Wednesday, February 28, 2018
The Chimera Of Generational Fairness In Fiscal Policy
My guess at the explanation of the popularity of the phrase is the use of overlapping generations (OLG) models. These are popular among mainstream academics, presumably because they can be manipulated to get the desired the results. The description of the economy in most of these models can only be described as ludicrous (a person's entire working career is one time step), and there is no way that they can provide any useful policy advice.
If we turn to the real world, we realise that most people have a working life of around 40 years, although post-secondary education can take a bite out of that time span. Furthermore, most citizens will be voting senior citizens for a number of decades after that. A lot of things can happen during more than four decades.
The usual story about intergenerational fairness is that if debt is run up, future generations will face a greater interest bill. (For example, this is discussed in passed in this article.) The problem with this sort of logic is that we cannot just isolate the interest bill or debt level, we need to look at the global effects of the policy that resulted in higher debt levels. Does the policy result in future policymakers having access to more infrastructure, or a better educated labour force? Will the animal spirits of the private sector be kindled, and result in a larger private sector capital stock? Obviously, not all policies that increase debt are good ideas, but we need to look at all of the effects of a policy stance.
The next thing to keep in mind is that the government does not have complete control over the level of deficits or debt in the long term. Models that suggest that the government can steer the debt/GDP level wherever it wishes are probably just a fantasy.
During an expansion, the government has the illusion of control. The economic environment in the short term is relatively stable, and small nudges to fiscal policy settings are not going to be enough to derail the private sector. There are plenty of feedback loop effects that stabilise growth rates during an expansion.
However, these plans go awry once the next recession hits. For example, the Canadian Federal Government has been slowly tightening its fiscal stance for an extended period of time. It has gotten away with this because the household sector has been willing to borrow insane amounts of money to purchase houses. This has just meant that when the day of reckoning comes, it will be a bloodbath in the private sector. If we look at what happened in the other countries whose housing bubbles definitely burst in 2008, debt-to-GDP ratios will blow out. The net result is that Canada could easily end up with a higher debt-to-GDP ratio than would have been the case if fiscal policy had shouldered more of burden of supporting aggregate demand during the expansion.
The private sector is facing very large needs for duration to match the liabilities posed by retirement income needs. The belief that fiscal policy can be set without taking this into account can only be described as wishful thinking. In other words, the rest of the economy reacts to the stance of fiscal policy, and the government cannot indefinitely steer debt ratios without taking this feedback into account.
Returning to the question of "intergenerational fairness," the implication is that debt analysis on horizons over 10 years is probably a waste of time. The feedback effects of private sector asset accumulation may erase the effects of current spending, in the same way that the debt overhang after World War II was largely erased by the 1960s. One could look at the implications of providing for the retirement income needs of the baby boom generation, but that is just an analysis of future income. Although one needs to be careful about promising a scheme that implies greatly unbalanced future income flows, at the end of the day, that is a question for future legislators to decide.
However, if we return to a horizon of 10 years or less, in what sense does "intergenerational" even make sense? The only human beings who will be alive in 10 years who are not currently alive now will be in the 10 year and under cohort -- who are economic dependants anyway (unless child labour is again legalised). Although particular politicians may retire, most citizens will have to accept the consequences of fiscal policy decisions made during their lifetime will show up within their lifetimes. If fiscal policy is inappropriately loose now, most living voters will end up facing higher tax bills when the policy is reversed, not some "future generation."
In summary, an appeal to "intergenerational fairness" is deliberately vague, and has little usefulness for describing policy.
(c) Brian Romanchuk 2018