In a recent article, Bob Murphy responds to my statement that counting the interest cost on the debt generated by war spending is not justified. I argued that it’s double counting and that the initial outlay is the correct measure of the cost. Bob lays out my argument more completely than I did. The argument is essentially that the cost of the spending, if paid totally by taxes, is the amount of spending and that the cost of the spending, if paid entirely by debt, is the present value of the interest payments and ultimate payment of the principal. These should be the same.

Bob then goes on to criticize my view and his doing so has caused me to revise my argument. He writes:

The biggest flaw with the standard analysis is that government interest payments to bondholders do “hurt the economy,” because they are financed through coercive taxation. (The government can also pay interest on its debt through further borrowing, which just postpones the problem, or through inflation, which is a form of indirect taxation.) Once we take this aspect into account, it’s no longer true that interest expenses are a form of “double counting.”

Good point. Bob elaborates:

Because of what mainstream economists call the “deadweight loss” of taxation, our hypothetical annual streams of $5 billion interest payments really do make society as a whole poorer, in terms of forfeited goods and services that could have been produced in the private sector.

It’s because of this deadweight loss that I realize I didn’t state the analysis correctly to begin with. So here’s my current thinking.

The cost to the United States of fighting a war paid for by taxes is the amount of the taxation times (1 + d), where d is the deadweight loss per dollar of taxes. If, instead, the U.S. finances a war using debt, then the cost of the war is the present value of all the interest payments and repayment of principal, except that each of these interest payments and the principal are multiplied by (1 + di) where di is the deadweight loss per dollar of taxes raised when the taxes are actually raised to pay the interest or the principal. In other words, the mistake in my original formulation is that I left out deadweight loss. But there is no particular reason why the di in a particular period is greater than d today. In fact, I remember Bob Barro arguing somewhere in the 1970s that when the war is really expensive, the way to minimize the present value of deadweight loss for a given expenditure is to have relatively even tax rates over time, which implies using some debt to pay for the war. In fact, Bob Murphy, I think agrees with me. He essentially admits my point in his footnote 2.

So thanks to Bob for helping me get my own thinking straight.