Saturday, September 29, 2012

Phantoms in the Dark Part 6: The Barro-Wight

I need to get to the crux of this, which is not really the issue of whether current deficits hurt or help growth, or whether the burden of current deficits are borne by the present population or by some distant future population.  No, the crux is really the question of how much total debt---not deficit---is too much, and whether there’s a point at which the total debt starts to slow growth down, or even reverse it, or otherwise cause damage to the economy.  That’s the real phantom here.  That’s the big one, the one that’s scaring everyone.  That’s the issue that makes people all over the political blogs claim that the country is, or will be, “bankrupt”, and that caused even Barack Obama to say at one point that we’ve run out of money.  So I need to discuss that, and I’ll do that soon.

But I’m aware, because I was reminded, that I never talked about the Barro/Ricardian equivalence idea about deficits, item number 3 in Nick Rowe’s list, which still talks only about deficits rather than total debt.  Barro’s idea is that whenever there is a federal budget deficit ordinary households will save more and spend less in order to prepare for what they think are the inevitable future taxes necessary to pay for the deficit.  As a result the total savings and total demand for goods and services is, according to this theory, the same if the government borrows to cover its costs as it would be if the government simply taxed the population and balanced the budget in the first place.  Deficits don’t burden future populations, this theory says, but only because the current populations rationally expect future taxation to pay for the deficits and all accumulated interest until the tax is applied.  Households rationally, and carefully, save just enough to pay the equivalent taxes, and pass their savings down the years until the taxes are imposed.

I am a little hesitant to approach this topic because it’s hard to know where to start: Robert Barro is a staggeringly smart economist, but I’m just puzzled by the whole set of assumptions that have to be made to make that concept work.  They seem to me to be the kind of assumptions you could make only if you have been absorbed in abstract mathematical models so deeply that you can no longer see the real world, absorbed so deeply that you think those models are the real world.  I can understand that.  I’ve been there, in my long-ago days in graduate school.  The mathematics were so beautiful that I wanted to live in the world they described instead of the world that exists.  But when we’re talking about actual policy prescriptions, we can’t pretend that the math is everything: we have to implement policy in the real world, and the results we get will be determined by how the real world works, not by how some seductive abstract model with perfect mathematical curves works.

But in any case, this post will be longer and wonkier than most of my posts, and longer and wonkier than I would like it to be.  I don’t know how else to express my problems with this item from the list. 

My examples will come from this version of Barro’s explanation of Ricardian equivalence.  To show what I mean about the assumptions that support the model, let’s start with this quote from that paper:

“I will sketch the standard model. The starting point is the assumption that the substitution of a budget deficit for current taxation leads to an expansion of aggregate consumer demand. In other words, desired private saving rises by less than the tax cut, so that desired national saving declines. It follows for a closed economy that the expected real interest rate would have to rise to restore equality between desired national saving and investment demand. The higher real interest rate crowds out investment, which shows up in the long run as a smaller stock of productive capital. Therefore…the public debt is an intergenerational burden in that it leads to a smaller stock of capital for future generations.”

It’s true that this model is fairly widely accepted in some parts of the economic world.  In fact, some parts of that world see this model, that government deficits reduce the total savings in the economy and that they therefore “crowd out” private investment, to be so self-evident that it requires no proof; there are those who are astonished and exasperated when anyone questions it. 

And I, on the other hand, am astonished and exasperated that anyone fails to question it, since to me it seems to be self evidently wrong. 

So let’s look at it.  Here are the assumptions I see in the quote above:

He assumes that deficit spending absorbs savings in the economy---that it competes with business for a limited supply of loanable funds.  It’s not a fixed supply, since he claims that a tax cut (or an increase in income caused by increased government spending) will increased desired savings, but, he asserts, not by as much as the deficit the government must cover. 

But as I pointed out a few posts ago, when the government spends, that act creates savings in the economy; it increases total savings by at least the amount of the government spending.  Someone in the economy, a business or a household, receives what the government spends.  I’m not proposing anything radical by saying this, these are just two sides of the same transaction.  Until that person or business spends the money, it is an increase in savings.  But what happens when a household does spend the money on consumption goods, for example?  Doesn’t that decrease savings?  No, it doesn’t.  The money is subtracted from the household’s bank account by the transaction---and is added to the bank account of the business that sold the consumption goods.  The savings is still there, but now it is corporate savings instead of household savings.  You can go through all the other possible kinds of transaction, such as investment or other spending by businesses, and you will find that because every transaction has two sides, one person buying and another selling, the money, the savings created by government spending, never leaves the system.  It always shows up as savings in someone’s account, unless the government taxes it away.   So when the government spends money, and then borrows to cover the cost, it is simply borrowing the savings that were created by its spending, not absorbing any share of a pool of savings that existed prior to those actions.  (That is not, of course, the end of the story: the actual savings that have shown up in people’s and business’s bank accounts may be more savings than they desire at their new level of income, and they will try to reduce it by spending or investing.  They will continue to do this until the total nominal national income rises enough to make the actual savings acceptable to the people and businesses who end up holding it---but that’s a much longer story than I can tell in this post.)

But even if it were not true as an accounting artifact that government spending creates new nominal savings, the quote from Barro above would be questionable, since it seems to assume that all savings that existed prior to the government action were already demanded by businesses or households for investment purposes. That is not necessarily true; in fact it is clearly not true right now.   There were $1.452 trillion dollars in excess reserves at the Federal Reserve bank as of September 19, 2012.

Now let’s get to the Ricardian model itself.  Barro says:

"The Ricardian modification to the standard analysis begins with the observation that, for a given path of government spending, a deficit-financed cut in current taxes leads to higher future taxes that have the same present value as the initial cut."

Alternatively, he would say that an increase in government spending without increasing taxes in the present must imply an increase in taxes in the future that has the same present value as the spending increase.  And he goes on to explicitly state:

"This result follows from the government's budget constraint, which equates the total expenditures for each period (including interest payments) to revenues from taxation or other sources and the net issue of interest-bearing public debt."

But if you have read the prior Phantom posts, you know that there are economists out there, from at least the time of Abba Lerner’s paper on Functional Finance, who do not accept the idea that the government even has a budget constraint.  Nor do I.   The usual expressions of an intertemporal government budget constraint that include only taxing, borrowing and spending as variables across time.  But if we include the government’s ability to create money into an expression of an intertemporal budget condition, or intertemporal budget equation, we see that it is no longer an intertemporal constraint: a  government that controls its own money supply can always purchase anything that is offered for sale in its own currency, either now or at any time in the future.  For other economic reasons, for example to avoid excessive demand that would drive inflation, the government may choose not to finance its spending by money creation, but its equally true that to stimulate demand and achieve full employment the government may prefer that means of finance in some periods in the future.  All of that simply means that the full intertemporal budget equation, including all methods of financing government activity, might be useful along with other equations in planning.  But it is not a constraint on government financing, and it can't be used in any simplistic way to forecast tax rates in the future.

So this whole Ricardian alternative depends on assumptions of eternal full employment of resources, eternal full employment of any existing savings, and the existence of an intertemporal government budget constraint, none of which are true in the real world.

But none of these is the biggest failing, in my view, of the Ricardian equivalence theory. The theory itself after all of this build up states that:

"household's demands for goods depend on the expected present value of taxes---that is, each household subtracts its share from the expected present value of income to determine a net wealth position."

This is the one that floors me, frankly.  I don't understand how anyone can suggest this with a straight face. 

Let me make this clear.  Future tax rates do not depend on current deficits even in theory, and if there is any such dependence as a practical matter it is a pretty feeble one.  As evidence, we could simply point to the post-WWII history of the United States, where deficits have been common but tax rates have consistently declined.  In fact when deficits exploded under Reagan/Bush in the eighties and under George W. Bush  in the oughts, tax rates declined a great deal in both decades.  The top tax rate at the end of WWII was above 90%.  In spite of all the decades of deficits since then the top tax rate is now 35%.

But ignoring all of that, ignoring all the questionable or simply false assumptions discussed above, and the feeble---in fact completely invisible---connection between observed tax rates and actual deficits, does anyone seriously believe that households---all of them, rich and poor, educated and not---take the time to calculate a discounted present value of all expected future taxes before they buy milk at Safeway?   People simply do not behave like this.  I don't mean that a few irresponsible people who fail to calculate their net wealth position including the discounted present value of all future taxes while they’re standing in the produce aisle weaken the theory.  I mean that because of this problem alone the theory is bunk because absolutely no one behaves like this.  If there are exceptions, I don’t know them.  I strongly doubt that Robert Barro behaves like this.  

Here's why I doubt it: the failure to do this calculation isn’t laziness.  And it isn't ignorance.  People do not try to make that calculation because neither an average person nor the world’s greatest economic expert can make it, so no rational person would try to make it as a basis for their daily decisions. While the CBO and other forecasters do try to peer into distant futures with huge macroeconomic models, they do so with a humility born of frequent error.  The CBO should not be blamed for these errors.  The distant future is impenetrable and unpredictable, even to the brightest and best-educated people on this planet.  As I pointed out in an earlier post, no one a quarter of a century ago could possibly have predicted the federal budget surpluses of the late nineties; they could not have predicted the dot-com boom or the subsequent dot-com collapse, because a quarter of a century ago even the concept of a dot-com was unknown and unimagined, except perhaps in the secret inner mind of Timothy Berners-Lee.  And if the best educated people on earth were trying to predict the stream of government revenue in the future they would include tax rates as only one of many variables: economic growth, population growth, income distribution, employment, the probability of new resources, new technologies, wars, booms, busts, and many other things would also enter their calculations.   And they still would not get it completely right.

So of the four items in Nick Rowe’s list on the burden of deficits, this is the one I find least plausible.  The real world is not nearly as perfect as the original “standard” model that Barro outlined in the quote at the top of this post.  The government does not actually face a budget constraint, so using one to predict tax rates in the future is misguided at best.  Unemployment does occur, not only of people, plant capacity, transportation capacity and other real things, but also of saved funds.  Future tax rates don’t really depend on current deficits, partly because future financing needs and strategies depend on many, many things, and accumulated debt is only one of them.  And finally, no one at all would ever, or could ever, make the calculations that Ricardian equivalence requires of them as they make their savings and consumption choices.

Tuesday, September 18, 2012

Mr. Romney---please.

I want to stay as impartial as I can on this blog.  I want to stay at least a tiny bit above the messy political battle.  It must be fairly clear that I have opinions, and that in those opinions I am fairly liberal, but I want to give credit to both sides of every argument when I can.  By far the most visited post I have ever published is this one, in which the whole point is that it doesn’t matter which party holds power, either in the executive or the legislative branch, that what matters is what policy the party in power pursues, and how those policies---not parties---impact the world. 

But Mr. Romney, please.  Give me some opportunity to show your side.  Do you really mean to say that half of the people in this country see themselves as “victims”, that half the people pay no taxes and expect all of life’s problems to be solved for them by government?  That half of the people are parasites on the economy?  Really?  I find that almost impossible to believe of you.  I would find it entirely impossible, but this latest video reprises your running mate Paul Ryan’s interview with the McGiver Institute, in which he said:

“We risk hitting a tipping point in our society where we have more takers than makers in society, where we will have turned our safety net into a hammock that lulls able bodied people into lives of dependency and complacency.”

Takers and makers?  A tipping point, where there are more takers than makers?  Where there are more lazy dependents living off the wealthy than there are producers who create that wealth?

Just as a quick FYI, Mr. Romney: almost the whole of the population of the United States works hard for what they get in life.  And almost the whole of the population of the United States pays taxes.  They may not pay federal income taxes every year of their lives.  But they pay taxes; yes, even the old, students, and the very poor pay taxes.  They pay, for example, gas taxes every time they fill their cars to fuel their trip to work or to school every day.  But those three groups, the old and the poor and the students, are the “takers” you are talking about, the dependent people who are unable to “take responsibility” for their lives. 

But the old did take responsibility for their lives.  They created the world you inherited, Mr. Romney---yes, you did inherit, perhaps not the fortune you now hold but the whole cultural and technological world you see around you.  We all inherited that.  Those who are retired now created it for us.  And the young, the students, are studying hard so that for the remainder of their lives they can pay taxes and contribute to the world along with the rest of us.  And the poor, most of them anyway, are trying to rise out of that situation, working hard to get a grip on some low rung up the ladder.

Here’s a graph from this study:

I’m not the first to republish this.  I found it here.  But the graph is important, and deserves a wide audience. 

Notice the fraction of people who pay federal income taxes in their prime earning years?  Notice the fraction of people who pay federal income or payroll taxes?  Payroll taxes, which are 15.3% of income, a higher fraction of income than you paid in the one year of tax returns you have released?  And this graph doesn’t show who pays local taxes, property taxes, sales taxes, gas taxes.  Almost everyone pays taxes of some kind, Mr. Romney.  And almost everyone during their working years pays taxes at a higher rate than you do.  That’s not a criticism; you have a right to organize your income in whatever way minimizes your tax obligation.  I don’t blame you for that.  But I find it hard not to blame you for castigating those who pay a higher percentage of their income in taxes than you do as somehow being freeloaders in the system.

Here’s the truth, Mr. Romney.  This country, like most countries through all of history, is full of people who work hard.  Yes, there are slick players, con artists, who slide through life contributing little and take what they can: there are players like that at every income level.  I won’t bother to list all the high-roller financial scams we have seen in the last few years.   You know them better than I do.  But I will mention that one of the most widespread types of scam is scams against the elderly---scams by predators that live on the wealth of older people, many of whom fall into the category you dismiss so caustically, of those who "pay no income tax", because they are living on Social Security or on payments out of their IRAs.  There con artists and scammers, without doubt.  But we are not even close to a “tipping point” where they outnumber the rest of us.  Most people work long hours to get ahead, work to make their lives and the lives of their families better.

These people, the working population of this country, are not living as parasites on the wealth that you have created, Mr. Romney.  You are not Atlas, with the world balanced on your shoulders, and we don’t live in fear that you will shrug.  In fact it is at least arguable that the shoe is on the other foot.  It’s arguable that you are living on the wealth that they create.  If working people shrugged, if they stopped making all the things you use your wealth to buy, what would your wealth mean?  What would any wealth mean?

Please.  Show me that my understanding of your remarks is flawed, that you really didn’t mean to say that half of the population of our country are idle “takers”, that only the rich are producers.  Show me that you understand the contributions that ordinary people make, and how vast the wealth is that they create.

Monday, September 17, 2012

The Agony of the Blogger

I’m sorry for the long silence.  I’m having a lot of lower back pain, and sitting at the computer typing seems to be its source.   

I have a friend in the massage therapy business who gave me a long lecture about the muscle groups that are affected by sitting, using crazy alien words like “Psoas” (pronounced, for some reason, “so as”), and iliacus (illy ack us).   These are words I’m sure she made up, but whatever.  She claims that I have a terrible malady that she has called, at least in my case, “Blogger’s Butt”. 

I didn’t think I blogged that much.  I don’t know how the truly prolific bloggers manage to maintain all their body parts in good working order.  Maybe there’s a special blogger conditioning program that I should know about.

So I have to slow down on the blogging for  a few days.  But I’ll get back to the Phantoms topic soon.  I still have to get to the real phantom, the really frightening mystery, which is not really the issue of whether some small amount of debt is a burden on current populations or future populations.  The real phantom is this: is there an upper limit of some kind to the amount of debt a nation can carry before it has a serious impact on the economy?  If we have a debt of 150% of GDP, are we doomed?  What about 300%?  3000%?  If there is a limit, what is it---and why is it?  What’s the theory that explains that limit?

Here’s a quick preview: I’m not sure anyone really knows what the limit is, or even if there is a limit.  And I’m not sure there is a very good theory explaining why there would be one.  Which seems odd, given the importance of the topic.

Monday, September 10, 2012

Phantoms in the Dark Part 5

Functional finance---at last.  If you are of a traditionalist frame of mind about government debt or taxes, and you have not yet encountered functional finance or modern monetary theory I feel obligated to provide some warning: this could shock your pants off, which might startle anyone who happens to be nearby.  If you’re reading this in a public place you might want to pause to fasten on a sturdy and reliable pair of suspenders.  You know, to be on the safe side.

Yesterday I quoted James Buchanan from this book saying:

“The efficient means of purchasing the services of unemployed resources is through inflation of the currency.”

In other words, if there are idle resources that the government wants to use, the best way to purchase them is to simply create the money from thin air.  Abba Lerner agreed with that---and if I thought it was politically possible I would probably agree with it too. 

In the 1943 Abba Lerner published a paper called “Functional Finance and the Federal Debt” in which he asked us all to do something radical: he asked us to discard our moralistic presumptions regarding the financing of government activity and judge each different method of financing by its actual direct effects.  Debt, taxation and the government’s unique power to simply create money from nothing are, in this vision, all equally valid tools. In Lerner’s words,

“The central idea is that government fiscal policy, it’s spending and taxing, it’s borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound.”

In fact, since the government has the ability to create money, and since creating money from nothing does not draw it from anyone’s private coffers, that should be the default method of financing the government.   Yes, that’s what he said.  The government should start from the assumption that it will simply create money to pay for anything it buys, and should use taxation or debt only when they serve some other function that is necessary to keep the economy operating well.  Lerner said:

“taxing is never to be undertaken merely because the government needs to make money payments…taxation must be judged only by its effects.  Its main effects are two: the taxpayer has less money left to spend and the government has more money.  The second effect can be brought about so much more easily by printing the money that only the first effect is significant.”

And similarly,

“the government should borrow money only if it is desirable that the public should have less money and more government bonds, for these are the effects of government borrowing.”

The main goal he prescribes for the finance methods used, the motive for choosing among finance methods is simply to adjust total spending to maintain full employment without inflation, that is, to make sure that the amount demanded in the economy is exactly equal to potential GDP. 

That, actually, is how he says we should choose between the two primary finance methods of printing money or taxing.  If demand is too low to maintain full employment the government should print money and spend it to absorb the unused economic capacity.  If the demand is too high the government should either reduce government spending or tax money away from the public.   There are many ways to tax (sales, income, value added, excise and so on) and each will have a different impact, but Lerner does not dwell in the paper on what kind of taxes to apply, or on targeting the resulting demand reduction.  He only emphasizes that in no case is the purpose to raise money for the government, since the government already has an infinite capacity to create whatever money it needs.  The purpose, he says, should be always and only to decrease overall demand sufficiently to avoid inflationary pressure. 

Similarly, the government should issue bonds only if it intends to raise the interest rate, and buy bonds back only if it intends to lower the interest rate, to either encourage or discourage longer-term investments by business or by consumers (in houses and cars, for example).

So in this vision, if Lerner is right, the government can exercise a lot of control over the larger economic variables without any need to interfere with details or direction of private economic activity.   But to achieve that we would all have to give up our fears about public debt and the creation of money from nothing. 

Lerner says, about the accumulation of national debt:

“this possibility presented no danger to society, no matter what unimagined heights the national debt might reach, so long as Functional Finance maintained the proper level of total demand for current output”

I have to say that I’m not comfortable with the idea of “unimagined heights” of debt (more on this below). On the other hand, I’m not sure why debt would ever be very large in a functional finance system. In fact I’m not completely sure why we would ever have any government debt at all.  It’s not easy to come up with good reasons for the government to issue bonds, in this system.  Why on earth would the government ever want to discourage longer-term investments by raising interest rates?  I can see why it might want to lower interest rates to encourage longer-term investments if the population became so short sighted and so voracious in its demand for pure consumption goods that the future of the country was in danger, but that could be done by raising taxes to reduce consumption demand, and balancing the economy again by printing and spending money on longer term projects---and the resulting decreased rate of interest would encourage private investment too.   

Functional Finance as Lerner described it sounds pretty radical.  But before we simply dismiss it as fantasy, I’d like to point out that the policy suggested by both Lerner and Buchanan in periods when there are idle resources is very similar to the net effect of what we are doing right now.  When the government issues bonds to the open market to cover the deficit, and then the Federal Reserve creates money to buy those bonds on the open market, the net effect is that the government owns its own bonds and has financed itself by printing money.  If the Fed holds those bonds until they mature, the Treasury will have to pay the bonds off, meaning it will have to pay the Fed the face value of the bonds.  But the Fed is non-profit.  At regular intervals it clears out any money it has accumulated by turning its profits over to the Treasury.   So when the Fed tries to combat unemployment by driving the interest rate down, which it does by buying bonds on the open market, that is almost exactly as though the fed simply went into the Treasury’s account and changed its balance to a larger number.   In the end I think the net effect of what we have done is exactly what Buchanan suggested, to finance ordinary government activity in slack times by printing money.  And our only failure in following Lerner’s explicit advice is that we are not doing it on a scale nearly large enough to achieve full employment.  

Of course, if we could be rational and open about the process, if we really could discard our moralistic presumptions regarding the financing of government activity and judge each different method of financing by its actual direct effects, we would stop disguising this money creation as a debt owned by the Fed, and just do the transaction in a straightforward way.  We would just let the Fed create money directly in the Treasury’s account whenever that was necessary to pay the government’s bills, particularly during recessions.  But if the public and the political world have trouble accepting large amounts of public debt, they feel even greater panic about the notion of the government “printing” large amounts of money.   So even though the net effect is the same, we have to keep pretending that the government is borrowing to finance the deficit, and the Fed is independently buying that debt to lower interest rates.

And as a result, the total national debt keeps rising (even though the Fed owns a sizable chunk of it, and other parts of the government like the Social Security Trust Fund own other sizable chunks of it), and public fear about its size keeps rising.  The phantom in the dark keeps growing.  As I said above, Lerner says the size of the total debt doesn’t matter, but I also said that I am not really comfortable with that.  I’ll try to explore my discomfort about it next.  But it may take a few days before I have time to get back to this.

Saturday, September 8, 2012

Phantoms in the Dark Part 4

I’ve been a bit under the weather for the last few days, but I didn’t abandon the “Phantoms in the Dark” project.  I did spend a completely unreasonable number of hours squinting at my computer screen, slogging down words on the Abba Lerner and James Buchanan alternatives.  One says that federal debt can’t hurt future populations, and the other says it must hurt future populations; I think both are kind of true, which is possible only because in spite of using similar words they are looking at different things.

And then I threw it all away, because in the end the basic arguments are pretty simple.  They are also in some ways a bit arcane and even to some extent irrelevant, or at least they seem so to me.  I’ll say why after I describe them. 

As I said a few posts ago, the Lerner faction is looking at allocation of resources, and the Buchanan faction---or at least Buchanan himself---is looking at human satisfaction.   He’s looking at people’s position on their utility surfaces (if that phrase is foreign to any reader, just ignore it and stick with “human satisfaction”.)

Both sides, or all sides, of the discussion on this would like to isolate just the core issue, which is the question of whether using debt rather than taxation to pay for something really moves the “burden” of payment through time.  So both sides would like to set aside any other effects this decision might have, such as an impact on inflation or unemployment or economic growth.   This is a little strange, but ok, we’ll (temporarily) vaporize those things up front by just assuming them away.

The essence of the Lerner-side allocation-of-resources argument is that we can’t reach forward in time, steal the resources that will be available in 50 years and use them for government purposes now.  Or for private purposes either, for that matter, or I’m sure some enterprising entrepreneur would have offered that service long ago.  Those future resources are sealed behind the impenetrable barrier of time, and we can’t get at them.  If the government is going to do something it has to use resources that are available at the time the government activity is undertaken.  If, for example, the government decides to build a ship it must hire people, buy steel and tools and fuel and all the other inputs it needs to complete that task.  Those people could be doing other things.  They could be making jewelry, or dealing blackjack at the nearby casinos, or teaching economics at the local university.  If the government is going to build the ship now, it needs to hire the labor that is available now, and the nation will have to forego any alternative current uses of that labor.  In that sense the material burden of building the ship in terms of diverted resources falls on the time the ship is built, not on some future time when the actual financial payment will be made.  The payment has an impact, but (since we’ve vaporized the notion of unemployment and inflation and economic growth) that effect is just a redistribution of cash toward those who hold the bonds when the nation chooses to pay them off.  Those people may use the money to increase their consumption, and those who are taxed may choose to decrease their consumption, but losses match the gains exactly, so the nation as a whole is no better or worse off than it was before.

I think this basic argument is inarguably true within its artificial world of limiting assumptions. 

But hold on, the Buchanan personal-satisfaction side says; you can’t just look at the distribution of physical stuff to figure out where a burden lies.  Burden should not be defined like that.   When a baker trades some loaves of bread to the tailor in exchange for some clothing, physical resources have been shifted around, but everyone is actually better off.  The tailor can eat, and the baker can get dressed.  And the personal-satisfaction side will point out that in the current period, when the government offers bonds, no one is forced to buy them.  Those that do buy them and give up cash that they could use for other purposes must be better off after that transaction, not worse off, or they would not voluntarily do it.  They bear no “burden” in personal-satisfaction terms.  And when the government buys the things it needs, labor and physical inputs, to build its ship, those transactions are all voluntary too.  Everyone is more satisfied in the current period than they were before, so the current period bears no satisfaction-burden anywhere.  But in the future, if the government pays off the bonds by taxing the general population, that transaction is not voluntary, and imposes a direct satisfaction-cost on the taxpayers.

And this, too, seems to me to be inarguably true within its limiting world of assumptions.

The problem with both of them, to me, is that I think the limiting worlds they describe are impossible, that the limiting assumptions can’t all hold at the same time.  But these economists were or are all very smart people.  I think they were, and are, aware of this.  Here’ how Buchanan put it here:

“Fiscal theory must always recognize the fundamental two-sidedness of the government's fiscal account. It is not methodologically permissible to examine, for example, a change in the level of taxes without examining, at the same time, the offsetting or compensating changes on the expenditure side, provided that the quantity of money is held unchanged… It would do the engineer little good to attempt to analyze the movements of one side of the teeter-totter on the assumption that the other side remains unchanged, for the other side must change to allow for any initial movement.”

Yes.  But when we do that, the whole issue changes.

When we say that the government has chosen to build a ship (presumably for defense), or or to build highways or sewage treatment plants or levees to hold back flood waters, these things take years to build and once built will last for decades. The population of the period during which the expenditures are made do not get a direct benefit from those expenditures; all of the benefit is felt by future populations.  So why should those future populations not be taxed to pay for them?  It could be argued that what we should do in cases like that is borrow the money now, and raise taxes enough to make payments over the life of the asset we build to pay that loan off.  In effect, that we should take out a mortgage to be paid off over the lifetime of the flow of general benefits from the expense.  But what is the lifetime of benefits for investment in the internet, or in research into affordable solar power, or a the discovery of a vaccine for polio?

And of course, the initial assumption that nothing we are doing will alter the trajectory of economic growth is utterly wrong from the start; damned near everything we do alters the trajectory of economic growth in one way or another.  Every time we have a new idea, or change our buying behavior by switching to bulk buying at Costco, or flock to Twitter to pass notes to the universe, that changes the future, often in ways we can’t begin to predict.  So once again, if something the government does now increases growth, or the potential for growth, is it a net burden to future populations who benefit from that growth to borrow the money to do it? 

Also: when we talk about future “generations” we seem to be talking about time periods fairly far apart from each other.   But the distant future is hard to predict; when we get to that future it may be hard for us hobbling creakers to even comprehend.   Even a period as short as 25 years is hard.  25 years ago was 1987: who, in that year, would have predicted the dot-com bubble?  No one even knew what a dot-com was; Timothy Berners-Lee and Robert Cailliau did not publish the proposal to create a hypertext presence on the internet until late in 1990, and the first publicly available WWW presence on the internet was established on August 6, 1991.  And who, in 1987, could have expected to survive long enough to be able to play a game on a telephone, much less a game like Angry Birds or Fruit Ninja on a wireless telephone they carry in their pocket?   And if small things can change the trajectory of the future as profoundly as that, how much more can we change the future by actually investing today, even if we have to borrow to do it, in new research (the Web was enabled by the existence of the internet, which emerged from government research in the 1960s and 1070s).   Laws, infrastructure, social expectations, technologies, methods and views about the distribution of incomes, can all change between now and the future time we are considering, and fine calculations of positions on utility surfaces that we make now may be simply swamped by other changes that are created by current actions, even if the actions seem small now.  It may be that the best we can do is to just make sure that nothing we are doing now will damage the production potential of that future time, or reduce the sheer quantity of consumption-plus-investment that is available in a future we don’t and can’t comprehend.  

And of course, employment is not always full---in fact it’s never completely full, or we would have runaway inflation.  But there are times, such as now, when employment is very far from full, and that is imposing enormous costs on the current population in areas of high unemployment, and also on future populations who will not be able to afford to go to college, or who will have to endure childhoods spent in greater poverty than they otherwise would.  How these deprivations cascade down through time is a question far larger than I can answer, but there is no doubt that they do.

And finally, at least for today, much of the discussion of debt takes it as given that the alternative is taxation.  But the government has the power to create money.  Why not finance current government expenditures that way, rather than borrowing or taxing?  Buchanan recognizes that possibility too, particularly during recessions.  He says, in Chapter 9 of the online book I linked to above, in a situation where there are idle resources,

“The actual private disposition over current resources need not be reduced. To provide the monetary means for its actual purchases of resource services, the government may create money quite readily. The efficient means of purchasing the services of unemployed resources is through inflation of the currency. Individuals owning the resources concerned are made better off, and no one in the economy is made worse off.”

And the emphasis is his, not mine.  Just to be clear, when he says currency inflation he means making money out of thin air, what is often popularly called “printing money”.  Lerner too---emphatically---recognized the possibility of using newly created money to finance government purchases, and I’ll talk about that, the long promised functional finance question, tomorrow, trying to figure out something about the limits of government debt, rather than just who bears its burden. 

The problem with Buchanan’s prescription about what to do during a recession, though, is that it is politically impossible, unfortunately. How many of his political allies in the fight against public debt would agree with his prescription for simply creating money during a recession to finance the use of idle resources?  How many would even understand it? 

Tuesday, September 4, 2012

Phantoms in the Dark Part 3

One of the assumptions that is sometimes adopted in discussing the impact of current government borrowing is that the economy is at full employment, including full employment of it’s financial capital (total accumulated savings), so that when the government consumes more of the country’s product then someone else must consume less.  If the government taxes the population to pay for its increased consumption then after-tax incomes decline and the population consumes less, which frees up product for the government to consume.  If the government doesn’t tax the people, and borrows from the stock of existing savings, that leaves less available savings for businesses to borrow to invest in productive capacity, or for households to borrow to invest in durable goods and housing.

A lot about that paragraph makes me squirm, and not just because half the words it contains are boring.  The assumption of full employment of labor is absolutely at odds with what we see around us right now.  The idea of full employment of the existing stock of savings also fails as a description of the current situation in the United States and much of the rest of the world too.  For example, the U.S. federal budget deficit for 2012 will be about $1.1 trillion, but the excess reserves (the extra money that banks have sitting idle at the Federal Reserve) is nearly $1.5 trillion.   In other words, the federal government of the United States could finance its entire deficit for 2012 from money the banks have just sitting idle in their accounts at the Fed.  We could just substitute Treasury bonds for their account balances; I’m not sure why they would object, either, since it would raise the interest rate they get from their deposits, and they’re not doing anything else with that money right now.

I want to be clear.  Crowding out does happen.  It happens all the time, and in a lot of different forms, not just because government consumes more but because anyone consumes more when markets are tight.  When you buy the last can of tomatoes from your local supermarket, the customers who come to the store after you are crowded out of the canned tomato market, at least at that store.  When markets become too tight, and crowding out happens too much for too long, prices rise for the things that are experiencing high demand.  In the case of accumulated savings available for borrowing, that would mean that when the market is tight and demand is high the interest rate on loans would rise.  

But I promise yesterday to discuss one specific variation of the “crowding out” assertion, the one that claims that crowding out must occur because Savings=Investment is an accounting identity. 

So here goes. 

When I hear that phrase my first reaction is to ask which of those two words, accounting and identity, the speaker does not understand.

Accounting, in the first place, is just a way of writing down what has happened in the world in some fixed period of time.  It’s not easy, because the world is immensely complex, and because people’s wealth depends on the accountants getting this right so people are fussy about details.  But it’s just an image of one slice of time, and it has no magical powers to change what it records.  To say that the accounting equations change what happens in the world is like saying that the weather map creates the thunderstorm, or the seismograph creates the earthquake.  That doesn’t mean that people can’t change their behavior after they see what the accounts record, but just because a picture of a sunset in Nepal may create a desire to visit Nepal doesn’t mean that the photograph caused the sunset. 

And in the second place, when the accounts are written down about a particular time period, that period is past.  Whatever happened is done, and can’t be changed by writing it down.

People who use this argument, that crowding out is a result of an accounting identity, might say that they don’t mean that it’s the act of accounting itself that has force, but that the accounting equation is a recognition of a force that’s already there in the economy.  So we have to move to the second word: the equation they have in mind is an identity!  That means it’s true by the construction of the equation, not because something in the world changed to make it true.  It’s always true, no matter what happens in the real world, and no matter how small or large the accounting period is.  If the government deficit doubles, it’s still true.  If investment expenditures double, it’s still true.  And if both of those things happen at once, it’s still true.

It’s true because in the accounting equation, savings is whatever is required to make it true. 

Part of the confusion may arise because the savings in the accounting equation is the savings that took place in a given time, and it has to be distinguished from all the savings from all of time that are available for borrowing.  It’s not the total of all money in bank accounts everywhere---the accounts only record the savings that have occurred in a slice of time; within the equation it’s a measure of the change in the amount of savings available within that accounting period, not the total accumulation across time.  Here’s how the Concepts and Methods of the U.S. National Income and Product Accounts describe how they derive savings from personal income:

This account shows the sources and uses of income received by persons…The right side of the account shows the sources of personal income—such as employee compensation and interest and dividend income. The left side shows personal taxes and outlays and personal saving, which is derived as personal income minus personal taxes and outlays. (emphasis mine)

Business savings and government savings are derived in a similar way: it’s whatever is left over from income when all direct uses of income have been subtracted.

Let’s go back to basics.  The first equation I saw when I first walked in to my first macroeconomics class was this: C+I+G+(X-M)=C+S+T.   The X-M is exports minus imports; let’s get rid of that right up front and pretend that the rest of the world doesn’t exist---not because it’s unimportant, but because this point is easier to see without it. So we’re left with C+I+G=C+S+T: Consumption+Investment+Government expenditures equals Consumption+Savings+Taxes paid.

C is in this equation twice, and holds the same value in each place, but conceptually it is not the same C.  On the left side, it represents the consumption goods sold: it’s a source of income to the businesses or people who are selling these things.  The revenue from that sale goes into someone’s bank account---in most cases, bits of it go into a lot of people’s bank accounts, since a lot of people worked to make, transport and sell the products.  On the right side, it’s consumption goods purchased: it’s a use of income.  Revenues from that C come out of someone’s bank account.  But since purchase and sale are two sides of the same transaction, these have to be the same number.   Transactions like this have no impact on savings, actually: the funds come out of one bank account and go into another---usually out of a household bank account, where it had been personal savings, and into a business bank account where until it is spent on something or paid out in dividends it is current retained earnings.  In either case, it’s part of the whole nation’s savings.

The same is true of all the variables on the left and right sides: everything shown on the left is something that goes into someone’s bank account, and everything on the right is something that comes out.  This is important to understand: because when investment goods sold in this equation increases, that new revenue all goes into someone’s bank account.  As with consumption goods, the money spent on investment goods comes out of one account and into another. 

But when goods and services sold to Government increases, that sale also goes into the seller’s bank account---but it doesn’t come out of any other private account; it comes out of the Treasury’s account at the Federal Reserve.  Contrary to the usual view, government deficits don’t crowd out private investment within this accounting framework: they are income to the people who have sold goods or services to the government, so they increase savings by the amount of the deficit.  This new savings is then available for the government to borrow, if it wants to do that to cover its deficit.  Government deficits create the savings that government borrowing might absorb: nothing is crowded out, and private investment in the accounting equation is not affected in any way.  This somewhat surprising result is a preview of the even more surprising and contrary functional finance vision, but in this case it’s also just a description of the way the National Income and Product Accounts really work.

The fact that we can’t use the accounting identity to “prove” crowding out doesn’t mean that it never happens.  It means we have to work a bit harder, and put some conditions on the circumstances, to show how it happens. For example, crowding out may occur because there actually is a shortage of some resource the government is trying to buy.

In sum, it’s not impossible, or even very hard, to construct an economic model where crowding out occurs.  But within the National Income and Product Accounts, government deficits simply increase the recorded savings, and government borrowing absorbs them: nothing else has to change to make this work.  This is an unavoidable result of the fact that the accounting equation in question is an identity, an equation that can’t be false no matter what the real world does.

Monday, September 3, 2012

Labor Day (or Phantom Interrupted)

I know that yesterday I promised a post today on boneheaded references to “accounting identities”, but…well, you know.  Today is Labor Day in the United States, a day spent in celebration of the social and economic achievements of American workers.  I was distracted.

So I spent the day in traditional Labor Day pursuits.  This morning I walked out to Connecticut Avenue to watch the Kensington Labor Day Parade, and then had a long wander through the street vendors and a show of the works of local artists.  The parade had all the staples.  It had fire engines and politicians, local business micro-floats, high school marching bands, girl scouts and boy scouts and cub scouts and brownies, horses, musicians, and Jews for Jesus.  There were lots of kids, and lots of dogs. 

It was awesome. 

For lunch I bought a pizza on the street from Frankly Pizza,  and it, too, was awesome.

And for dinner this evening I had grilled chicken marinated in olive oil and smoked salt, and at the end brushed lightly with a BBQ sauce; to go with that we had fresh corn and potato salad, and of course watermelon.  How much more Labor Day can it get than that?? 

In a bold display of solidarity with the suffering labor in Spain, I also had a glass or two of Alvarez de Toledo Godello wine that I bought for a very reasonable price at my local coop. 

On the whole, a very very pleasant day.  I still know that there are terrible debt phantoms wandering about, but in the sunshine today I have to admit that I couldn’t see them.

I’ll see them better tomorrow.  I’ll write then.

Sunday, September 2, 2012

Phantoms in the Dark Part 2

 In the Nick Rowe blog post I linked to in the previous blog post, he outlines the views of the economic world this way:

“There are 4 possible positions to take on the debt. One of them doesn't make sense; the other 3 do. Which of those 3 is right is an empirical question.

Here are the 4 positions. I gave each one a name. I made up the quotes.

1. Abba Lerner. 'The national debt is not a first-order burden on future generations. We owe it to ourselves. The sum of the IOU's must equal the sum of the UOMe's. You can't make real goods and services travel back in time, out of the mouths of our grandkids and into our mouths. The possible second-order exceptions are: if we owe it to foreigners; the disincentive effects of distortionary future taxes; the lower marginal product of future labour if the future capital stock is smaller.'

2. James Buchanan/uneducated person on the street. 'The national debt is a burden on future generations of taxpayers. Foreigners are basically irrelevant. Any second order effects of distortionary taxes and lower capital stock are over and above that first order effects of the taxes themselves.'

3. Robert Barro/Ricardian Equivalence. 'The national debt is not a burden on future taxpayers (except for the deadweight costs of distortionary taxation) but only because ordinary people take steps to fully offset the burden on future generations by increasing private saving to offset government dissaving and increasing bequests to their heirs to offset the debt burden.'

4. Samuelson 1958. 'If the rate of interest on government bonds is forever less than the growth rate of the economy, the government can run a sustainable Ponzi finance of deficits, where it rolls over the debt plus interest forever and never needs to increase taxes, so there is no burden on future generations.'

I personally was taught 1 as an undergraduate. And I believed in 1 until about 1980, when I spent some time reading Buchanan and Barro arguing with each other. And I worked 4 into my own beliefs soon after.

And now, I believe 1 is false. The truth is some sort of mixture of 2,3, and 4. What precise mixture of 2,3,4 is true is an empirical question. My prior is one third-one third-one third.”
So, from the quote above, the answer from the world of economics to the question “does the debt burden future generations” is “no”, “yes”, “it would if all the valiant people didn’t sacrifice themselves to prevent it”, and “we’ll be ok if we can keep up with the payments”.  

Well that’s helpful, isn’t it?

I agree with Rowe when he says that three of these make sense and one doesn’t, but I don’t agree with him about which one doesn’t.   I think the first and second views are both largely correct even though they seem to be opposites---I’ll explain below---and I think the fourth is self evidently true, although I don’t think the use of the word “Ponzi” is appropriate here since the universe of players is not finite.   

But the third makes no sense at all to me.   I’ll explain more in a later post, but just as a first practical point I’ll observe that no one I know behaves like that.  No one bases their current savings/consumption decisions on what taxes might be in twenty years.  Not even people with doctorates in economics who are brave enough to hazard a wild guess about future tax rates behave like that, largely because they all know that no matter how good they are their guess about things that far away is likely to be wrong.  But to the average person who does not study economics the future debt, while it may be a scary phantom in the woods that grabs their vote, is a distant abstraction in daily life.  It doesn’t change the fact that they need a new dishwasher.  So even if it worked theoretically (and I don't think it does) it would not describe a real process that exists in the real world.

At the end of his post he adds this:

“But my brain just can't figure it out, yet. Maybe some of you younger, keener, brighter, people could work on this?”

I’m pretty sure I’m not any younger than Nick Rowe, and I certainly can’t claim to be brighter, but maybe if I explain how I see this it will spark something that will lead him, or someone, to some kind of progress in this long debate.

So to start, let me say that I think the people in the four views above are talking past each other, talking about different things using different conceptual tools. 

In view number 1 Abba Lerner is talking about physical stuff, the real economy, houses and trucks and grapes, not accounting or finance.  Lerner does get into finance---functional finance, which is really fun (no, really!), and which I’ll describe in a day or two in very rudimentary form as a treat for those who haven’t heard of it before---but the concept in Rowe’s quote is about physical things, and makes the point I started with several blog posts ago: we can’t eat the carrots from future gardens, so as long as we continue to invest and educate our children and all the rest of the things that will impact future productive capacity, we can’t grab their things and consume them now.  They, in the future, will divide up among themselves the same amount of stuff whether we have a federal debt at that time or not.  The idea that “we owe it to ourselves” means that we shift the right to consume among the people who are around in that future period, but the loss to some is a gain to others, so on the whole, as a country, we have not lost anything.

In view number 2 Buchanan is talking about the inner life of people: he’s saying that the amount of material satisfaction, or for econ people utility, can change from one period to another, or even within a period, even if the amount of stuff available for consumption doesn’t.  This is a discussion of personal choice, and of a utility burden rather than a financial burden.  It’s entirely possible to concede that the amount of stuff is unaffected by debt, but to argue that the burden in terms of utility falls completely on the later group---and in some places Buchanan does exactly that, in a very simple way.  He points out that in the first time period, when some people purchase government debt, they do so voluntarily so they must be happier buying the bonds than they would have been if they had bought consumption goods instead.  In the first period, the bond buyers are better off, in terms of their satisfaction with what they buy.  But in the second period the bonds must be paid off by taxing the population, which is a direct loss to each of the taxpayers.   So the people in the first period are more satisfied with life, while the people in the second are less satisfied with life.

Views 3 and 4 both seem to me to be talking about finance, that is, not about the amount of physical stuff available or about how satisfied we are consuming them, but about how and when we pay for them. 

As I said before, I think 3 is a puffy concoction created solely to support a contention that the government has no impact on the real world, a contention which is completely and obviously false. It does have the virtue that it gets a bit beyond finance alone and talks about human reactions to financial events, which is to say that it gets into actual economic behavior, but the assertion it makes about how humans react seems wholly unreal.  Sorry, I don’t mean to be harsh, but that’s how it looks to me.  But I’ll expand on that later, and readers can savage me at their whim. 

View 4 is just a basic statement of good investment: if your returns are greater than the cost of borrowing, you come out ahead.

It’s late, and dinner is calling, so I’ll continue tomorrow.  But tomorrow I’ll look first at a variation that isn’t really listed above: crowding out.  That’s the assertion that government borrowing displaces private investment, so in the end it has to reduce future productive capacity, and future consumption.  And I’ll start with the most boneheaded possible version, the assertion that savings equals investment as an accounting identity, so there's no way around it:  when government deficits go up investment must go down.

Some very good economists have said things like this.  And it’s completely, incredibly wrong.

Phantoms in the Dark

I’m writing again on the issue of public debt, and so are many others on economic blogs (here and here and here and here and here and here  and here, and each of these has other links to follow), and on political websites (here and here , and many, many more to come).

The political voices are all clear: we are facing certain DOOM!!  Then END is NEAR!!!  Our national debt is so immense that we cannot escape the impending disaster unless we act, with radical abandon, to cut our deficits now, without delay.  The Paul Ryan budget plan passed by the House of Representatives as their 2013 budget plan (available here) says:

“This budget offers a blueprint for safeguarding America from the perils of debt, doubt and decline.”  

Holy cow!  Peril, and doubt, and decline!  And it says:

“For years, bad policies advanced by both political parties have contributed to an irresponsible build-up of debt in the economy, and this debt now poses a fundamental challenge to the American way of life.”

The report from the National Commission on Fiscal Responsibility and Reform (the Simpson-Bowles plan, available here) was titles “Moment of Truth”, and states in its preamble:

“Our challenge is clear and inescapable: America cannot be great if we go broke. Our businesses will not be able to grow and create jobs, and our workers will not be able to compete successfully for the jobs of the future without a plan to get this crushing debt burden off our backs.”

Crushing.  Not just any debt burden, but one that will crush us. 

Terror!  Terror, and we must, we must, we must! 

We must what?  We are being herded by the threat of terrible phantoms, always just out of sight in the dark woods around us, herded toward the adoption of radical change, herded by distant voices filled with dread, voices of one group or another calling out, terrified in the night, terrified about the future they see if we don’t adopt their plan, and reject all others.  We must raise taxes right now, or we must cut taxes right now, or we must cut social programs to the bone right now, or whatever.  Cut research, since it doesn’t have an immediate reward and so we can’t afford it; or cut defense because we don’t need to spend money on all those foreign wars.  Impose a different kind of national tax (sales, value added).  The compromise position is to do all of those things at the same time, even though each of these options takes us in a different direction. 

But any radical change has its own dangers, and its own costs.  We are being asked to make difficult and risky choices which will change our lives, and the lives of all of those “future generations” we hear about.  If we change the nature of Medicare, or of Social Security, that will effect future generations.  If we fail to maintain our national infrastructure, that will also effect future generations.  So the question of what the debt will do to us matters.  We should not make radical decisions while we are consumed with panic.  We need to understand this issue before it drives us to make decisions that hurt us from a dread of something that may not.

And if you follow the links to the economic blogs, you’ll find a range of opinions on what the impact of debt on the future might be, all of them with long histories and held by very smart, highly educated scholars.  It’s worth taking some time to understand them, and figure out which theories apply to our situation right now.   

The solution to night terrors is daylight.  So I’m going to try to find some.  If I don’t finish the task in the current blog post (I won’t, it’s late) then I’ll continue in the next, and the next until I get to the other end of what I need to say.   

Because we need to stop running at full tilt in random directions, smacking into each other in the dark.  Someone is going to get hurt.