When Real Interest Rates Are Negative, Taxing Is More Costly Than Borrowing

A remarkable Damon Linker article about the “worrying rise of reckless liberal pundits” disparages the fiscal policy views of Paul Krugman and Damon Linker without bothering to mount any counterarguments to them. I like Linker, generally, but this is the very worst kind of common sense political pundity. A good article about public policy ought to be making some kind of non-obvious point about the world in order to get people to think about things differently. Simply responding by saying that the suggestion sounds funny is absurd.

In particular, I have previously suggested that with real interest rates negative it makes more sense to finance government activities with borrowing than with taxes. Linker finds this “fanciful” but can’t quite say what’s fanciful about it:

Krugman is not the only liberal to stake out such a fanciful position. Slate economics blogger Matthew Yglesias has even gone so far as to make the outlandish suggestion that the government stop collecting taxes altogether and finance its spending entirely through debt. Reading Krugman and Yglesias on the topic, you’d never guess that the principal on a loan (even one taken at zero or negative interest) eventually has to be repaid.

Let’s break this down. You’re the mayor of a city. A storm strikes and ruins a whole bunch of your police cars. Now you need to buy new ones. You have two options for paying for the cars—you can borrow the money and pay the bill ten years from now, or you can raise taxes and pay right now. The case for paying later is pretty clear. In ten years’ time your city’s overall economic output will be higher so the burden of paying off the loan then will be lessened. On the other hand, the case for paying now is also pretty clear—lenders generally expect interest payments in exchange for their loans so the total cost of the debt option is higher. But wait! The city’s accountants show up and point out that it’s currently possible for the city to borrow at a negative real rate. Suddenly the interest costs are off the table as a reason to prefer paying sooner.

So what’s left? Nothing. The city will be richer in ten years, so pay then. The logic becomes especially compelling when you recognize that the city’s income will grow more rapidly under the lower-tax regime that encourages more investment in residential and commercial property and more business activity.

What’s particularly odd is Linker then pivots to an entirely off-topic conclusion:

Entitlements will need to be means-tested and spending slashed — for the seemingly obvious reason that revenue cannot be conjured out of thin air. That’s reality in early 21st-century America. Liberals need to face it like grown-ups — and stop giving the president advice straight out of fairy tales.

Maybe so! Perhaps Linker and I disagree about what kind of reductions in Medicare and Medicaid spending would be optimal, but I have no disagreement that they should be reduced to below their currently projected levels. That said, under any scenario the government is going to be spending money in 2013. The question on the table was should we finance that spending with taxes or should be finance it with borrowing. My view is that with real interest rates below zero, it makes sense to tax less and borrow more. This has literally no relationship to my view about the appropriate level of future government spending.