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This post revisits many of the points made in a similarly-titled post 18 months ago. It's a worthwhile exercise, because many people seem to accept, as an article of faith, that our huge and rising federal debt will crush the economy in the future. As I explain here, it is not repaying the debt that creates a problem, it is the spending that requires taking on the debt that crushes the economy.

From a macro perspective, debt is a zero-sum game, since one man's debt is another man's asset. Debt is an agreement between two parties to exchange cash now with a reversal of that exchange, plus interest, in the future. It's a voluntary exchange, and if the borrower lives up to his future obligations, then presumably everyone is happy. If the borrower fails to repay his debt, then he benefits by being relieved of some or all of his debt service obligations, while the lender suffers by not receiving some or all of his expected cash flows. If the U.S. government defaults on its debt, the net effect will be to cause a massive transfer of wealth from the private sector, and the rest of the world, to the U.S. government. Those who lent to the government will be devastated, but taxpayers will be relieved.

The rationale behind every debt transaction is that the borrower uses the lender's money for some productive purpose that will generate a cash flow sufficient to service and eventually repay the debt when it matures. So taking on debt is not necessarily a bad thing. Indeed, it is usually a very good thing, since both borrowers and lenders benefit; the borrower creates new economic activity while the lender collects income. Of course, issuing new debt does not by itself create new demand or otherwise expand the economy; this happens only if the debt is put to productive use, and it happens over time.

By the same logic, servicing or paying off debt does not extinguish demand, nor does it otherwise shrink the economy-it is not equivalent to flushing money down the toilet. The money borrower B pays to lender A is money that A will spend on something else. The amount of money available to the economy doesn't change when debt is serviced or paid off. Aggregate demand doesn't change either, because money simply changes hands. If and when the federal government services and pays down its gargantuan debt, it will be distributing massive amounts of money to its lenders in the private sector and the rest of the world. There is no a priori reason to think this will be bad for anyone.

Debt becomes problematic, however, when the money borrowed is put to unproductive use, because that leaves the borrower without the resources to repay the loan, and that will eventually disappoint the lender. Most of the money that Uncle Sam has borrowed in recent years has not been put to productive use, and that is a big problem, because the economy has not grown sufficiently to pay back the debt. The federal government has borrowed trillions of dollars in order to 1) send out checks to individuals who are retired, unemployed, disabled, and/or earning less than some arbitrary amount; 2) pay salaries to millions of bureaucrats, 3) subsidize bloated state and local governments, and 4) subsidize corporations engaged in activities (e.g., wind farms, ethanol production) that would otherwise be unprofitable. The money was essentially wasted, since it wasn't used to create new sources of revenues with which to service the debt in the future.

We have flushed trillions of dollars down the toilet already, and we have very little to show for it. The economy has already suffered because we have squandered our scarce resources; we have eaten much of our seed corn, and our future harvests are looking insufficient. Think of it another way: over the past several years, the net after-tax profits of U.S. businesses have been almost identical in size to federal budget deficits. Businesses have contributed trillions in profits to the capital markets, and the federal government has borrowed trillions from the same markets. Trillions of dollars have changed hands, but growth has been disappointing because the money was simply taken out of one person's pocket and put in another's - it wasn't spent productively.

I think this discussion goes a long way towards explaining why this has been the weakest recovery in history. The burden of our debt binge is already upon us because we have borrowed trillions of dollars to support consumption, rather than new investment. What matters in the future is how productively we spend the proceeds of future bond sales, not how we pay off the bonds we've already sold. We can make progress on the margin if we can reduce federal spending relative to the size of the economy, since that in turn will reduce the amount of the economy's resources we waste. Allowing the private sector to increasingly decide how to spend the fruits of its labors will likely improve the overall productivity and strength of the economy, because the private sector is most likely smarter about how it spends its own money. We've got to get the government out of the way if we are to move forward.

Source: Debt Musings And Misconceptions