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Wednesday, February 28, 2018

The Chimera Of Generational Fairness In Fiscal Policy

Although mainstream economics prides itself on being highly precise and mathematical, this is not apparent when looking at the discussion of fiscal policy. It is very easy to find appeals to intergenerational fairness when discussing fiscal policy. Such a term is essentially meaningless in technical terms; it is mainly used as a ploy to evoke images of doe-eyed grandchildren being robbed by nefarious politicians. This article explains why the concept is largely worthless as an analytical concept.

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

5 comments:

  1. “….we need to look at the global effects of the policy that resulted in higher debt levels.” True, but the crucial question (as pointed out by Nick Rowe, I think) is this: assuming all investment decisions are optimal, is it then true to say that borrowing to fund an investment imposes a burden on future generations?

    The usual answer is “no” because future generations inherit, 1, the physical investments, 2, the bonds that funded those investments, and 3, the obligation to repay bondholders. Thus on balance, the next generation simply inherits an investment, e.g. a bridge. Nick Rowe’s answer to that is (assuming I’m summarising him correctly) that if generation A makes an investment, and generation B buys the bonds off generation A to fund the retirement of gen A, and gen C buys the bonds off gen B to fund the retirement of gen B, then a real burden can in fact be imposed on future generations.

    My answer to that (set out some time ago on my blog, Ralphonomics) is that each generation will buy whatever amount of assets it wants to fund its retirement regardless of what additional investments are made. Plus if no investments are made at all, and the only available asset is land, those saving for retirement will buy land. Thus there is little that investment makers can do to impose burdens on future generations.

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    1. With regards to the gen A,B, C anecdote, Niick Rowe was apparently thinking about mayflies. Most bridges (in this part off the world) have an expected life span of 50 years. Younger workers on that bridge would be in the early part of their retirement when the bridge is decomissioned. The financial effect would have been erased long earlier. How is there going to be 3 generations involved?

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  2. «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 is in part an aside, but it is important: public spending contraction and private debt expansion are strictly related and intentionally so, as G Osborne's, as english chancellor of the exchequer argued not long ago:

    "A credible fiscal plan allows you to have a looser monetary policy than would otherwise be the case. My approach is to be fiscally conservative but monetarily active."

    What this means is simple: given a set goal for "inflation" (which really means wage inflation) a sufficiently contractionary government fiscal policy will "force" the central bank to run an extremely loose monetary policy, with very low interest rates and massive debt expansion.

    Because the central bank and the government are run by the same cliques, clever yet simple "regulation" will make sure that the extremely loose monetary policy only drives up unproductive asset price speculation, and won't have much of an impact on business investment, thus keeping wage inflation low, and "forcing" the central bank to loosen debt creation even more.

    The general strategy has been called by english sociologist "privatized keynesianism" as it replaces public tax-and-spend with private borrow-and-spend, largely financed by borrowing against asset price capital gains. Looked at from a distance it is what is called in the business sector an asset stripping strategy: massively increase debt to turn into liquid cash as much illiquid equity as possible.

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  3. If you believe in Abba Lerner's idea that the deficit is just a way to match aggregate demand to supply, then a deficit(or surplus) should be just a function of current decisions made about public spending and the need to thread a path between unemployment and inflation. That function depends only on current conditions, there should be no time element, right?

    If we are concerned about our descendant's wealth, we need to leave them with the right education and the right infrastructure--social as well as physical--that will enable them to create their own wealth and prosperity.

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    1. Sure. Inflation is not too sensitive to the fiscal deficit, so there is a limited ability to steer it without affecting inflation. Conventional thinking is that we can move the deficit a lot, without there being too much of an effect on inflation, as it will be controlled by monetary policy.

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