But unlike before, suppose that factory-owner Jones, to avoid spending his own money, persuades government to buy from the rivers’ owners permission for him to dump whatever amount of effluents he likes. To get the funds to buy this permission, government raises taxes on Smith and Williams, who live hundreds of miles from the river. Under this financing scheme, how much ‘river-pollution permission’ will be bought – and, hence, how much effluent will be dumped into the river – relative to the situation in which Jones spends only his own money buying permission to pollute the river? The answer is clear: more.

If Jones can, through government, compel Smith and Williams to pay for the permission he needs to pollute the river, Jones will buy more such permission than he would buy if he had to pay for such permission using only his own money. In the limit, if Jones can compel Smith and Williams to pay fully for whatever amount of permission he desires, then the amount of effluent that Jones will emit into the river will be identical to the amount that he would emit if the river were an open-access dumping ground – one with no owners possessing rights to prevent or to modify the pollution of the river.

The only difference between the case in which government compels Smith and Williams to pay for the permission that Jones needs to pollute the river, and the case in which Jones uses the river as an open-access dumping ground, is the identity of the individuals who suffer the external (or “social”) cost. If the river is an unowned, open-access resource, the individuals who pay the cost of Jones using the river as a dumping ground are those who live and work downstream. If, instead, the river is owned but permission for Jones to pollute the river is paid for fully with tax revenues extracted from Smith and Williams, then the persons who suffer the external costs of the excess pollution of the river are Smith and Williams. But regardless of which particular third parties are compelled to pay the cost of polluting the river, from ‘society’s’ perspective Jones dumps into the river too many effluents. Jones enjoys benefits paid for unwillingly by others.

Fleecing the Future

Above I assumed that Smith and Williams are contemporaries of Jones. Realistically, Jones might encounter difficulty persuading government to tax them for his benefit. After all, Smith and Williams vote. It’s possible that they’ll successfully object to being taxed for the purpose of subsidizing the operation of Jones’s factory. Is there a way for government to acquire tax dollars for Jones’ benefit without inciting taxpayer resistance? Yes! Deficit financing.

If government today borrows money, its creditors – in exchange for the promise of receiving more spending power in the future – voluntarily part with spending power today. This spending power is today then used by government to buy river-owners’ permission to let Jones pollute the river. As before, the operation of Jones’s factory is subsidized by taxpayers. And so, also as before, Jones dumps into the river more effluents than he would dump were he obliged himself to pay fully for permission to pollute the river. As before, too many pollutants are dumped into the river. Yet unlike before, Jones’s contemporaries – Smith and Williams – suffer no increase in their tax burdens.

When government borrows funds, the individuals who are compelled to pay the taxes used to finance government spending today are taxpayers tomorrow. If the maturity date of the government bonds is sufficiently far in the future, most of the people who’ll be compelled to pay for Jones’s use of the river as a dumping site might not yet even be born. Such taxpayers will offer no resistance to government’s subsidization of Jones’s pollution of the river.

With deficit financing, government spending is excessive. Just as persons located downstream on an open-access river helplessly suffer the burden of excessive amounts of pollutants emitted by factories located upstream, citizens-taxpayers in the future helplessly suffer the burden of excessive debt borrowed by government in the present. The very same economic logic that tells us that a factory’s open-access to an unowned river results in excessive pollution tells us also that government’s open-access to future-taxpayers’ purses results in excessive government spending.

And therefore, just as the problem of river pollution won’t be solved merely by changing the identity of the owners of upstream factories, the problem of excessive government spending won’t be solved merely by changing the identity of the representatives of citizens-taxpayers. In the same manner that a solution to the problem of excessive emissions of pollutants requires meaningful and enforceable restraints on the actions of those who would pollute other people’s properties, a solution to the problem of excessive government spending requires meaningful and enforceable restraints on the actions of those who would spend other people’s money.

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