…pondered Robert Barro in his famous 1974 paper (‘ol Bazza’s one of the favourites to pick up this year’s Nobel Pri… – I mean – Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, to be announced in a few days, partly for his work on this and the micro foundations of macroeconomics). More to the point – does the financing of government debt by selling bonds to the public have different effects on consumption than would be by financing it with increased taxes? No, according to Barro (and intermediate macroeconomic textbooks). This is just an extension of the Barro-Ricardian equivalence, which more or less reckons that consumers will not adjust their consumption levels if there is a tax cut, because they know that the government deficit which may result will have to be paid off by tax increases in the future. The same goes for government bonds – when government sells bonds to finance debt, they will have to increase taxes in the future to pay these bonds off. So bonds aren’t part of net wealth at all, and shouldn’t affect consumption patterns. All well and good I guess, but there’s one thing that sounds a bit dodgy about this (I’m not worthy enough to argue with a Nobel-Laureate-in-waiting over his own work, but no one else seems to have brought this up, and my tutor was stumped too). Funding debts by raising taxes and selling bonds are two different things. Everyone pays taxes, but only those who choose to purchase bonds are affected by bonds. When these bonds mature and the government raises taxes to pay these off, everyone is hit with a tax hike. So in the end, people who purchase bonds have indeed increased their net wealth, as the tax hikes they pay is more than offset by the returns on their bonds. Conversly, those who did not purchase the bonds are worse off.
Having said that, I suppose on the aggregate level, net wealth doesn’t change, but perhaps there is an equity issue in dealing with bonds, given its zero-sum-type nature.
Plus, there are obviously several major limitations to Barro-Ricardian equivalence such as liquidity contraints and myopia. The theory didn’t hold up during Reagan’s ‘let’s cut taxes and raise spending at the same time’ era either.