Are Government Bonds Net Wealth? — Barro, Robert J., Journal of Political Economy (1974)

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Robert J. Barro's 1974 article in the Journal of Political Economy 82(6): 1095-1117 asks whether government bonds are perceived as net wealth by the private sector, and argues in an overlapping-generations model that finite lives do not matter so long as current generations are connected to future ones by a chain of operative intergenerational transfers, with social security payments working the same way. Finding that net-wealth effects from imperfect capital markets or a government monopoly in 'liquidity services' depend on the government being more efficient than the private market at the margin, Barro concludes there is 'no persuasive theoretical case' for treating government debt, at the margin, as net household wealth.

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Are Government Bonds Net Wealth?

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Barro, Robert J. 1974. Are government bonds net wealth? Journal of Political Economy
82(6): 1095-1117.

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Are Government Bonds Net Wealth?

Robert J. Barro

University of Chicago

The assumption that government bonds are perceived as net wealth by
the private sector is crucial in demonstrating real effects of shifts in the
stock of public debt. In particular, the standard effects of ‘“‘expansionary”’
fiscal policy on aggregate demand hinge on this assumption. Government
bonds will be perceived as net wealth only if their value exceeds the cap-
italized value of the implied stream of future tax liabilities. This paper
considers the effects on bond values and tax capitalization of finite
lives, imperfect private capital markets, a government monopoly in the
production of bond “‘liquidity services,” and uncertainty about future
tax obligations. It is shown within the context of an overlapping-
generations model that finite lives will not be relevant to the capitaliza-
tion of future tax liabilities so long as current generations are
connected to future generations by a chain of operative intergenerational
transfers (either in the direction from old to young or in the direction
from young to old). Applications of this result to social security and
to other types of imposed intergenerational transfer schemes are also
noted. In the presence of imperfect private capital markets, government
debt issue will increase net wealth if the government is more efficient,
at the margin, than the private market in carrying out the loan process.
Similarly, if the government has monopoly power in the production
of bond ‘“‘liquidity services,”’ then public debt issue will raise net wealth.
Finally, the existence of uncertainty with respect to individual future
tax liabilities implies that public debt issue may increase the overall
risk contained in household balance sheets and thereby effectively re-
duce household wealth.

The assumption that government bonds are perceived as net wealth by
the private sector plays an important role in theoretical analyses of
monetary and fiscal effects. This assumption appears, explicitly or im-
plicitly, in demonstrating real effects of a shift in the stock of public debt

I have benefited from comments on earlier drafts by Gary Becker, Benjamin Eden,

Milton Friedman, Merton Miller, José Scheinkman, Jeremy Siegel, and Charles Upton.

The National Science Foundation has supported this research.
[Journal of Political Economy, 1974, vol. 82, no. 6}
© 1974 by The University of Chicago. All rights reserved.

1095
1096 JOURNAL OF POLITICAL ECONOMY

(see, e.g., Modigliani 1961, sec. IV; Mundell 1971; and Tobin 1971,
chap. 5), and in establishing nonneutrality of changes in the stock of
money (Metzler 1951, sec. VI). More generally, the assumption that
government debt issue leads, at least in part, to an increase in the typical
household’s conception of its net wealth is crucial for demonstrating a
positive effect on aggregate demand of ‘“‘expansionary” fiscal policy, which
is defined here as a substitution of debt for tax finance for a given level of
government expenditure (see, e.g., Patinkin 1964, sec. XII.4; and Blinder
and Solow 1973, pp. 324-25). The basic type of argument in a full-
employment model is, following Modigliani (1961), that an increase in
government debt implies an increase in perceived household wealth;
hence, an increase in desired consumption (a component of aggregate
demand) relative to saving; hence, an increase in interest rates; and,
finally, a decline in the fraction of output which goes to capital accumula-
tion. However, this line of reasoning hinges on the assumption that the
increase in government debt leads to an increase in perceived household
wealth. In a non-full employment context it remains true that the effect of
public debt issue on aggregate demand (and, hence, on output and
employment) hinges on the assumed increase in perceived household wealth.

It has been recognized for some time that the future taxes needed to
finance government interest payments would imply an offset to the direct
positive wealth effect. For example, in a paper originally published in
1952, Tobin (1971, p. 91) notes: ‘‘How is it possible that society merely
by the device of incurring a debt to itself can deceive itself into believing
that it is wealthier? Do not the additional taxes which are necessary to
carry the interest charges reduce the value of other components of private
wealth?” Bailey (1962, pp. 75-77) has gone somewhat further by arguing:
“It is possible that households regard deficit financing as equivalent to
taxation. The issue of a bond by the government to finance expenditures
involves a liability for future interest payments and possible ultimate
repayment of principal, and thus implies future taxes that would not be
necessary if the expenditures were financed by current taxation. ... If
future tax liabilities implicit in deficit financing are accurately foreseen,
the level at which total tax receipts are set is immaterial; the behavior of
the community will be exactly the same as if the budget were continuously

There seem to be two major lines of argument that have been offered
to defend the position that the offset of the future tax liabilities will be
only partial.’ One type of argument, based on finite lives, supposes that

1 Of course, most analyses of government debt effects do not offer a specific defense
for this position. For example, Blinder and Solow (1973, p. 325, n. 8) say: ‘“This [analysis]
includes government bonds as a net asset to the public. We are well aware of, but not
persuaded by, the arguments which hold that such bonds are not seen as net worth by
individuals because of the implied future tax liability.”
GOVERNMENT BONDS 1097

the relevant horizon for the future taxes (which might correspond to the
remaining average lifetimes of the current taxpayers) will be shorter than
that for the interest payments.” Accordingly, a stream of equal values for
interest payments and taxes will have a net positive present value. This
argument has been used explicitly by Thompson (1967, p. 1200). The
second type of argument, usually based on imperfect private capital
markets, supposes that the relevant discount rate for tax liabilities will
be higher than that for the interest payments. Hence, even with an infinite
horizon for tax liabilities, a stream of equal values for interest payments
and taxes will have a net positive present value. This argument has been
used by Mundell (1971).3

The first part of this paper deals with the effect of government bond
issue on the calculus of individual wealth in an overlapping-generations
economy with physical capital where individuals have finite lives. No
elements of “‘capital market imperfections” are introduced into this model.
The key result here is that, so long as there is an operative intergenerational
transfer (in the sense of an interior solution for the amount of bequest or
gift across generations), there will be no net-wealth effect and, hence, no
effect on aggregate demand or on interest rates of a marginal change in
government debt. This result does not hinge on current generations’
weighing the consumption or utility of future generations in any sense on
an equal basis with own consumption, nor does it depend on current
generations’ placing any direct weight at all on the consumption or utility
of any future generation other than the immediate descendant. Current
generations act effectively as though they were infinite-lived when they
are connected to future generations by a chain of operative inter-
generational transfers.

The analysis then shows that social security payments are analogous to
changes in government debt. Marginal changes in this type (or other
types) of imposed intergenerational transfers have no real effects when
current and future generations are already connected by a chain of opera-
tive discretionary transfers. The effects of inheritance taxes and of
“transaction costs” for government bond issue and tax collections are also
considered. It is shown that inheritance taxes do not affect the basic
results, but that the presence of government transaction costs implies that
the net-wealth effect of government bonds would actually be negative.

The second part of the paper deals with the existence of imperfect
private capital markets. It is shown that, to the extent that public debt

? This type of argument applies to head taxes or to taxes based on wage income, but
not to taxes which are based on the value of nonhuman assets. This distinction has been
made by Mundell (1971, pp. 9, 10).

3 A different line of argument that leads to a similar conclusion is that the government
acts like a monopolist in the provision of the liquidity services yielded by its liabilities.
I discuss this argument in part III, below.
1098 JOURNAL OF POLITICAL ECONOMY

issue entails a loan from low-discount-rate to high-discount-rate individ-
uals, a positive net-wealth effect results if the government is more efficient
than the private market in carrying out this sort of loan. If the government
is more efficient only over a certain range, and if the public choice process
determines the amount of government debt issue in accord with efficiency
criteria, it is again true at the margin that the net-wealth effect of
government bond issue is nil.

The third part of the paper discusses government debt as a bearer of
nonpecuniary “‘liquidity services.” It is shown that if the government acts
like a competitive producer of these services, as would be dictated by a
public choice process which reflects efficiency criteria, then the net-
wealth effect of government bond issue would be zero on this count. More
generally, the net-wealth effect would be positive if the government acts
like a monopolist and would be negative if the government is an
overproducer of liquidity services.

The last part of the paper deals with the risk characteristics of govern-
ment debt and of the tax liabilities associated with the interest payments
on this debt. It is argued that if relative tax liabilities are known, a change
in government debt will not alter the overall risk contained in household
balance sheets. When relative tax liabilities are uncertain, the effect of
government debt issue on the overall risk may be positive or negative,
depending on the nature of the tax system and on the transaction costs
associated with private insurance arrangements.

I, The Effect of Finite Lives—a Model with Overlapping Gener-
ation

A. Setup of the Model

I use here a version of the Samuelson (1958)-Diamond (1965) over-
lapping-generations model with physical capital. Each individual lives
two periods, which will be distinguished by the superscripts y (young)
and o (old). Generations are numbered consecutively beginning with the
generation which is currently old (subscript 1); followed by its descendant,
which is currently young (subscript 2); followed by its descendant; and
so on. I assume here that there are the same number of people, N, in each
generation, and that all individuals are identical in terms of tastes and
productivity. I also abstract from any technological change over time.
The members of each generation work (a fixed amount of time set equal
to one unit) only while young and receive an amount of wage income w.
Expectations on w for future periods (i.e., for future generations) are
assumed to be static at the current value. Asset holdings (A) take the form
of equity capital (K). Subsequently, government bonds are introduced as
an additional form in which assets can be held. The rate of return on assets
GOVERNMENT BONDS 1099

is denoted by 7 and is assumed to be paid out once per period. Expectations
on r for future periods are assumed to be static at the current value. A
member of the 7th generation holds the amount of assets A while young
and the amount 4§ while old. The asset holding while old constitutes the
provision of a bequest, which is assumed to go to the immediate descen-
dant, a member of generation i + 1. Since the focus of the analysis
concerns shifts in tax liabilities and government debt for a given level of
government expenditure, it is assumed for convenience that the govern-
ment neither demands commodities nor provides public services. In this
section, it is also assumed that the amounts of government debt and taxes
are zero. Using the letter ¢ to denote consumption, and assuming that
consumption and receipt of interest income both occur at the start of the
period, the budget equation for a member of generation 1, who is currently
old, is

A} + A = 02 + (1 — r)AP. (1)

The total resources available are the assets held while young, A}, plus the
bequest from the previous generation, Aj. The total expenditure is con-
sumption while old, cz, plus the bequest provision, A?, which goes to a
member of generation 2, less interest earnings at rate r on this asset
holding.

The budget equation for members of generation 2 (and, more generally,
for members of any generation i > 2) is, assuming that wage payments
occur at the start of the young period,

w= ci + (1 — r)A}, (2)
and, for the old period,
A+ AS =o + (1 — NAB. (3)

A portion of the lifetime resources of a member of generation 7 goes to a
bequest provision, A?, which I assume is motivated by a concern for a
member of generation i + 1. This concern could be modeled by intro-
ducing either the (anticipated) consumption levels or attainable utility
of a member of generation z + | into the utility function for a member of
the zth generation. For the purpose of the present analysis, the crucial
condition is that this utility depend on the endowment of a member of
generation 7 + | rather than, per se, on the gross bequest, A?. (The
distinction between the gross bequest and the net bequest, which deter-
mines the endowment of z + 1, will be discussed below.) So long as a
member of generation z can transfer resources to a member of generation
t + 1 only through the transfer of unrestricted purchasing power (which
rules out the “merit good”’ case discussed in n. 8 below), the two types of
models of interdependent preferences—concern with consumption levels
and concern with attainable utility—will be equivalent in the sense of
T1100 JOURNAL OF POLITICAL ECONOMY

indirectly implying a concern for the endowment of a member of
generation 7 + 1.

For present purposes, it is convenient to assume that the utility of a
member of generation 7 depends solely on own two-period consumption,
c} and cf, and on the attainable utility of his immediate descendant, U7, ,.
The asterisk denotes the maximum value of utility, conditional on given
values of endowment and prices. Hence, the utility function for a member
of the ith generation has the form,*

Subsequently, I consider the implications of entering the attainable
utility of a member of the previous generation, U;*,, as an additional
argument of the U; function.

Each member of generation 1 determines his allocation of resources
to maximize U,, subject to equations (1)—(4) and to the inequality
conditions, (c%, cf, AS) = O for all z. The key restriction here is that the
bequest to the member of the next generation cannot be negative.* The
choice of bequest, subject to this restriction, takes into account the effect
of A? on generation 2’s resources, the impact of U3 on U,, and the chain
dependence of U, on Uf, of U; on Uf, etc. The solution to this problem
will take the general form

o _ 40 y 0
cy = cy(A? + Ap, w, 1),

5)
7 (
ap = 5 (A? + Ag — ey) = Ap(4y + Ag; w, 7).

Similarly, for members of generation 2 (and, more generally, for members
of any generation? > 2), the solution would take the form,

ch = ci(Aj, w, 7),
|

4r= 5 (w — ¢3) = A3(A?, w, 7),

(6)

cy = ¢3(Az + AP, w, 7),

Ay = i (Az + Ay — ¢3) = A3(A4z + A?, w, 7).
— 7

+ A member of generation 7 is assumed to be concerned with own consumption and
with the attainable indifference surface of his descendant. Further, it is supposed that a
member of generation 7 can attach a metric to generation 7 + 1’s indifference surface
which makes it comparable to c? and cf in terms of generating U, in the form of eq. (4).
The nature of this sort of utility function is discussed in the general context of inter-
dependent preferences in Becker (1974, sec. 3.A).

>I have not imposed the condition, 4} > 0, so that young individuals are allowed
to issue interest-bearing debt on themselves. Ifissued, these debts are assumed to be perfect
substitutes for equity capital. These debts correspond to the consumption loans which
have been discussed by Samuelson (1958).
GOVERNMENT BONDS IIOI

The model can be closed, as in Diamond (1965, pp. 1130-35), by
specifying a constant-returns-to-scale production function that depends
on the amounts of capital and labor input, and by equating the marginal
products of capital and labor to r and w, respectively. The value of r for
the current period would then be determined in order to equate the
supply of assets to the demand—that is,

Kir, w) = A? + AZ, (7)

where K(r, w) is such as to equate the marginal product of capital to r.
The current demand for assets, Ay + A}, depends, from equations (5)
and (6), on 7, w, and the previous period’s value of K, which is equal to
A? + Aj. Since the number of people in each generation is assumed to
equal a fixed number N, it is not necessary to enter this number explicitly
into the aggregate asset demand in equation (7). Similarly, N is omitted
from the aggregate formulations below. Since N is constant and technical
change is not considered, the current and previous periods’ values of K
would be equal in a steady state.

With the marginal product of labor equated to w and with constant
returns to scale, output is given by

y=rK + w. (8)

Equations (2), (3), (7), and (8) imply a commodity market clearing
condition,

cy + cz + AK = », (9)

where AK denotes the change in capital stock from the previous to the
current period. The value of AK would be zero in a steady state, but the
present analysis is not restricted to steady-state situations.

B. Government Debt

Suppose now that the government issues an amount of debt, B, which can
be thought of as taking the form of one-period, real-valued bonds. These
bonds pay the specified amount of real interest, rB, in the current
period and the specified real principal, B, in the next period.® It is
supposed that asset holders regard equity and government bonds as
perfect substitutes. It can be assumed, for simplicity, that the government
bond issue takes the form of a helicopter drop to currently old (generation
1) households. Equivalently, it could be assumed that the bonds were
sold on a competitive capital market, with the proceeds from this sale
used to effect a lump-sum transfer payment to generation | households.

© The amount of bond issue would be limited by the government’s collateral, in the
sense of its taxing capacity to finance the interest and principal payments (see n. 12
below).
IIO2 JOURNAL OF POLITICAL ECONOMY

Allowing some portion of the proceeds to go to generation 2 households
would not alter any of the basic conclusions.

The future interest payments on the government debt must be financed
in some manner. Further, the principal may eventually be paid off—
that is, the government may not reissue the bonds when they come due
in the next period. I assume, provisionally, that the current period’s
interest payments are financed by a lump-sum tax levy on generation 2
households (while young), and that the principal is paid off at the begin-
ning of the next period by an additional lump-sum tax levy on generation
2 households (while old). In this setup there is no direct effect of the
government debt issue and its financing on generation 3 and later genera-
tions. I examine, subsequently, the implications of imposing some part of
the taxes on generations of the more distant future.

The generation 1 budget constraint is now

A? + A2 + Bac? 4+ (1 —7r)AY, (10)

where B represents the lump-sum transfer payment, which is assumed to
occur at the beginning of the period. For generation 2, the current
budget constraint is now

w= ci} + (1 — r)A} + 7B, (11)

where rB represents the tax levy for the government interest payments.
The next period’s budget constraint for generation 2 is now

AX + A? = c8 + (1 — 1) Ao + B,

where B represents the tax levy for repayment of principal. The two
constraints on generation 2 can be combined into a single two-period
budget equation,

w+ (1l—r)A?— B=c? + (1 — ref + (1 —1)7AB. (12)

The form of equation (12) implies that the utility attainable by a member
of generation 2 can be written in the indirect form,

Ux = fe [(l — r)A? — B, w, 1), (13)

that is, the “net bequest,” (1 — r)A? — B, determines the “endowment”
for members of generation 2.

From equation (10), it is also clear that c? varies inversely with
(1 — r)A? — B for a given value of A}? + A§. Hence, given the pre-
determined value of c}, and using equations (4), (10), and (13), U, can
be written in the form,

U, = U, (cj; ¢f, Us) = fi[(1 — r)A? — B; c}, AY + Ag, w, 1].

For given values of c?, A? + A$, w, and r, the choice problem for members
of generation 1 amounts to the optimal selection of the net bequest,
GOVERNMENT BONDS 1103

(1 — r)Ay — B, subject to the constraint that the gross bequest, A?, be
nonnegative. In particular, if the solution to this problem is associated
with a value of A? in the interior—that is, if the constraint, A? > 0, is
not binding—any marginal change in B would be met solely by a change
in A? that maintains the value of the net bequest, (1 — r)A? — B. This
response in Ay will keep unchanged the values of ¢?, ¢3, c3, and A?.
Hence, the utility levels attained by members of generations 1, 2, etc.,
will be unaffected by the shift in B.

In terms of the effect on 7, the current asset market clearing condition
of equation (7) would now be modified to

K(r, w) + B = A? + AB. (14)

The increase in B implies a one-to-one increase in the asset supply on the
left-hand side of equation (14). However, Aj rises by 1/(1 — r) times the
change in B in order to maintain the size of the net bequest, (1 — r)A? — B.
Further, with c3 fixed, the increase in rB (taxes) in equation (11) implies
that A? falls by r/(1 — r) times the change in B. On net, total asset
demand on the right-hand side of equation (14) rises one-to-one with B,
so that no change in 7 is required to clear the asset market. Equivalently,
the commodity market clearing condition, as expressed in equation (9),
continues to hold at the initial value of r because the bond issue has no
impact on aggregate demand.

Essentially, a positive value of B, financed by a tax levy on the next
generation, enables a member of the old generation to “‘go out”’ insolvent
by leaving a debt for his descendant. However, if, prior to the government
bond issue, a member of the old generation had already selected a positive
bequest, it is clear that this individual already had the option of shifting
resources from his descendant to himself, but he had determined that such
shifting, at the margin, was nonoptimal. Since the change in B does not
alter the relevant opportunity set in this sense, it follows that—through
the appropriate adjustment of the bequest—the values of current and
future consumption and attained utility will be unaffected. On the other
hand, if a member of generation 1 were initially at a corner where
A; = O—in particular, if A? < 0 would have been chosen had it been
permissible—then an increase in B creates a relevant new opportunity.
In this situation a generation 1 household would react by increasing c?
along with B, as long as the corner solution for Aj still applied. The
upward shift in B would then correspond to an excess of earning-asset
supply over demand (even after taking account of a shift in A}), which
would tend to raise the value of 7. This increase in r would induce a drop
in capital formation, which constitutes the real effect of government debt
issue which has been described by Modigliani (1961). However, the main
point is that the existence of this government debt effect hinges on a non-
II104 JOURNAL OF POLITICAL ECONOMY

operative bequest motive—that is, on households being at the corner
where the amount of bequest is zero.”

It should be stressed that the crucial consideration for the above result
is an operative intergenerational transfer, rather than an operative
bequest motive per se. For example, the transfer could take the form of
parental expenditure on children’s education, etc., during the overlapping
tenure of parent and child.® Further, the transfer could be occurring in
the direction opposite to that specified above. In particular, Uj could be
entered as an argument of the U, function, and the possibility of gifts from
the young to the old generation could be introduced. In that case the
same conclusions on the effect of a change in the government debt would
be reached if a “gift motive” were operative.” The mechanism through
which changes in B were offset would then be an alteration in the amount
of gifts from young to old, rather than an alteration of the amount of
bequests from old to young.

The results will now be extended to a situation where the taxes which
finance the government debt affect some generations which are not
currently alive. The extension will be made explicitly only to generation 3,
since the extension to generations further advanced in the future is
straightforward.

Suppose now that the current period’s interest payments are financed
by a lump-sum tax levy on (young) generation 2, the next period’s interest
payments (on the reissued bonds) are financed by a lump-sum tax levy on
(young) generation 3, and the principal is paid off by a lump-sum tax
levy on (old) generation 3.1° The generalization of the earlier results to
this situation can be demonstrated by working backward from generation
3. By analogy to equation (13), the attainable utility of generation 3 can

7 When households are not identical, the aggregate effect of government debt issue
will depend on the fraction of households at a corner. As long as some households are in
this situation, a shift in B will have some upward effect on r in this model. However, this
effect would be “‘small”’ if the fraction of households at a corner were small. The role of a
bequest motive in eliminating the perceived net-wealth effect of government debt has
also been discussed by Miller and Upton (1974, pp. 176-79).

8 The previous results on the effect of B might not hold if parents were concerned with
specific consumption components of their children (‘‘merit goods’’), rather than with
their children’s attainable utility. Formally, U; in eq. (4) could depend on (components
of) c?,, or ¢7,1, rather than on U;*,,. If generation i can tie its aid to generation i + |
to a specific type of expenditure (as could be the case for education), the previous results
would not hold if this tied aid were an effective constraint—in the sense of forcing the
next generation to “‘purchase”’ more of the item than it otherwise would—and if the
parents were not making any other transfers which were equivalent to the transfer of
general purchasing power. Becker (1974, sec. 3.C) presents a detailed discussion of the
merit goods case in an analogous context.

? A model which allows for a reciprocal dependence between U; and U;,,1 is formally
similar to the model discussed by Becker (1974, sec. 3.A) in the context of transfer
payments among members of a family.

10] do not deal here with the possibility of net government debt issue during the
old-age tenure of generation 2. No new considerations would arise here (see however,

n. 12 below).
GOVERNMENT BONDS 1105

be written in the indirect form,
U; = fsT(1 ~ r) Az ~~ B, Ww, r|,

where (1 — r)Aj? — B now determines the endowment for members of
generation 3. Since generation 2 no Jonger pays off the government debt
principal, its budget equation is modified from the form of equation (12) to

wt (l—r)Alo—- B= + (1 —neo + (1 —n[(l — nA? — Bl.

For given values of w, 7, and the net bequest from generation 1,
(1 — r)A? — B, generation 2 would select an optimal value of the net
bequest to generation 3, (1 — r)Aj? — B. This net bequest would be
invariant with B as long as the solution for A} were interior. Assuming
that this solution is interior, the attainable utility of generation 2 can be
written in the indirect form,

which coincides in form with equation (13). The situation has therefore
been reduced to the previous case in which marginal changes in B led
solely to changes in A? which kept (1 — r)A? — B constant without
affecting any values of consumption or attained utility.

The three-generation results generalize to the case in which taxes are
levied on m generations, with the mth generation paying off the principal.
By starting with generation m and progressing backward, it can be shown
for all 2 <i < m — 1 that, if A$ is interior, U;* can be written in an
indirect form as a function of (1 — r)A¢_, — B. As long as all inheritance
choices are interior’* (as anticipated by current generations), shifts in B
imply fully compensating shifts in bequests, so as to leave unchanged all
values of consumption and attained utility.'?

11 Intuitively, if this condition is violated for some generations, the impact of these
violations on current behavior should be less important the further in the future the
violating generations. I make no claim to having proved this conjecture.

12 This line of proof does not apply as m - 00. The main issue seems to be whether
the assumption that the principal is eventually paid off is crucial. If the amount of out-
standing government debt were constant, the impact of the principal on current decisions
would become negligible for large m as long as r > 0. However, a difficulty arises here
when B is allowed to grow over time. Suppose that the growth of B were limited to the
growth of the government’s collateral in the sense of its taxing capacity, which depends
in turn on the growth of real income. Suppose that the growth rate of real income is
equal to n, which can be viewed as the combined effects of population growth and
technical progress, which are now allowed to be positive. In that case the present value
of the principal would have to become negligible as m + 00 ifn < r. The situation in
which n > r applies is inefficient in that it is associated with a capital stock in excess of
the golden rule level (see, e.g., Diamond 1965, p. 1129). It is possible in Diamond’s
model (p. 1135) that the competitive equilibrium can be in this inefficient region.
However, this situation is not possible in growth models where individuals are infinite
lived and utility is discounted (see, e.g., Koopmans 1965). As long as intergenerational
transfers are operative, the overlapping-generations model would seem to be equivalent
to the infinite-life model in this respect— that is, the possibility of inefficiency in Diamond’s
model seems to hinge on finite lives with inoperative intergenerational transfers. Hence,
when these transfers are operative, n < r would be guaranteed, and the possibility of
‘perpetual government finance by new debt issue could then be ruled out.
1106 JOURNAL OF POLITICAL ECONOMY

The results in this section have demonstrated that changes in govern-
ment debt would not induce any alteration in consumption plans even in a
model where (1) the present generations have finite lives, (2) the present
generations may, in some sense, give lesser weight to the consumption or
utility of future generations than they give to own consumption, and
(3) the present generation may give no direct weight at all to the con-
sumption or utility of generations beyond their immediate descendants
(who are also finite-lived).

A sufficient condition for changes in government debt to have no impact
on consumption plans and, hence, no effect on aggregate demand and
interest rates is that the solution for the current generations’ inheritances
be interior, and that the solutions for future generations’ inheritances (as
perceived by current generations) also be interior. More generally, the
result will hold as long as current generations are connected to all future
generations by a chain of operative intergenerational transfers, either in
the direction from old to young or in the direction from young to old.

The derivation of conditions under which the solution for inter-
generational transfer would be interior appears to be a difficult problem
and would seem to require some specialization of the form of the utility
functions in order to make any headway. However, it seems clear that
bequests are more likely to be positive the smaller the growth rate of w
(assuming that w is now viewed as variable across generations), the
higher the interest rate, the higher the relative weight of U;., in the U;
function, and the larger the value of B.13 The reverse conditions favor a
gift from young to old.!*

C. Social Security Payments and Other Imposed Intergenerational Transfers

The above results on government debt also apply to social security pay-
ments.’ Suppose that a scheme is instituted which immediately begins
payments to the current old generation (generation 1) of amount S,
financed by a lump-sum tax levy of amount S on the current young

13 In a more general context B should be viewed as outstanding public debt less the
value of physical capital held by the government.

14 There is an alternative argument, which Gary Becker refers to as the “‘enforcement
theory of giving,”’ which suggests that bequest motives would typically be operative.
Suppose that, instead of receiving utility from the perceived utility of his child, a parent
is concerned with own consumption and with the amount of attention, etc., shown by his
child during their overlapping tenure. Suppose, further, that the child has some in-
formation on the size of his parents’ estate and that—acting as a good optimal controller—
he regulates the amount of attention as a function of the estate size. In this situation the
estate would surely be positive if parents place a high value on getting at least a small
amount of attention, and if the child provides no attention when the estate is zero.
However, although a positive estate could be guaranteed in this fashion, it seems that the
previous conclusions about the marginal effect of B on consumption plans would not
hold in this model. The nature of the interactions between parents and children would
have to be analyzed more fully for this case.

15 The view of social security as analogous to government debt has also been taken by
Miller and Upton (1974, pp. 182-84).
GOVERNMENT BONDS I107

generation (generation 2). Generation 2 expects to receive a transfer of
amount S while old, financed by a lump-sum tax levy on (young) genera-
tion 3, etc. It is assumed here that an individual’s payment received while
old is independent of his own contribution to the scheme while young, and
that neither the old receipt nor the young payment depends on the
amount of work, income, etc. Assuming interior bequests (which would be
guaranteed by a sufficiently high value of 5), a change in S$ would induce
the current old generation (generation 1) to maintain its choice of c? and,
correspondingly, to raise A? by 1/(1 — r) times the change in S. This
increased inheritance would just offset the increased tax liability imposed
on (young) generation 2. With its consumption unchanged, generation 2
would use its own higher social security receipt to raise its bequest to
generation 3, A$, by 1/(1 — r) times the change in S. As in the case of
changes in government debt, if the solutions for bequest are interior, the
impact of a marginal change in S would be solely on the size of bequests
and not at all on the pattern of consumption.'® The same results would
follow in the case of operative intergenerational transfers from young to
old, with a marginal increase in § implying a corresponding reduction in
the size of gifts from young to old.

The results for social security payments would apply also to other
programs which amount to imposed intergenerational transfer schemes.
In particular, public support of education involves a forced transfer of
resources from old to young. In the main, this sort of imposed transfer
would be offset by adjustments in the opposite direction of discretionary

D. Inheritance Taxes

Suppose now that inheritances (or gifts) are taxed at a proportionate rate
t. In particular, the bequest from a member of generation 7, A‘, yields a

16 Asin the case of government debt issue, the formal proof depends on the assumption
that the scheme is eventually liquidated (see n. 12 above). The consumption patterns
would also not be affected by a social security scheme that involved the accumulation of a
government “trust fund.” Assuming that the fund were held in the form of earning assets,
an increase in the fund would be equivalent to a negative government debt issue. Real
effects of a social security system would arise if the payments were contingent on the work
behavior of the old generation. In that case there would be allocative effects produced
by the disincentive to work in later years.

17 On a theoretical level, government education programs will involve real effects to
the extent that (1) there is an efficiency difference between public and private production
of education, (2) public expenditure on education is pressed sufficiently far so that a re-
duction of discretionary transfers cannot occur on a one-for-one basis, and (3) there are
distributional effects involving relative educational expenditures and tax liabilities
across families. As an empirical matter, Peltzman (1973) has shown that public subsidies
for higher education are offset to an extent of about 75 percent by reductions in private
expenditures for higher education. However, Peltzman’s 75 percent figure does not
coincide with the desired estimate of the effect on discretionary transfers, since other
components of discretionary transfers may also be affected and (on the other side) since
not all private expenditures for education constitute intergenerational transfers.
1108 JOURNAL OF POLITICAL ECONOMY

net receipt to his descendant, a member of generation 7 + 1, of size
(1 — 1)A%. Of course, the tax receipts must also go somewhere. Suppose
that these receipts are transferred to members of generation 1 + 1 (while
old) in accordance with a rule that is independent of the size of each
individual’s inheritance.

Since an individual’s contribution to general tax revenue will typically
be valued by him at less than an equal amount of own income, it is clear
that an increase in t will tend to lower the amount of intergenerational
transfers. In particular, the higher the value of 1, the less likely that a
bequest or gift motive will be operative. Suppose, however, that the value
of t is sufficiently low that all intergenerational transfers are operative,
even if at reduced levels. In this case the previous results on the effect of a
change in government debt remain valid.

Consider the situation in which the principal on the government debt is
paid off by generation 2. Equation (10) continues to apply in the presence
of inheritance taxes, but equation (12) must be modified to

= ¢} + (1 — r)cz + (1 — 1)*AQ,

where tA represents the transfer to a member of (old) generation 2
corresponding to his share of the receipts from the total taxes paid on the
average generation 1 bequest, 4%. In deciding on a plan for consumption
and intergenerational transfers, an individual is assumed to treat 1A®
as exogenous. Consider the conjecture that, when B rises, each member
of generation | continues to respond by maintaining the value of c{ and,
hence, by maintaining the value of the net pretax bequest, (1 — r)A{ — B.
This response requires an increase in A{ by 1/(1 — r) times the increase
in B. Each individual’s net posttax bequest would fall in this case, but this
fall would be offset, at least on average, by an increase in the transfers to

generation 2 which are financed from the inheritance tax receipts, tA’.
In this circumstance, the individual values of c}, c?, and A$—and, hence,
the attained value of U,—would remain fixed. Hence, by maintaining the
net pretax bequest, each member of generation 1 achieves the same
combination of c{ and Uj as before the shift in B. On the other hand, if
an individual member of generation | decided to increase his net pretax
bequest, while all other members held their net pretax bequests fixed,
it would turn out for this individual that Uy would increase, while c{
would decrease. The terms on which an individual can exchange c{ for US
depend on 1 and 7, and these terms have not been altered by the change
in B. Further, when the transfer to generation 2 of size tA® is included,
there is also no change in an individual’s overall wealth position. There-
fore, the pattern which maintains the net pretax bequest—and thereby
GOVERNMENT BONDS I109g

involves no shift in cf or Uj—must be the optimal pattern for an
individual. It follows that constancy of the net pretax bequest for all
members of generation | is the equilibrium solution.'® In this case, a
marginal shift in B again has no effect on consumption patterns.

The basic conclusion here is that the existence of taxes on intergenera-
tional transfers makes less likely an interior solution for these transfers,
but if these transfers are operative, even if at reduced levels, the marginal
effect of B on consumption plans—and, hence, on r—remains nil.

E.. Bond Issue and Tax-Collection Costs

Suppose now that the issue of government debt and the collection of taxes
to finance this debt involve transaction costs. In particular, in the case
where the principal is paid off by generation 2, suppose that a net issue of
B to generation | is now associated with a tax levy of (1 + y)rB on
(young) generation 2 and a levy of (1 + y)B on (old) generation 2.
That is, y amounts to a proportional transaction cost associated with
government debt issue and tax collection.!° For simplicity, suppose now
that the inheritance tax rate is zero. Equation (10) again remains valid,
but equation (12) is now modified to

w+ (l—r)Ao — (1 + y)B=c3 + (1 — rch + (1 — 1)? AS. (15)

Consider, again, the conjecture that, when B rises, cj and, hence,
(1 — r)AS — B remain fixed. From equation (15), y > 0 implies a
negative-wealth effect on generation 2, so that UX would fall. Since this
effect would be anticipated by generation 1, it can be supposed in the
normal case that A{ would actually rise by somewhat more than
1/(1 — r) times B, so that c{ would fall. In general, y > 0 implies that an
increase in B amounts to an overall negative-wealth effect, which would

18 The equilibrium satisfies two properties: (1) each individual chooses his bequest
optimally, subject to a given choice of bequests by all other individuals; and (2) all
individuals choose the same value for their bequests. It can also be shown that the solution
that maintains the net pretax bequest for all individuals is the unique equilibrium.
Finally, it can be noted that the solution involves the assumption that each individual

perceives the shift in the transfer term, tA°, associated with the average response of

bequests to the change in B. Alternatively, if individuals treated tA® as fixed, they would
view an increase in B as, effectively, a negative change in wealth. The typical response
would be a reduction in cf, which would be associated with an increase in A{ by more
than 1/(1 — r) times the change in B. In the aggregate, there would be an increase in
desired saving, A3 + A}, which would lead to a reduction in r and to an increase in
capital formation. In particular, if the shift in transfers associated with inheritance tax

revenues, TAY, is not perceived, the effects would be opposite to the standard case in
which perceived net wealth rises with B.

19 If the initial debt issue is associated with a decrease in other taxes, rather than an
increase in transfers, there could be an offsetting reduction in transaction costs. The
parameter y, which is assumed to be positive, must be interpreted in this net sense.
IIIO JOURNAL OF POLITICAL ECONOMY

typically involve reductions in both cf and U;. This effect can be seen by
combining equations (10) and (15) into the single two-generation budget
equation,

The decline in total resources on the left-hand side of equation (16)
produced by an increase in B would typically be reflected in declines in all
terms on the right-hand side—c{, c}, ¢5, and A$.

In this circumstance the effect on r of a shift in B would be unclear.
The commodity market clearing condition of equation (9) would now be
modified to include the resources devoted to bond and tax transactions.
The revised market clearing condition would be

co + ch + AK + yrB =».

The effect of B on current 7 will depend on whether, for a given value of
r, the sum, cf + 63, falls by more or less than the increase in yrB. This
relationship seems to be ambiguous.?°

II. Imperfect Capital Markets

This part of the paper analyzes the implications of divergences among
individual discount rates. This source of a net-wealth effect for government
bonds has been stressed by Mundell (1971), who argues that, because of
high discount rates for some individuals, the taxes which finance the
government debt will not be fully capitalized—hence, an issue of govern-
ment bonds will involve a net-wealth effect. To analyze this effect, it is
necessary to construct a somewhat different model. Suppose that there are
now two types of individuals—those who have a low discount rate, 7,, and
those who have a high discount rate, 7,. It can be supposed that the high-
discount-rate individuals have relatively “‘bad collateral,’ so that loans
to these individuals involve high transaction costs, which are reflected in
high (net-of-default-risk) borrowing rates.*! In particular, suppose that
the two discount rates are related according to

rm, = (1 + dn;

where 4 > 0 represents the proportional transaction costs involved in the
loan process.?? I suppose in this part of the paper that both types of

20 From eq. (16), the negative wealth effect is yB, which is the present value of the
flow, yrB. The sum, ce? + 3, will fall by as much as yrB if the total “‘propensity to con-
sume”’ associated with the negative “income” flow, yrB, is equal to one.

21 Tn this respect see Barro (1974).

22 T am assuming that the r, individuals are actually borrowing, so that r, represents
both their borrowing rate and their marginal discount rate. Alternatively, 7, could be
viewed as a marginal discount rate which could be somewhere between the borrowing
and lending rates, as in Hirshleifer (1958).
GOVERNMENT BONDS III!

individuals are infinite-lived, since the effect of finite lives has already
been examined above.

It is convenient to suppose that government debt now takes the form
of a perpetuity that carries a real interest payment of 7 per year. Suppose
that the government issues an additional bond of this type. This bond
would be purchased by a low-discount-rate individual and would be
evaluated as B = i/r,.*3 Suppose then that the government uses the
lump-sum proceeds from this sale, B, to effect a lump-sum transfer (or
lump-sum tax reduction) to individuals, and suppose that a fraction a of
this transfer goes to r, discount rate individuals and a fraction (1 — «) to
r, discount rate individuals. Finally, the taxes for financing the government
interest payments are (1 + y)z, where y represents, as in section IZ, the
proportional transaction costs associated with government bond sale and
tax collection. Suppose that these taxes are distributed across discount
rates in the same manner as the lump-sum proceeds**—that is, a fraction
a to r, individuals and a fraction (1 — a) to 7, individuals.

Consider, in turn, the wealth effects for the r; and 7, groups. The bond
sale itself involves no wealth effect for the 7, group. The lump-sum transfer
to r,; individuals is eB = ai/r;, while the present value of the 7; share of
tax liabilities, discounted at rate 7;, is (1 + y)a/r;. Clearly, if y > 0, the
net-wealth effect for 7, individuals is negative, as it was in the case
discussed in section IZ, where all discount rates were equal.

For the 7, group, the lump-sum proceeds are (1 — «)B = (1 — a)z/r),
while the present value of the tax lability, discounted at rate 7,, is
(1 + y)( — a)i/r,. Using 7, = (1 + A)r,, the net-wealth effect here can
be expressed as

r) + r(1 + 4)

which is positive if 4 > y. That is, the net-wealth effect for the 7, group
is positive if y, which measures the government transaction costs for bond
issue and tax collection, is smaller than 4, which measures the private
transaction costs implicit in the existing pattern of (net-of-default-risk)
discount rates. To the extent, | — «, that the transfer payment and tax
liability involve the 7, group, the government bond issue amounts to
effecting a loan from the low-discount-rate to the high-discount-rate
individuals. On the other hand, this sort of transfer could already have

23 This analysis abstracts from any “liquidity yield” of bonds (see part III, below).

24 Tf the fractions for transfer and tax liability vary, then the wealth effects on the
two discount-rate groups are likely to be in opposite directions. The net effect on current
consumption demand would depend, in part, on relative propensities to consume, which
are not obvious. In any event, this case would amount to the effect of income distribution
on consumption demand, rather than the effect of government bond issue per se on
net wealth and consumption demand.
II1I2 JOURNAL OF POLITICAL ECONOMY

been accomplished privately, except that the transaction costs, as
measured by A, made this transfer marginally unprofitable. Hence, the
government-induced transfer implied by its bond issue can raise net
wealth only if the government is more efficient than the private capital
market in carrying out this sort of lending and borrowing operation.

Some additional observations can be made concerning this result. First,
if the government is really more efficient than the private market in the
lending process (presumably because the benefits of economies of scale
[in information?] and the ability to coerce outweigh the problems of
government incentive and control), it may be able to exploit this efficiency
better by a direct-loan program, rather than by the sort of bond issue
described above. In my simple model, a fraction a of transfers and tax
liabilities involved the 7; group, and this process entailed a dead-weight
loss to the extent that y > 0. A program which limited the loan recipients
to high-discount-rate individuals would be more efficient in this respect.
However, the information requirements for this sort of program may be
much greater than those for a program which does not attempt to dis-
criminate-—in the transfer and tax liability aspects—among discount rates.
The crucial point which can make the bond issue work as a loan program
is that the purchasers of the bonds automatically discriminate among
themselves as to their discount rates.

Second, the government may be more efficient than the private market
only over a certain range of B. In particular, there may be a sufficiently
large value of B such that, at the margin, the net-wealth effect of govern-
ment debt is zero. If the public choice process leads to this value of B
(as it should on efficiency grounds), then, at the margin, the net-wealth
effect of government bonds would be zero, despite the continued existence
of “imperfect private capital markets.”’?>

III. A Government Monopoly in Liquidity Services

Suppose now that government debt provides a form of “liquidity service”’
to the holder, in addition to the direct interest payments. Suppose that,
at the margin, these services are valued at the amount L per bond per
year. Hence, in the context where all individuals have the same discount
rate, r, an additional perpetual government bond would be evaluated as

The taxes for financing the government debt can be thought of as the
interest costs, 2, plus any costs involved with the process of creating

25 Of course, government debt issue would be “productive” in a total sense even in
the case where the marginal net wealth effect was nil. However, it is this marginal effect
which enters into analyses of (marginal) fiscal and monetary policies.
GOVERNMENT BONDS I113

liquidity services (which could involve the y-type costs discussed above).
Suppose that c denotes the marginal costs per bond per year associated
with the production of liquidity services. Hence, at the margin, the wealth
effect of a change in government debt will be

r r r

If the public choice process is such as to motivate the government to act
like a competitive producer of liquidity services (as it should on efficiency
grounds), then L = ¢ and the marginal-wealth effect of government debt
would be nil. On the other hand, if the government operates mono-
polistically, so that L > c, then the marginal-wealth effect of government
debt would be positive.”© However, it is also possible that the government
overextends its production of liquidity services, so that L < ¢ and the
marginal-wealth effect of government debt would be negative. This last
case corresponds implicitly to the one discussed above in section IE,
where L = 0 and c > O were assumed.

Of course, liquidity services can also be provided by private producers.
If the types of services rendered by private and public debt instruments
are close substitutes, and if the private market is competitive, then
governmental monopoly power can arise here only to the extent that, at
the margin, the government is more efficient than the private market as a
producer of liquidity services. Even if the government is a more efficient
producer over a certain range, a sufficient expansion of government
“output”? would eliminate this efficiency differential at the margin if the
production of liquidity services is, at least eventually, subject to increasing
marginal costs. As in the case of an imperfect private capital market, as
discussed above, the net-wealth effect of government debt depends on the
relative efficiency at the margin of government versus private production.

IV. Risk and Asset Substitutability

‘The previous sections have dealt with the net-wealth effect of government
debt. I have not discussed explicitly in these sections the risk characteristics
of government bonds, tax liabilities, and the other types of available assets
and liabilities. Tobin (1971, p. 2) has argued: “The calculus of total
wealth is less important than the change in the composition of private
balance sheets that the government engineers by borrowing from the
public—forcing on taxpayers a long-term debt of some uncertainty while
providing bond-holders highly liquid and safe assets. Since no one else

2© Of course, this observation would also apply to government money, which yields a
zero rate of explicit interest. The usual real balance effect for outside money assumes that
the marginal cost to the government of maintaining real balances is zero, and that the
government acts like a monopolist in determining its supply of real balances.
I114 JOURNAL OF POLITICAL ECONOMY

can perform the same intermediation, the government’s debt issues
probably do, within limits, augment private wealth. Another way to
make the point is to observe that future tax liabilities are likely to be
capitalized at a higher discount rate than claims against the government.”
I have already considered, above, arguments for effectively discounting
tax liabilities at a higher rate because of finite lives, imperfect private
capital markets, and a government monopoly in the production of
liquidity services, and these arguments need not be repeated here. In this
part of the paper, I will consider briefly some implications of the risk
characteristics of government bonds and of the future tax liabilities
associated with the finance of these bonds.

Suppose, first, that there were no uncertainty about the relative burden
of the (lump-sum) tax liabilities that finance the government debt. In
this situation the uncertainty in an individual’s real tax burden associated
with government interest payments would reflect solely the variability
over time in the real-interest payments themselves. In terms of present
values, the variability in the tax liabilities would reflect the variability in
prices and interest rates—that is, the same factors which lead to variability
in real bond values. In particular, holdings of government debt—amount-
ing to aclaim to a certain fraction of total government interest payments—
would be the perfect hedge against variations in tax liabilities.” In this
context a simultaneous increase in government interest payments (i.e.,
government bonds) and in the tax liabilities for financing these payments
would not involve any net shift in the risk composition of private balance
sheets. 78

Suppose now that the tax liabilities are subject to an additional vari-
ability concerning the relative burden across individuals. Suppose, first,
that the variation in relative taxes is purely random, in the sense of being
unrelated to variations in relative income, etc. In that case, it is clear that
an individual’s tax liability associated with government interest payments
would be subject to a source of variability above that of the total interest
payments. In particular, the fractional holdings of government bonds
which corresponds to the expected fraction of tax liabilities would no
longer provide a perfect hedge against variations in the tax liabilities.
Of course, it would be possible for individuals to utilize private insurance
markets to reduce the risks associated with variations in relative tax
liability. However, to the extent that insurance arrangements entail
transaction costs, the risk associated with relative liability would not
generally be fully eliminated. In this case an increase in government bonds
would produce a net increase in the risk contained in household balance

27 T am ignoring here effects which relate to the maturity structure of the government
debt. In order to provide a perfect hedge, an individual’s holding of debt by maturity
would have to correspond to the overall maturity distribution.

28 There could be an effect on individuals who do not hold any government bonds
(or assets subject to similar risks).
GOVERNMENT BONDS ITI5

sheets—that is, there would be a decline in effective household wealth.
The typical household reaction would be twofold: first, an increase in
desired total saving, and, second, a shift in portfolio composition away
from more risky assets, such as equity capital, and toward less risky assets.
The impact on the equity rate of return, and, hence, on capital formation
would depend on which of these two responses was the dominant force.

The above discussion would be altered to the extent that variations
in tax liability reflect variations in income. In this context the variation in
relative tax liabilities can serve to reduce the net variability in disposable
income—that is, the income tax works, in part, like a public program of
income insurance. If the income-offsetting feature of taxes were the
dominant element in relative tax variability, then a shift in government
bonds could lead to a reduction in the overall risk contained in household
balance sheets. In that case the effects on desired total saving and on
portfolio composition would be opposite to those described above.
However, it should also be noted that the public program of income
insurance which is implied by an income tax system will also involve
transaction costs. There are costs associated with administration and with
individual reporting effort, as well as “moral hazard” costs associated
with incentives for earning income. A full analysis of the wealth effect of
government bonds under different tax systems would have to involve a
comparison of these types of public transaction costs against the transaction
costs associated with the pooling of income risks under private insurance
arrangements.

One final observation can be made here. The argument in the early
literature for a net-wealth effect of government bonds—for example, that
given by Modigliani (1961)—involved a neglect of the tax liabilities
associated with the financing of the debt. Similarly, Tobin’s argument for
effects based on the risk composition of household balance sheets seems to
neglect the tax liabilities as an element of these balance sheets. It seems
clear that, either in the sense of effects on perceived total wealth, or in the
sense of the risk composition of household portfolios, the impact of
changes in government debt cannot be satisfactorily analyzed without
an explicit treatment of the associated tax liabilities. Once the variability
in relative tax liability is considered, there seem to be no clear results
concerning the effect of government debt issue on the overall risk contained
in household balance sheets. The net effect hinges on the extent to which
variations in relative tax liability reflect variations in relative income,
and on the transaction costs for public programs of income insurance
relative to those of private programs.

V. Summary and Conclusions

This paper has focused on the question of whether an increase in govern-
ment debt constitutes an increase in perceived household wealth. The
1116 JOURNAL OF POLITICAL ECONOMY

effect of finite lives was examined within the context of an overlapping-
generations model of the economy. It was shown that households would
act as though they were infinitely lived, and, hence, that there would be
no marginal net-wealth effect of government bonds, so long as there
existed an operative chain of intergenerational transfers which con-
nected current to future generations. Net-wealth effects associated with
imperfect private capital markets and with a government monopoly in the
production of liquidity services were shown to depend on the assumption
that the government was more efficient, at the margin, than the private
market either in the loan process or in the production of liquidity services.
Further, the introduction of government transaction costs for bond
issue and tax coltection implied that the net-wealth effect of government
bonds could be negative. Finally, a consideration of the risk characteristics
of government debt and of the tax liabilities associated with the financing
of this debt suggested that an increase in government bonds could raise
the overall risk contained in household balance sheets. However, this
effect depends on the nature of the tax system and on the transaction
costs associated with private insurance arrangements.

The basic conclusion is that there is no persuasive theoretical case for
treating government debt, at the margin, as a net component of perceived
household wealth. The argument for a negative wealth effect seems,
a priori, to be as convincing as the argument for a positive effect. Hence,
the common assertion (as in Patinkin 1962, chap. 12, p. 289) that the
marginal net-wealth effect of government bonds is somewhere between
zero and one and is most likely to lie at some positive intermediate value
has no a priori foundation. If, in fact, the marginal net-wealth effect were
negligible, the implications for monetary and fiscal analysis would be far-
reaching. In particular, in the case where the marginal net-wealth effect
of government bonds is close to zero, (1) the Metzler-type argument for
nonneutrality of changes in the stock of outside money would not be valid,
(2) a change in the stock of government debt would have no effect on
capital formation, and, more generally, (3) fiscal effects involving changes
in the relative amounts of tax and debt finance for a given amount of
public expenditure would have no effect on aggregate demand, interest
rates, and capital formation.??

References

Bailey, M. J. National Income and the Price Level. New York: McGraw-Hill, 1962.
Barro, R. J. ““Uhe Loan Market, Collateral, and Rates of Interest.’ Center for
Math. Studies in Bus. and Econ., Univ. Chicago, Report 7401, January 1974.

29 The usual fiscal analysis involves a shift in the flow of government debt rather than
a one-time shift in the stock. The zero net-wealth effect applies also to the flow case if
individuals perceive the implications of the current flow for the future time path of the
stock of government debt.
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