Animal Farm Redux
In his 1945 book Animal Farm, George Orwell explained Stalin's Russia with 3 pigs, 9 dogs and a horse living on a farm. Apparently, the economics and politics of the American debt problem can be illustrated just as succinctly with farm animals. For fun, let’s borrow the animals from Orwell to populate our economy.
There are two farms in our simplified economy: the Animal Farm and the Foxwood Farm. The Animal Farm has two animals: Napoleon (the Pig) and Boxer (the work horse). Napoleon has been elected to handle finances and administration for the farm, while Boxer does all of the farming. Boxer agrees to share the farm’s outputs equally with Napoleon. Essentially, 50% of the Farm's production is being "taxed" to support the "Administration". Mr. Pilkington works and manages the Foxwood Farm. Each farm produces 4 peaches per year. Peaches, which do not store well, must be consumed in the year produced.
Issuing government debt (to foreign and domestic investor)
Now, suppose Mr. Pilkington is planning to go into semi-retirement in 5 years, reducing his work level to half time. In anticipation of reduced peach production at Foxwood Farm, Pilkington negotiates a plan with Napoleon to sell one peach to the Animal Farm each year for an IOU, which pays one peach 5 years later. Pilkington consumes 3 of the 4 peaches produced on Foxwood farm and exchanges 1 peach for 1 IOU with the Animal Farm administration.
Napoleon believes that he will need to increase government consumption (expenditure) to meet the complexity of managing the IOU program. (The unstated truth is that Napoleon has developed an appetite for even more peach consumption) He convinces Boxer to enter into a similar agreement. Boxer, who is interested in building wealth in order to consume more in the latter stage of his life, agrees to “exchange” his peach for an IOU as well. After paying 50% tax (2 peaches to the Napoleon administration) on the farm production, Boxer receives 2 peaches, which he consumes 1 and exchanges 1 for an IOU with the Administration.
The rise of deficit spending
In keeping with Orwell’s original character development, let’s assume Napoleon hires his buddy Squealer to help him manage the IOU program; together they split the 2 peaches (that came from issuing 2 IOUs) as added administrative expense. Under this arrangement, Mr. Pilkington, Boxer and the Napoleon administration consume 3, 1 and 4 peaches each year, respectively.
After 5 years, the Animal Farm has a “government” debt of 10 IOUs, which consists of a “foreign debt” of 5 IOUs owed to the Foxwood Farm and a "domestic debt" of 5 IOUs owed to Boxer. The Animal Farm government has become poorer, as measured by its debt (IOUs). Over that same time period, Mr. Pilkington and Boxer have become wealthier, as measured by their savings (holding IOUs is holding government bonds).
What happens when government debts are repaid
5 years hence, as Mr. Pilkington (now entering semi-retirement) and Boxer cash in their IOUs, Animal Farm Administration must raise taxes (from 50%) on the Farm's “peach income” to meet its debt repayment. Pointing to mounting government debt, Napoleon first shows resolve by laying off his buddy Squealer in an effort to shrink the government. He then pleads with Boxer to agree to a temporary tax hike to keep the farm solvent and operating. Begrudgingly, Boxer agrees to let Napoleon tax the farm’s production by 3.5 peaches per annum (87.5% tax rate)—using 2 peach to repay IOUs and 1.5 to support a reduced government (government expenditure went from 2 to 4 to now 1.5 peaches). Over the next 5 years as the IOUs are being repaid, Mr. Pilkington, Boxer and the Napoleon administration consume 3, 1.5 and 1.5 peaches each year, respectively.
Notice that Pilkington has been able to smooth his consumption in retirement through "international savings" or running trade surplus.
What if we raised taxes instead?
We also discover from a government document that Napoleon had originally considered raising taxes instead of issuing IOUs to Boxer, as a way to acquire additional peaches for the Administration's consumption. The plan was to tax the Animal Farm production by 3 peaches (75% tax rate) instead of the original 2 peaches (50% tax rate), which would leave only 1 peach for Boxer but allocating 3 peaches to the government. The analysis show that this plan would result in a similar consumption profile as issuing domestic debt to Boxer. Under this tax hike scenario, Mr. Pilkington, Boxer and the Napoleon administration would also consume 3, 1 and 4 peaches each year respectively. 5 years later, Napoleon could then reduce taxes from 75% to 62.5%, collecting only 2.5 peaches in taxes. Using 1 peach to repay Pilkington’s IOU leaves the Administration with 1.5 peaches. The resulting consumption profile would again be identical to before: Mr. Pilkington, Boxer and the Napoleon administration would consume 5, 1.5 and 1.5 peaches each year respectively.
Ultimately Napoleon decided against raising taxes to finance his administration's expenditure. First, he feared that Boxer might react poorly to paying high taxes and kick (hey, a horse pun!) him out of the office at the next election. Second, he realizes that Boxer derives high personal satisfaction from feeling "wealthy" through holding IOUs. Napoleon rationalizes that the only way to allow Boxer the happiness of saving money was for the Administration to issue IOUs to Boxer and to consume the consumption that Boxer happily gives up.
Death and estate taxes are Uncle Sam's best friends
A classified document also shows a contingency plan, in the event that Boxer does not agree to a tax hike, for Napoleon to impose a 60% estate tax and for an "unfortunate accident" to happen to Boxer. This would reduce Animal Farm’s domestic debt from 5 IOUs to 2 IOUs, which would significantly reduce the need to raise taxes on Boxer's son, who would takeover to work the farm.
What can we and what should we learn?
We can learn much from studying lives on this simple farm. First, the trade deficit that Animal Farm incurs (importing peaches from Foxwood Farm and paying with IOUs) allows it to increase current consumption without increasing domestic production. Prosperity, as measured by increased consumption, has resulted from an increase in “foreign debt” instead of increase in production. In dorky econ terms, it means standard of living can increase faster than per capita GDP growth from running trade deficits. This, in part, explains the relative happiness between the Americans and the Japanese households [one consume a lot more than his output and the other consumes a lot less than his output] =).
Second, the increased Animal Farm domestic debt associated with the Napoleon/Boxer agreement does not change the wealth of the Animal Farm. As Animal Farm raises debt through IOU issuance to Boxer, Boxer’s wealth increases, and the two effects cancel out. As a whole, Animal Farm is not richer or poorer (today or in the future) due to the savings activity of Boxer or the deficit consumption orchestrated by the Napoleon administration. Animal Farm can only get poorer through running trade deficits (issuing IOU to Pilkington to consume Foxwood Farm peaches).
Third, when the Animal Farm starts repaying Pilkington and Boxer, it must increase taxes on farm production. Importantly, the impact on the Animal Farm consumption differs depending on whether the IOU is domestic (within Animal Farm) or foreign (with Foxwood Farm). When the Animal Farm Administration taxes to repay one of Boxer’s IOUs, the total consumption of peaches does not change at Animal Farm; Napoleon would simply eat half of a peach less, while Boxer eats half of a peach more. Notice that an increase in internal debt does not decrease the future consumption for the citizens of Animal Farm. It merely distorts the current and future sharing of the Farm’s peach production. On the other hand, when taxes are raised to repay Pilkington, Animal Farm’s peach production does not fall, but its consumption falls significantly until all outstanding foreign IOUs are repaid.
Finally, in this simple economy, issuing domestic debt and raising taxes produce the same identical outcome in current and future consumption. In that sense, taxes and debt issuance should be viewed as identical policy tools. However, it is also clear that the average voter fails to appreciate this point. Cunning politicians can take advantage of the situation by replacing taxes with government debt and punting the responsibility of raising taxes to future administrations. In this light, the first order effect of issuing debt is exactly the same thing as raising taxes—making it a pure wealth transfer mechanism. Make no mistake about it; it is not a transfer from the future generation to the current generation. It is a transfer from the savers to the non-savers today. The savers simply get an attaboy in the form of a government IOU, which creates the illusion of wealth. However, in the future, the government will still need to find ways to fund the consumption of the non-savers. The only option is to tax the savers (who are likely also the taxpayers) or to ask the savers to keep saving and not convert their wealth into consumption until the next administration is ushered in to contemplate the unpleasant conversation of raising taxes.
So, what are we to make of the government debt level? The part, which corresponds to foreign debt, tells us how much of our future GDP we must share with foreigners. The larger is our net foreign debt level, the less of the fruit-of-their-own-labor would our children consume. The domestic debt component forecasts how much future political bickering will result as savers/non-savers, taxpayers/non-taxpayers, and bankers/OWSers fight over the sharing of the American pie—but then again, that’s almost always true regardless of the level of government debt.
I concede that this simplified analysis abstract away from many other very important questions. Here I assume that a crowding out of the private sector by the public sector does not lead to reduction in future production--that is I assume that government does not invest in wasteful and poor quality projects. I also assume that higher taxes does not create incentive issues--that is I assume that businesses and workers (Boxer) does not work less or work with less passion due to higher taxes. Both of these assumptions are obviously unrealistic and would predict that high domestic debt level would negatively impact subsequent aggregate production.
In any case, if you have never read the original Animal Farm, I would simply submit to you that you probably don’t want to be Boxer.