One of the first concepts taught in any macroeconomics course is the identity that links the financial balance of the private sector, the financial balance of the government and the current account (which is the financial balance of the country as whole). In a closed economy the financial balance of the private sector has to be equal in size to the financial balance of the government but with the opposite sign. I find this identity very powerful when I teach my students as it links concepts that are normally seen as independent by those who have never studied macroeconomics before.
The identity is also a great source of confusion when it is used in a dynamic setting, to understand growth. For example, there are those who wrongly claim that this identity shows that government deficits cannot create growth because by definition the private sector would be saving every dollar that the government spends. This is wrong.
Via Mark Thoma I land on this interview published in Business Insider of Jan Hatzius (Goldman Sach's chief economist). Most of what I read in the interview is fine but I find, once again, that the identity is being misused to understand growth. Here are a couple of paragraphs from the interview:
"...every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero."
This is only correct if we assume that the economy is closed, but that's not the point I want to make.
"That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector's financial balances. If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending."
This paragraph is misleading (I will ignore again the fact that in an open economy things are more complex). It states (at least this is the way I read it) that growth depends on the "desired changes in these sector's financial balance". This is not correct. I can imagine an economy where those financial balances are not changing at all where output is growing very fast (and I can also imagine another one where output is collapsing). There is no connection between growth and these financial imbalances. As long as demand (private or public) is feeding into production and income, the private or public sector might be spending more than last year but their income is also increasing which can make the financial balance remain at the same level as before.
If we believe that we are in a situation where the output gap is large, there are unused resources and, as a result, output is determined by demand, what matters for growth is whether demand increases relative to last year and not so much the change in the desired changes in the financial balances of either the private or public sector.
Antonio Fatás
Wednesday, December 12, 2012
Sunday, December 9, 2012
A narrow definition of supply
Economic debates are many times portrayed as a fight between economists who think that demand defficiency is the main cause of economic crisis and those who believe that what really matters is the supply side. In the current crisis we had the camp that saw the crisis as mainly a cyclical phenomenon and advocated for policies to increase demand and those who saw it as an outcome of excessive spending, whose effects could only be addressed by structural policies that improve the productive capabilities of a country.
Portraying economists as falling in each of these two camps is an oversimplification. Most economists in the profession recognize the important of structural reforms and improving the supply side of an economy. In fact, all economists I can think of when they write or teach about growth in the long term they talk about how a country can improve its productivity, effort, capital stock, all of them variables that are associated to the supply side of an economy (the assumption is that demand adjusts at the same time as production feeds into income and then expenditures).
What I find interesting is that the consensus that supply (incentives, productivity, innovation) drives output and welfare in the long run is then used in the political debate to push the argument that small governments and low taxes are the only sensible economic policy (at any point in time). And any argument in favor of higher taxes or a stronger roles for governments is dismissed on the grounds that it will create massive distortions and low growth.
Best way to find the extreme use of this simplifying argument is the definition of "Supply-Side Economics" that one can find at the Laffer Center (for Supply-Side Economics):
The point is not that taxes do not matter when it comes to economic growth but that the oversimplification that makes supply side = small governments and low taxes seems to miss many of the variables that the academic literature identifies as determinants of growth, some of which could require a larger and not a smaller role for governments and regulation.
Antonio Fatás
Portraying economists as falling in each of these two camps is an oversimplification. Most economists in the profession recognize the important of structural reforms and improving the supply side of an economy. In fact, all economists I can think of when they write or teach about growth in the long term they talk about how a country can improve its productivity, effort, capital stock, all of them variables that are associated to the supply side of an economy (the assumption is that demand adjusts at the same time as production feeds into income and then expenditures).
What I find interesting is that the consensus that supply (incentives, productivity, innovation) drives output and welfare in the long run is then used in the political debate to push the argument that small governments and low taxes are the only sensible economic policy (at any point in time). And any argument in favor of higher taxes or a stronger roles for governments is dismissed on the grounds that it will create massive distortions and low growth.
Best way to find the extreme use of this simplifying argument is the definition of "Supply-Side Economics" that one can find at the Laffer Center (for Supply-Side Economics):
"Supply-side economics emphasizes economic growth.."So far so good, we all like higher economic growth
"...achieved by tax and fiscal policy that creates incentives to produce goods and services." In particular, supply-side economics has focused primarily on lowering marginal tax rates with the purpose of increasing the after-tax rate of return from work and investment, which result in increases in supply. The broader supply-side policy mix points to the importance of sound money; free trade; less regulation; low, flat-rate taxes; and spending restraint, as the keys to real economic growth. These ideas are grounded in a classical economic analysis that understands that people adjust their behavior when the incentives change. Accordingly, the lower the regulatory and trade barriers, and the lower and flatter the tax rate, the greater the incentive to produce."Why the focus on tax and fiscal policy or marginal tax rates or restrained spending? What about other institutions, rules, incentives that can affect growth? What is surprising is that the academic literature that has explored the determinants of economic growth finds limited support for many of these variables as key determinants of differences in growth rates across countries. Other things such as investment, education or innovation matter much more. And while one can argue that these variables themselves could be ultimately driven by taxes, the evidence is once again very weak on inexistent.
The point is not that taxes do not matter when it comes to economic growth but that the oversimplification that makes supply side = small governments and low taxes seems to miss many of the variables that the academic literature identifies as determinants of growth, some of which could require a larger and not a smaller role for governments and regulation.
Antonio Fatás
Wednesday, December 5, 2012
The defeat of the Euro bond vigilantes?
Paul Krugman has written many blog posts downplaying the fears of a sudden increase in US government bond interest rates (what he calls the invisible bond vigilantes). Despite continuous warnings by some market commentators about the risk of high inflation and the possibility that investors start dumping US government bonds, interest rates on these bonds have gone in the opposite direction and are now lower than when some of these fears were first expressed.
In Europe the evolution of interest rates for governments bonds has been very different with several countries seeing very high levels and in some cases no access to funding. The fear was due to probability of default and potentially an exit from the Euro area, not so much inflation. But after a volatile period and following the statement of Mario Draghi supporting the Euro (no action yet) and the more recent agreement for funding for Greece and Spain, interest rates are coming back to levels which are not far from the historical average during the Euro period (and significantly lower than what these countries faced before joining the Euro).
Below are 10-year government bond rates for Spain and Italy.
Rates remain higher than the low values of 2006 but they are at levels which are not far from what we had seen in the early years of the Euro. Of course, this does not mean that the level of confidence is the same as those years, for that we want to measure the premium relative to German bonds, where we will see higher levels. But, at the same time, what matters for sustainability of government debt is the interest rate that a government pays and not its relative value relative to other countries.
There is still plenty of uncertainty in both of these countries and I am almost sure we are not done with swings in confidence and some negative surprises but it is good to see that, at least measured by these rates, there is a growing sense of stability in financial markets.
Antonio Fatás
In Europe the evolution of interest rates for governments bonds has been very different with several countries seeing very high levels and in some cases no access to funding. The fear was due to probability of default and potentially an exit from the Euro area, not so much inflation. But after a volatile period and following the statement of Mario Draghi supporting the Euro (no action yet) and the more recent agreement for funding for Greece and Spain, interest rates are coming back to levels which are not far from the historical average during the Euro period (and significantly lower than what these countries faced before joining the Euro).
Below are 10-year government bond rates for Spain and Italy.
Rates remain higher than the low values of 2006 but they are at levels which are not far from what we had seen in the early years of the Euro. Of course, this does not mean that the level of confidence is the same as those years, for that we want to measure the premium relative to German bonds, where we will see higher levels. But, at the same time, what matters for sustainability of government debt is the interest rate that a government pays and not its relative value relative to other countries.
There is still plenty of uncertainty in both of these countries and I am almost sure we are not done with swings in confidence and some negative surprises but it is good to see that, at least measured by these rates, there is a growing sense of stability in financial markets.
Antonio Fatás
Tuesday, December 4, 2012
Planning for (fiscal) miracles
The debate in the US about how to deal with the "fiscal cliff" has produced a counterproposal by the Republicans on how to avert a crisis. The proposal is criticized by many because of its lack of details (see here, here, here and here). The way the proposal avoids dealing with the real issues and suggests solutions that do not impose a cost on anyone reminds me of some of the debates in Europe about finding a plan to deal with Greek government debt or the capitalization of Spanish banks. In all these cases you hear proposals that seem to generate resources without anyone having to pay for them. Republicans in the US want to raise revenues without increasing tax rates, cutting spending without really cutting it. And the Spanish government will bailout banks without imposing any cost on tax payers. In some cases these proposal have no logic in others there is some logic but a lot of wishful thinking that generates economic miracles.
It is remarkable that the public debate on these issues is not done with more clarity on the real trade offs that are unavoidable when looking for a solution. The fiscal cliff debate in the US cannot escape two set of trade offs:
The first tradeoff is an intertemporal one. The government needs to produce budgetary plans that are sustainable, which given current conditions means to find additional resources. But trying to find resources too fast (cutting spending and increasing taxes over a short period of time) will have a negative effect on growth and might make the adjustment more difficult. This is the problem faced by the US economy over the coming months. Some want to create the impression that the problem is one of exploding deficits but this is not the "real cliff", the issue is the automatic cuts in spending and increases in taxes that will happen without any policy change. So when a plan claims to have found a solution by producing a $2 Trillion reduction in the deficit, it is not addressing the real issue.
The second set of tradeoffs are the fundamental ones in managing a budget: there needs to be consistency between spending and revenues (over a reasonable horizon). Here is where the debate is even less coherent and more likely to produce plans that assume miracles. Here are some of the miracles that tend to be present in these plans:
1. We can find a way to dramatically improve the efficiency of the government and, as a result, generate a large amount of resources. Interesting idea but there needs to be a realistic plan that is based on feasible improvements in efficiency and not jus wishful thinking.
2. No need to raise tax rates, we just need to close loopholes. This arguments tends to work because we all assume that it is only others who benefit from the loopholes. It would be better to identify who is going to pay for this rather than talking about loopholes.
3. We do not need to raise tax rates, we will cut spending. This goes well with the argument of efficiency, especially among those with strong priors that governments do not produce any value. But when we start talking about cutting items like pensions or healthcare, we either admit that we are happy getting fewer of those services or we will simply have to pay for them ourselves. So there is no real gain here you still need to pay for healthcare, not with taxes but with an increase in your insurance premiums (unless you make, once again, the efficiency argument).
A real plan needs to include first a statement on what are the services that we want the government to provide with an understanding that reductions in those services can have real consequences on individuals welfare. And then we need clarity on who is going to pay for these services. Here we cannot anchor the debate on the status quo (as I argued in my previous post), but it has to be a broad society decision on what we consider to be a fair distribution of the bill across different population groups.
Antonio Fatás
It is remarkable that the public debate on these issues is not done with more clarity on the real trade offs that are unavoidable when looking for a solution. The fiscal cliff debate in the US cannot escape two set of trade offs:
The first tradeoff is an intertemporal one. The government needs to produce budgetary plans that are sustainable, which given current conditions means to find additional resources. But trying to find resources too fast (cutting spending and increasing taxes over a short period of time) will have a negative effect on growth and might make the adjustment more difficult. This is the problem faced by the US economy over the coming months. Some want to create the impression that the problem is one of exploding deficits but this is not the "real cliff", the issue is the automatic cuts in spending and increases in taxes that will happen without any policy change. So when a plan claims to have found a solution by producing a $2 Trillion reduction in the deficit, it is not addressing the real issue.
The second set of tradeoffs are the fundamental ones in managing a budget: there needs to be consistency between spending and revenues (over a reasonable horizon). Here is where the debate is even less coherent and more likely to produce plans that assume miracles. Here are some of the miracles that tend to be present in these plans:
1. We can find a way to dramatically improve the efficiency of the government and, as a result, generate a large amount of resources. Interesting idea but there needs to be a realistic plan that is based on feasible improvements in efficiency and not jus wishful thinking.
2. No need to raise tax rates, we just need to close loopholes. This arguments tends to work because we all assume that it is only others who benefit from the loopholes. It would be better to identify who is going to pay for this rather than talking about loopholes.
3. We do not need to raise tax rates, we will cut spending. This goes well with the argument of efficiency, especially among those with strong priors that governments do not produce any value. But when we start talking about cutting items like pensions or healthcare, we either admit that we are happy getting fewer of those services or we will simply have to pay for them ourselves. So there is no real gain here you still need to pay for healthcare, not with taxes but with an increase in your insurance premiums (unless you make, once again, the efficiency argument).
A real plan needs to include first a statement on what are the services that we want the government to provide with an understanding that reductions in those services can have real consequences on individuals welfare. And then we need clarity on who is going to pay for these services. Here we cannot anchor the debate on the status quo (as I argued in my previous post), but it has to be a broad society decision on what we consider to be a fair distribution of the bill across different population groups.
Antonio Fatás
Sunday, December 2, 2012
The wrong benchmark for tax rates
The New York Times presents a comparison of average tax rates since 1980 to make the argument that most taxpayers in the US face lower taxes today that back in 1980. Greg Mankiw does not like the fact that they link the year 1980 to Ronald Reagan's policies as instead he picks the end of Ronald Reagan's second term.
It is important to look at the evidence on how tax rates have changed but what should be the benchmark here? Should we be alarmed if were to find that tax rates have gone up in the last decades? Should we be pleased that tax rates have gone down?
Governments need to raise revenues in a way which is consistent with their levels of expenditures. Their level of expenditures is determined by political choices (demands for services that are provided by governments) combined with the efficiency that governments have at providing those services. It is impossible to make a general argument about the need for governments to become smaller or larger over time unless one is willing to provide the details on what are the services that should or should not be provided by the government or what are the efficiency gains that could be achieved. It is only after those arguments are presented that one can talk about whether tax rates should be flat, increasing or decreasing.
One thing we know is that some of the services that we ask governments to provide, are becoming more expensive over time. In particular, if we look at health care we all are interested in buying more of these services and when we buy them, their cost is growing faster than inflation. As a result, when we look at health care expenditures as a % of GDP, they keep increasing. And this has nothing to do with governments. I produced the chart below in an earlier post that shows how the share of health care expenditures in private consumption has increased dramatically over the last decades (US data).
Given the above trend and given that healthcare expenditures represents a large share of total government expenditures in advanced economies, it should have not been a surprise to see that governments are becoming larger and that, as a result, tax rates are going up. That is the benchmark against which we need to compare the data, not one with a constant tax rate.
Antonio Fatás
It is important to look at the evidence on how tax rates have changed but what should be the benchmark here? Should we be alarmed if were to find that tax rates have gone up in the last decades? Should we be pleased that tax rates have gone down?
Governments need to raise revenues in a way which is consistent with their levels of expenditures. Their level of expenditures is determined by political choices (demands for services that are provided by governments) combined with the efficiency that governments have at providing those services. It is impossible to make a general argument about the need for governments to become smaller or larger over time unless one is willing to provide the details on what are the services that should or should not be provided by the government or what are the efficiency gains that could be achieved. It is only after those arguments are presented that one can talk about whether tax rates should be flat, increasing or decreasing.
One thing we know is that some of the services that we ask governments to provide, are becoming more expensive over time. In particular, if we look at health care we all are interested in buying more of these services and when we buy them, their cost is growing faster than inflation. As a result, when we look at health care expenditures as a % of GDP, they keep increasing. And this has nothing to do with governments. I produced the chart below in an earlier post that shows how the share of health care expenditures in private consumption has increased dramatically over the last decades (US data).
Given the above trend and given that healthcare expenditures represents a large share of total government expenditures in advanced economies, it should have not been a surprise to see that governments are becoming larger and that, as a result, tax rates are going up. That is the benchmark against which we need to compare the data, not one with a constant tax rate.
Antonio Fatás
Monday, November 26, 2012
Ignorance as an excuse
Via Greg Mankiw I read a response to the argument by Peter Diamond and Emmanuel Saez that the top marginal tax rate in the US should be raised to about 73%. I do not want to enter into the substance of the debate but instead discuss the logic used by the criticism of Diamond and Saez work.
The authors of the response present a contrast between the willingness of Peter Diamond to offer a concrete policy recommendation with the answers that two other Nobel Prize winners (Tom Sargent and Chris Sims) gave after receiving their prize. When asked in 2011 what should the government do to help growth, Sims answered:
"I think part of the point of this prize in the area that we work in is that answers to questions like that require careful thinking, a lot of data analysis, and that the answers are not likely to be simple. So that asking Tom [Sargent] and me for answers off the top of our heads to these questions — you shouldn’t expect much from us."
And when asked for a specific policy conclusion he added:
"If I had a simple answer, I would have been spreading it around the world."
The authors praised Sims' answers as the "model of how academic economists should behave when facing questions about specific policy." I find this to be an odd and depressing conclusion as it portrays a very pessimistic view on what academic economists should (can) do. I understand that some of what we do as academics is not useful enough for policy makers, and in these circumstances is better to be honest and stay out of the debate. But as Sims points out in his statement, one can find answers to those questions after careful thinking and a lot of data analysis. That's what Diamond and Saez have done. One can disagree with their analysis but one cannot simply disregard it because they are academic economists.
The authors of the response then go into the details of the analysis and they present their arguments on why the calculations of Diamond and Saez are wrong. But when presenting their arguments they protect themselves from criticism by saying that they do not have an answer to this policy question: "if we had a simple answer we would be spreading it around the world". Although "they can be pretty sure that the answer if significantly lower than 73%". Isn't this a simple answer? Or maybe the fact that they are not willing to provide a number but a range ("significantly lower than 73%") makes it a complex answer?
There is no simple answer to the question of what should be the top marginal tax rate. But policy makers need to chose a number, not a range. Diamond and Saez presents their arguments and data analysis in a way that is at least as competent as any other analysis on the same subject. They can be criticized on their assumptions or calculations but not on their willingness to advance the knowledge on an issue of great policy relevance. If any, they should be praised as academics who want to go beyond writing great papers to make those papers useful for policy makers or society at large.
Antonio Fatás
The authors of the response present a contrast between the willingness of Peter Diamond to offer a concrete policy recommendation with the answers that two other Nobel Prize winners (Tom Sargent and Chris Sims) gave after receiving their prize. When asked in 2011 what should the government do to help growth, Sims answered:
"I think part of the point of this prize in the area that we work in is that answers to questions like that require careful thinking, a lot of data analysis, and that the answers are not likely to be simple. So that asking Tom [Sargent] and me for answers off the top of our heads to these questions — you shouldn’t expect much from us."
And when asked for a specific policy conclusion he added:
"If I had a simple answer, I would have been spreading it around the world."
The authors praised Sims' answers as the "model of how academic economists should behave when facing questions about specific policy." I find this to be an odd and depressing conclusion as it portrays a very pessimistic view on what academic economists should (can) do. I understand that some of what we do as academics is not useful enough for policy makers, and in these circumstances is better to be honest and stay out of the debate. But as Sims points out in his statement, one can find answers to those questions after careful thinking and a lot of data analysis. That's what Diamond and Saez have done. One can disagree with their analysis but one cannot simply disregard it because they are academic economists.
The authors of the response then go into the details of the analysis and they present their arguments on why the calculations of Diamond and Saez are wrong. But when presenting their arguments they protect themselves from criticism by saying that they do not have an answer to this policy question: "if we had a simple answer we would be spreading it around the world". Although "they can be pretty sure that the answer if significantly lower than 73%". Isn't this a simple answer? Or maybe the fact that they are not willing to provide a number but a range ("significantly lower than 73%") makes it a complex answer?
There is no simple answer to the question of what should be the top marginal tax rate. But policy makers need to chose a number, not a range. Diamond and Saez presents their arguments and data analysis in a way that is at least as competent as any other analysis on the same subject. They can be criticized on their assumptions or calculations but not on their willingness to advance the knowledge on an issue of great policy relevance. If any, they should be praised as academics who want to go beyond writing great papers to make those papers useful for policy makers or society at large.
Antonio Fatás
Wednesday, October 17, 2012
Semantics and the Debt Burden
Does government debt impose a burden on future generations? A relevant question given the high current government debt levels to which most people will answer with a clear "yes": we are spending today and passing the bill to the next generation. But this answer is incorrect (or to be more precise it might be incorrect). The link between debt and burden on future generations is much more complex than what many think.
Recently, a debate has populated the economics blogosphere as some argue that that debt only imposes a burden when it is held externally, others coming up with counterexamples where this is not true (borrowing from Noah Smith a list of links to the debate: here, here, here, here, here or here.)
The debate becomes even more complex as the issue of desirability of another round of fiscal stimulus is mixed with the notion of intergeneration transfers associated to increasing government debt.
Unfortunately, economists tend to go in circles and debate the same subjects over and over again without reaching consensus, so when I went back a few months (January this year) I found a very similar debate with practically identical arguments being put forward by both sides.
The lack of consensus in this particular debate is much more about semantics that about disagreements on how the economy works. My reading of the debate is summarized well by Noah Smith long list of updates to his blog entry. In particular the following question: is government debt an indicator of the (fiscal) burden we are imposing on the next generations? And the answer is a clear no. Debt does not matter. What matters is taxes and spending, debt is just a vehicle to deal with imbalances between the two. Debt is not a burden per se but it can be the outcome of tax and spending decisions that lead to redistribution of resources.
We can construct examples where a government with high debt levels is not imposing any costs on future generations. We can also construct examples where a government with very little of no debt imposes large burden on a given generation (tax everyone under 50 and give the revenues as a transfer to everyone over 50).
And while seeing these debates come back without a resolution is frustrating, the advantage is that I can cut and paste below a longer and more detailed post that I wrote last time the debate happened. Just for those who still want to read more about it.
Antonio Fatás
------
Paul Krugman makes the point that government debt matters less than most people think because in some cases we simply owe money to ourselves. He is right and what he has in mind is the notion that government debt is (in many countries) mostly held domestically. Japan is an extreme case where more than 90% of the government debt is held by its nationals but even in the US the majority of government debt is held by US citizens or institutions. For some it is debt but for others it is an asset, they cancel out from a national point of view.
We can think of an extreme case where government bonds are held by all taxpayers in proportion to their income - in a way that mimics tax rates. In that case, government debt is not imposing a future burden on anyone, it simply cancels out with the assets that all investors/taxpayers have.
How do future generations enter into this analysis? What if we try to pass the bill to future generations? Let's start with the case of a closed economy/system. In a closed system (the world, no international trade or capital flows) the debt that the current generation has will end up in the hands of the future generation in one of two ways: either it gets simply passed to the next generation as a bequest or, alternatively, the current generation could try to sell their assets and spend all their wealth if they do not want to leave a bequest to their children. But the debt must be bought by someone. And given that this is a closed economy, it can only be bought by the future generations. In both cases the bond holders are also the taxpayers.
If we bring other countries into the picture then the analysis is different. The government debt that other countries hold is a claim on our current and future income and as such it is a financial burden that either the current generation or the future one will have to pay for. But Krugman's point, which is correct, is that many make the mistake of assuming that government debt is equivalent to external debt and they overestimate the burden that it imposes on a country.
Let's go back to the case of a closed economy: is it really true that debt does not matter? Not quite, because there are distributional issues of two types: first there is no perfect match between bond holders and taxpayers so it is not quite true that we owe money to ourselves. Some citizens owe money to others. The second distributional issue is about generations and here we need to go back to the example above to understand how difficult the analysis can get. The best way to understand the argument is to stop talking about debt and talk about spending and taxes, which is what really matters. A government spends some income today (builds a road, provides health services to the population). It decides not to tax anyone but instead it issues debt bought by the current generation. The government decides that it will only pay back the debt in the future when it raise taxes on the next generation, not the current one. Are we passing a burden to the next generation? It all depends on what the current generation does. If they decide to spend all their income and leave no bequests for their children then the answer is a clear yes. The current generation enjoyed services that they did not pay for themselves and did not compensate the next generation in any way for the future taxes they will have to pay. Just to be clear, the future generation will be holding the debt that the previous generation sold to them when they were spending their inheritance, but this is not a transfer of resources, the asset was sold at market price. So the fact that in the future bondholders are also the taxpayers does not mean that we are not passing a burden to the next generation.
There is a second scenario where there is no burden passed to the next generation. It can be that the current generation is responsible, understands that the government is asking future generations to pay for the goods and services that they enjoyed and they decide to leave a larger-than-planned bequest to their children so that they have resources to pay for all the taxes (you can think about the bequest being the government debt itself). In this case no burden is passed to the next generation.
This simple example (*) makes it clear that answering the question of what distributional impact government debt has across generations requires an understanding of the patterns of spending, taxes and saving of different generations. What matters is not debt but who enjoys the spending that the government does and who pays for it. Debt is just a vehicle that can be used to transfer resources across different individuals or generations. Debt is not a problem, the problem, from a generational point of view, is the potential mismatch between spending and taxes (even if future taxpayers are also the holders of government bonds when they are paid back).
(*) The example ignores many issues: the type of goods government buy, the possibility of default, the possibility of crowding out (government bonds displacing other forms of saving),...
Recently, a debate has populated the economics blogosphere as some argue that that debt only imposes a burden when it is held externally, others coming up with counterexamples where this is not true (borrowing from Noah Smith a list of links to the debate: here, here, here, here, here or here.)
The debate becomes even more complex as the issue of desirability of another round of fiscal stimulus is mixed with the notion of intergeneration transfers associated to increasing government debt.
Unfortunately, economists tend to go in circles and debate the same subjects over and over again without reaching consensus, so when I went back a few months (January this year) I found a very similar debate with practically identical arguments being put forward by both sides.
The lack of consensus in this particular debate is much more about semantics that about disagreements on how the economy works. My reading of the debate is summarized well by Noah Smith long list of updates to his blog entry. In particular the following question: is government debt an indicator of the (fiscal) burden we are imposing on the next generations? And the answer is a clear no. Debt does not matter. What matters is taxes and spending, debt is just a vehicle to deal with imbalances between the two. Debt is not a burden per se but it can be the outcome of tax and spending decisions that lead to redistribution of resources.
We can construct examples where a government with high debt levels is not imposing any costs on future generations. We can also construct examples where a government with very little of no debt imposes large burden on a given generation (tax everyone under 50 and give the revenues as a transfer to everyone over 50).
And while seeing these debates come back without a resolution is frustrating, the advantage is that I can cut and paste below a longer and more detailed post that I wrote last time the debate happened. Just for those who still want to read more about it.
Antonio Fatás
------
(Repost) Debt does not matter. Spending and taxes do.
Monday January 2, 2012.Paul Krugman makes the point that government debt matters less than most people think because in some cases we simply owe money to ourselves. He is right and what he has in mind is the notion that government debt is (in many countries) mostly held domestically. Japan is an extreme case where more than 90% of the government debt is held by its nationals but even in the US the majority of government debt is held by US citizens or institutions. For some it is debt but for others it is an asset, they cancel out from a national point of view.
We can think of an extreme case where government bonds are held by all taxpayers in proportion to their income - in a way that mimics tax rates. In that case, government debt is not imposing a future burden on anyone, it simply cancels out with the assets that all investors/taxpayers have.
How do future generations enter into this analysis? What if we try to pass the bill to future generations? Let's start with the case of a closed economy/system. In a closed system (the world, no international trade or capital flows) the debt that the current generation has will end up in the hands of the future generation in one of two ways: either it gets simply passed to the next generation as a bequest or, alternatively, the current generation could try to sell their assets and spend all their wealth if they do not want to leave a bequest to their children. But the debt must be bought by someone. And given that this is a closed economy, it can only be bought by the future generations. In both cases the bond holders are also the taxpayers.
If we bring other countries into the picture then the analysis is different. The government debt that other countries hold is a claim on our current and future income and as such it is a financial burden that either the current generation or the future one will have to pay for. But Krugman's point, which is correct, is that many make the mistake of assuming that government debt is equivalent to external debt and they overestimate the burden that it imposes on a country.
Let's go back to the case of a closed economy: is it really true that debt does not matter? Not quite, because there are distributional issues of two types: first there is no perfect match between bond holders and taxpayers so it is not quite true that we owe money to ourselves. Some citizens owe money to others. The second distributional issue is about generations and here we need to go back to the example above to understand how difficult the analysis can get. The best way to understand the argument is to stop talking about debt and talk about spending and taxes, which is what really matters. A government spends some income today (builds a road, provides health services to the population). It decides not to tax anyone but instead it issues debt bought by the current generation. The government decides that it will only pay back the debt in the future when it raise taxes on the next generation, not the current one. Are we passing a burden to the next generation? It all depends on what the current generation does. If they decide to spend all their income and leave no bequests for their children then the answer is a clear yes. The current generation enjoyed services that they did not pay for themselves and did not compensate the next generation in any way for the future taxes they will have to pay. Just to be clear, the future generation will be holding the debt that the previous generation sold to them when they were spending their inheritance, but this is not a transfer of resources, the asset was sold at market price. So the fact that in the future bondholders are also the taxpayers does not mean that we are not passing a burden to the next generation.
There is a second scenario where there is no burden passed to the next generation. It can be that the current generation is responsible, understands that the government is asking future generations to pay for the goods and services that they enjoyed and they decide to leave a larger-than-planned bequest to their children so that they have resources to pay for all the taxes (you can think about the bequest being the government debt itself). In this case no burden is passed to the next generation.
This simple example (*) makes it clear that answering the question of what distributional impact government debt has across generations requires an understanding of the patterns of spending, taxes and saving of different generations. What matters is not debt but who enjoys the spending that the government does and who pays for it. Debt is just a vehicle that can be used to transfer resources across different individuals or generations. Debt is not a problem, the problem, from a generational point of view, is the potential mismatch between spending and taxes (even if future taxpayers are also the holders of government bonds when they are paid back).
(*) The example ignores many issues: the type of goods government buy, the possibility of default, the possibility of crowding out (government bonds displacing other forms of saving),...
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