Are deficits good or bad? That depends. Sometimes they are good, and sometimes they are bad.
But even when deficits are good, don't use bad arguments to defend them.
It really annoys me.
First as an economist, because it's bad economics.
Second, as a (Canadian, but whatever) citizen. Because we want governments to run deficits when it's good to run deficits, and not run deficits when it's bad to run deficits. And if people use bad arguments to justify deficits, even at times when deficits might be a good thing, we might continue to get deficits even when deficits are a bad thing, if people continue to believe those bad arguments. And I don't want Canadian policy on deficits to get screwed up by bad arguments coming in from south of the border or anywhere else. Especially since the Canadian (Federal) policy on deficits has been reasonably good (in the sense of "not obviously horribly wrong in a big way") since about 1996. Martin/Chretien ran surpluses in the good times, and Flaherty/Harper ran deficits in the recession, and are slowly eliminating the deficit as the economy recovers.
Here's a list of arguments for deficits:
0. "There is no burden on future generations because the extra taxes to service the debt will be paid to those same future generations that inherit (sic) the bonds." That is a really bad argument. It's just plain wrong, unless you believe in Barro-Ricardian Equivalence, which the people making that argument do not believe. Because if they did believe in Barro-Ricardian Equivalence, they would not be saying that increased deficits are a good thing to stimulate demand today (they might argue for balanced budget increases in government spending). So be honest, and don't use that argument.
1. "Yes, future taxes will be a burden on future generations, but monetary policy won't work at the zero lower bound, and we need fiscal deficits to increase demand now, and the benefits exceed the costs." I happen to disagree with the assumption that monetary policy can't work at the ZLB. But I might be wrong. And if it's really important to get out of a recession (which it is) there is something to be said for wasting your grandkids' money to buy suspenders even if you think your belt will keep your pants up.
2. "Yes, future taxes will be a burden on future generations, but the roads and schools etc. we are borrowing to build will be an even bigger benefit to those future generations". Good argument.
3. "Yes, future taxes would be a burden to future generations, but all we are doing is building the same roads and schools a couple of years earlier than we would have done, and doing it when roads and schools are cheap to build, and real interest rates are very low or even negative, so there's a chance that future taxes might even go down if we run a deficit today and pay it all back by building fewer roads and schools in a couple of years." Another good argument.
4. "Yes, future taxes would be a burden to future generations, but the rate of interest on government bonds will on average remain below the growth rate of the economy forever, so we can increase the debt, rollover the debt plus interest forever, without ever having to increase taxes on future generations, who will actually be better off because they will get a higher rate of return on their savings." This argument is valid. But I admit it does scare me, because we don't know for sure what future interest rates and growth rates will be. And because if we overdo it and issue too many bonds, the rate of interest will rise higher than the growth rate. And it would be hard to explain to the public why Ponzi schemes can be stable. But if that's your reason for believing deficits are a good thing, there's nothing for it but to try to explain Samuelson 1958 to the general public, and convince them your assumption is correct!
5. "Yes, future taxes will be a burden on future generations, but future generations will be richer than we are, and it's OK to transfer wealth from richer to poorer". OK. Maybe.
6. "Running deficits in bad times and surpluses in good times but balanced budgets on average doesn't mean higher taxes on future generations, and it's better than having government spending procylical and tax rates countercyclical". Yep, because government spending has diminishing marginal benefits, and tax rates have increasing marginal (deadweight) costs, so we want to keep them smooth over time. Standard micro public finance. Quite apart from any Keynesian macro automatic stabiliser arguments.
There are probably other good arguments I've forgotten. But don't use any of that "we owe it to ourselves" nonsense.
Worthwhile Canadian Initiative 
Nick, OK, your response to me would explain if Dean Baker had taken the current net interest cost and cut it in half. But that’s not what he did. He cut it by 80 to 90% I think.
In addition to the point about some bondholders having kids, he also put in something about taxes coming from people who do or don’t own bonds. So I still think he believes that if the government taxes you to give YOU interest payments on the bonds you hold, that that’s a wash and shouldn’t be included when estimating the size of the Nick Rowe Effect.
If that’s what he’s saying, he’s obviously wrong, and is still reverting to the “we owe it to ourselves” fallacy.
But, it was an offhand remark he made, so I am not 100% sure that’s what he means.
Didn’t DeLong and Krugman do a whole series of post on how R-B equivalence didn’t invalidate fiscal stimulus? So, couldn’t one, technically, hold both beliefs?
Plus R-B equivalence isn’t just about dynastic modeling, but also an absence of liquidity constraints. So if one believed in forward thinking permanent rational agents who face liquidity constraints, deficits could not be a burden but provide macro stabilization.
Nick: It might be workers 20 years from now, or landowners 100 years from now, or people owning bonds 42 years from now…but it’s a burden to someone, if taxes have to be increased.
Taxes are not absolute but mostly relative, i.e. in %. An increase in % does not mean that the volume will increase. So if you, say, decrease % but the taxed volume still increases, do you call it an increasing burden? I am very curious.
My point is that the tax system and its interactions with broader economy is way too complex and much more complex to say whether deficits are good or bad. Don’t you think that “good” and “bad” in itself depends on the structure of tax system and its interaction with broader economy? And for another tax structure your today’s “good” deficit might be “bad”?
Shangwen: yep. There are a lot more costs than I’ve included. And only people really familiar with the nitty gritty details could really give us a good estimate. All I can do is say whether their estimates would make sense at the macro level.
Bob. I’m not at all sure either. My guess is that he is assuming that 80% to 90% have kids, and that anyone who has kids is Ricardian??? And that bit about where taxes come from (bondholders or not) might indeed suggest he doesn’t get it.
OGT: Yep. I did a whole slew of posts on that too. A temporary increase in G might (for a given r) increase AD, even under Ricardian Equivalence. (Might, because it all depends what the government buys). But if RE were true, you would get that same increase in AD if you increased G regardless of whether you financed that G by increased taxes or by borrowing. So the deficit per se, given G, wouldn’t affect AD.
If RE were false because of liquidity constraints, part of the burden might be on our future selves, later in life, rather than on future generations. It all depends when taxes are increased, and whether the forced saving early in life (due to liquidity constraints) affects our bequests.
Sergei: I would say that all taxes (except maybe Pigou taxes) are a burden. Some are a bigger burden than others, for the same $1 of revenue collected, so some will cost a little more than $1 and others will cost a lot more than $1. (Pigou taxes cost less than $1.)
Nick, do I read you right then that if you do not change % but taxes nevertheless increase then you still treat it as increasing burden?
Sergei: I’m probably not understanding you right. (You are not thinking in terms of that old Carl Christ model from the 1970’s, are you? The one where the long-run spending multiplier is 1/t, where t is the tax rate????. I hope not!)
You are talking foreign language. So I think it is a safe bet that no, I do not. There are two (somewhat independent and somewhat interdependent) variables in this story: tax rate and taxed volume. Which one is that one that you use for your “good” vs. “bad” deficits story?
I’m not sure whether you’d consider this a variant of your reason #4, but let me try to propose a very special rule #7. (You can think of it as the W.C. Fields “It is morally wrong to allow a sucker to keep his money” Rule)
7) It is a good idea to issue to run deficits when (a) you can finance them entirely by borrowing from foreigners, and (b) you have no intention of paying the money back — you’ll just effectively default.
Technically, you might claim this is just rule (4) where I’m assuming that the rate of interest on the debt is negative, but here I’m being explicit that I don’t care about the rollover problem. Instead, I’m dropping your assumption that investors will never offer a free lunch.
Presently, investors in many countries are offering the US govt. (perhaps others?) the chance to borrow at negative real interest rates in US dollars. It is clear that lenders would have little effective recourse in the event of a selective US default or substantial USD depreciation (as we saw in the 1980s with large-scale Japanese investment in the US followed by a large and rapid USD depreciation from 1985 onwards…followed by a financial meltdown in Japan.) Pretty influential and smart people have argued that foreign tastes for US govt. debt were not rational even before the global financial crisis (e.g. http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm)
Yes, I understand that this rule is very open to abuse. Yes, I understand that we should not expect this rule to apply often. At the same time, I think the rule merits serious consideration in some important special cases. At a minimum, would we all agree that this should be part of any rational government’s strategic thinking?
Isn’t #5 just a reformulation of “growth rate will exceed interest rate?”
Which is only a reasonable hypothesis in the short term, and anyone who’s using this argument should review Liveo’s post about how extraordinary growth rates in the 19th, 20th, and 21st centuries have been. (http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/is-the-stationary-state-coming.html)
Personally, I’m a fan of #2 & #3, except that both are contingent on a well-managed government, which could happen, but is certainly unusual.
I remain a big fan of reforming government accounting to stop obsessing about how much cash is being spent and debt being taken on in the present, and start focusing on actual operating costs (including borrowing costs) + amortization of assets (capital cost spread over the expected life of the asset). It creates a much better sense of the sustainability of borrowing.
Sergei: my apologies. I misunderstood your “taxed volume”. You are talking about what we normally call “broadening the tax base” (taxing some things that didn’t used to be taxed).
To answer your original question: yes, it’s a burden, no matter whether we pay it by increasing the tax rate or broadening the tax base. But one might be more or less burdensome than the other.
Simon: nice (or nasty, I can’t decide!).
Neil: “Isn’t #5 just a reformulation of “growth rate will exceed interest rate?”
Yes. Same thing.
“Which is only a reasonable hypothesis in the short term, and anyone who’s using this argument should review Liveo’s post about how extraordinary growth rates in the 19th, 20th, and 21st centuries have been.”
Good point.
Sergei: my apologies. I misunderstood your “taxed volume”. You are talking about what we normally call “broadening the tax base” (taxing some things that didn’t used to be taxed).
To answer your original question: yes, it’s a burden, no matter whether we pay it by increasing the tax rate or broadening the tax base. But one might be more or less burdensome than the other.
Simon: nice (or nasty, I can’t decide!).
Neil: “Isn’t #5 just a reformulation of “growth rate will exceed interest rate?”
Yes. Same thing.
“Which is only a reasonable hypothesis in the short term, and anyone who’s using this argument should review Liveo’s post about how extraordinary growth rates in the 19th, 20th, and 21st centuries have been.”
Good point.
Nick, I do not mean broadening tax base. At least the way I understand it. To give an example – VAT (or sales tax). Here we have it set at 20%. If the volume of transactions expands then taxes increase while both tax rate and tax base stay constant. So my question is – do you consider such situation still as an increasing burden?
I don’t get how you’re saying all taxes to pay for debt are a burden. If I lend the government money presumably it’s because I don’t think there is any better spending opportunities available. So the present value of that decision is not based on what else I could have bought now, but on what I can buy in the future. (And remember that by buying government bonds I should already be aware I may be taxed to pay my own bond.)
This is why I don’t understand your saying if Ricardian inheritance is half-true you’d only get a smaller stimulus because: 1. Bondholders should not be expecting high returns anyway. 2. People buying bonds are not liquidity constrained. They’re risk averse. Why else are they buying bonds? Where do they get the cash? Why do people think buying government bonds is a for-profit business like any other?
It seems like your arguments only apply to the Volcker recession: with high inflation we should raise rates and taxes (or cut spending) at the same time if the budget deficit is increasing.
Yes. Because your model is formally identical to my model. I call them “bonds”; you call them “deposits at the government savings bank”.
Great! Now, sticking with this assumption, the “burden” that the government must pay each period is the number of deposit accounts * interest rate on those accounts. In a static (no recession) analysis, as the number of deposit accounts goes up, the interest payments must go up, to preserve price stability.
But if the savings demands are changing — say in even and odd periods, then in even periods savings demands are high, and the government must either increase the number of deposit accounts, or decrease the interest paid. In odd periods, the reverse must happen.
Now, are you are saying that the operation of changing the interest paid per dollar in the account (e.g. interest rate policy) does not impose burdens, but the operation of changing the quantity of deposit accounts does impose burdens?
It seems to me that the situation is perfectly symmetrical. Fiscal policy has intergenerational burdens if and only if monetary policy does.
There is no disadvantage to fiscal policy vis-a-vis monetary policy as a result of an increased risk of inter-generational transfers. You are multiplying two numbers together to get the interest obligation, or “burden”, and government can change either one at will.
Why the preference for the second number instead of the first? Why is one safe and the other risky?
Moreover, the argument that Noah gave can be interpreted in this model as saying that if there is any unwanted transfer between generations that are alive, the government can simply mark down the deposit accounts of one cohort and mark up the deposit accounts of another cohort to ensure that both cohorts carry whatever burden we want them to carry, relatively. This operation is deficit neutral.
So via a combination of changing the total quantity of accounts across time, and then changing the distribution of accounts among generations in each period, you can effect as situation in which shifts in aggregate savings demands are counterbalanced and consumption within each cohort is also stabilized across periods, with no individual cohort gaining at the expense of any other.
Nick I don’t think Dean Baker was assuming 90% kids, I think he was doing the “if you pay taxes to retire a bond you yourself hold, it’s not a burden” thing in conjunction with the kids thing.
You know Nick, sometimes I think that not even you are as fanatical about this issue as I am. I am the only one in this generation who really cares.
The liquidity issue strikes me as a relatively important one. It’s why I tend to conceive of deficits as being akin to Miles Kimball’s Federal lines of credit, you’re helping with consumption smoothing liquidity constrained people can not do themselves.
Reasons 3 and 6 are the best. However, in an austerity situation like Spain’s it seems to be education and infrastructure that are getting cut, possibly further aggregating the long term burden. Not sure how your counter factual model resolves itself if the CB never corrects its mistake.
Bob: “You know Nick, sometimes I think that not even you are as fanatical about this issue as I am. I am the only one in this generation who really cares.”
You are right. And you have just bags more energy than I have. God only knows, after Daniel’s latest posts! They grind you down. I did all those posts showing yes, you could get a burden on future generations, and some people said “that’s only because you are assuming full employment!”. So in my last post I construct a New Keynesian model, with unemployment, and show you can still get a burden! And now they really really really don’t want to understand that model, even though it’s an absolutely bog-standard NK model, except with OLG.
Like this:
rsj: Look at the model! Set r=n, and F=0, and Look! No recession! No burden!
I need a drink.
Bob and Nick,
I don’t think Dean was just talking about bequests but also people spending directly (or indirectly) on their kids now. “Direct” things like buying them food, computers, beds, cars, dance lessons, summer camp, college tuition, whatever. Or “indirect” like maybe, I’m guessing, a family swimming pool or central air and heating?
If you think debt is a burden because it might, just might, someday, have to paid down, then debt is not the measure of the burden because a real mercantilistic government would not be satisfied with paying it off but insist on amassing a hoard and there is no limit on the size of that.
Nick, I am saying that you do not need to use monetary policy to stabilize the economy, you can use fiscal policy to do the same thing.
If you screw up the fiscal policy, you can use monetary policy at the risk of passing a burden onto future generations.
If you screw up the monetary policy, you can use fiscal policy at the risk of passing a burden onto future generations.
If you screw up both, you can pass a burden and/or have a recession.
The situation is symmetric. This has nothing to do with assuming r = n. r can be anything.
But I would very much like to see the post
“Six (maybe) good arguments for monetary policy” with obsessive attention paid to the fact that some generations can take delivery of too little or too much interest income than they should, effecting a transfer from one generation to another. Why the double standard?
rsj: Aaaarrgh! Look at the model! This is why we build models! Set r=n in each period (so r moves up and down with n), and keep F=0, and there is no recession, and no burden!
The scotch hasn’t kicked in yet.
Nick, try Ardbeg.
In your equil #4, tax the old in every period (except the first by F) and give F to the young.
This is deficit neutral so it has no bearing on whether fiscal policy is used or not.
Now, everyone’s consumption is the same every period, and the recession is avoided via fiscal policy. Am I getting something wrong? Where is the burden due to fiscal policy?
Or, another way to think about this:
The CB is setting the interest rate, r, too high. People are willing to accept a lower rate, s. So one thing that fiscal policy can do, by spending more now and taxing the older generation later is to reduce post-tax rate back to s, even though the pre-tax rate is r.
Another reason from Ed Prescott:
You can use government debt to lower distortionary taxes.
Click to access qr3111.pdf
“Some naively think that government debt is a burden
on the young. This is not the case, since the welfare of
the young and government debt are both large in the
efficient saving-for-retirement system. Indeed, in the
inferior tax-and-transfer system, government debt is
zero. We go on to show that switching from a pay-asyou-
go system to a savings system benefits everyone
and incurs no costs. All that needs to be done to make
the switch is to stop taxing labor income. During the
transition period, transfers to the old would be financed
by a large deficit and the stock of government debt would
rise to its needed level.”
Whoever said he thought Baker was including stuff like old people now using their government transfer payments to live in a nice neighborhood, thereby benefiting their kids, etc., you’re right I agree Baker was thinking of stuff like that too.
Lord, I agree with you that it’s not just the servicing of the debt, but paying the debt down, that is the crucial thing.
Nick, you aren’t going to believe this, but I’m taking a giant step toward the MMT camp on this. Before, I thought the issue was future generations being taxed to service the debt, but now I’m thinking the only way you make them poorer on net is if the taxes to deal with the debt are higher than the interest payments to the debtholders. So that means, only if the debt is shrinking. In the examples I cooked up–and I think you too?–the way you make everybody alive in period X poorer, is you have net debt reduction. I think if middle generations just floated the debt without moving it up or down, then they break even collectively.
Gasp, dare I say it, they break even because they are paying the interest to themselves? Real GDP is unaffected so total income is unaffected?
I am not going to do a formal post until Monday, Nick, so if you think I’m being seduced by the Dark Side you have the weekend to save me…
Bob: “…but now I’m thinking the only way you make them poorer on net is if the taxes to deal with the debt are higher than the interest payments to the debtholders.”
Nope. If taxes = interest receipts, then lifetime consumption is unchanged, but lifetime utility is lower. You can see that from your own examples, or mine, with U=log(C when young) + [1/(1+n)]log(C when old).
Think about it: if I persuade you to postpone some of your consumption by offering you interest, and then take that interest away, you are worse off.
Or, think about it: if paying taxes made an individual better off, you wouldn’t need the IRS.
(Actually, you could really upset Daniel here, if you wanted, by showing that utility in any given year is also lower in this case, even though aggregate consumption in that same year is the same.)
(And that wouldn’t be turning MMT anyway. When I see you mumbling “apples bought = apples sold” to yourself, then I will know you’ve turned MMT. You were much closer to MMT one year ago, when you belived, like they do, in Abba Lerner’s Functional Finance view on the non-burden of the debt.)
Join me in a Scotch, Bob.
rsj: Suppose the government gives the young a bond worth F in period 1, then tax the old F(1+r) in period 2. If they know you are doing it, it makes no difference whatsoever to what happens. Look at the Euler Equation: (consumption when old/consumption when young)=(1+r)/(1+n). They save all the transfer payment. Full-blown Ricardian Equivalence in that case, because the individuals in cohort A know that they themselves will be paying for the transfer payment when they are old. It doesn’t cure the recession.
Ardbeg, eh? Grant’s was on special, so I’m drinking that.
Nick
If g < n < r, known & forever, then debt is trivially a burden. OLG is needed only to show how the pain is being ‘pushed forward’. Gov bonds and private capital are substitutes, and govt borrowing when the private sector won’t is a pure redistribution. The recessionary shock in period 1 is unrecoupable, by construction.
At the absolute very least, you have to allow for:
g < n < r(private).
r(gov) < r(private).
Then, the welfare calculus becomes interesting because we have to first choose a benchmark to evaluate public debt and then compare r(gov)&n.
[Edited to put spaces both sides of < symbol. NR]
Nick, right, I am OK with what you are saying now, but for sure I didn’t quite have it before. I didn’t realize how essential DMU was. I am not saying you were wrong in anything, I’m just saying the generalizations I was drawing before, weren’t quite right.
Here’s what’s tripping me up Nick: Is “poorer” interchangeable with “lower utility”? It seems like it is–if you were just as wealthy (after tax) you could buy the same bundle, and achieve the same utility. And yet, it seems weird that we have to insist of DMU to get that result. Something is just not clicking with me…
Bob,
You can have positive taxes that aren’t a burden in the growth case. Here is an example, where I augmented Nick’s original example. I held the debt at
For g = 10%, r = 5%, Debt = 100, Taxes = 5
Generation 1: consumes 300 (as opposed to a 200 endowment)
Generation 2: consumes 215 (old (110+100+5) young =0 + as opposed to 210)
Generation 3: consumes 226 (old (121+100+5) young = 5 as opposed to 221)
…
The third generation gets 110 when young, but transfers 105 to pay and service the debt. Then when old they get endowed with 121 and receive 105.
I haven’t tried solving for prices with concave utility, though, but it should be possible since consumption is increasing across generations. It would require a smaller initial transfer though.
You might be able to do it in the no growth case with a certain interest rate path as long as you don’t transfer 100 at the beginning. Just don’t let all the old get the benefit spread it out over generations.
For example:
Year 1 transfer 50
Year 2 transfer 75
Year 3 transfer 87.5
…
That way every generation has higher lifetime consumption rather than just the first old generation. The first full generation, transfers 50 but gets 75, the second transfers 75 but gets 87.5…
Bob: Let “n” be the rate of time preference proper (von Mises Pure rate of time preference): such that lifetime utility = U(C when young) + 1/(1+n)U(C when old).
If we do not have DMU, then this becomes Lifetime Utility = C when young + [1/(1+n)]C when old. And r must = n at all times. So lifetime Utility equals the present value of lifetime consumption. Taxes equal to interest payments will mean the present value of lifetime consumption will be lowered, even if the undiscounted sum of lifetime consumption is unchanged.
Nick,
I’m drinking Four Roses small batch now and have had a few. The Giants are staying alive so far.
Not sure how you are turning RE off and on like an emergency light. I thought we were not assuming it in this game of inter-generational warfare.
Point being, do you agree that if the CB sets rates too high, the. Treasury can lower them via taxation, fixing the CBs mistake? We are assuming the market clearing rate is lower, so the investors are OK with being taxed.
rsj: “Not sure how you are turning RE off and on like an emergency light.”
It’s in the model. RE works within the cohort, because they are lifetime utility maximisers. But it doesn’t work across generations, because they don’t care about the kids.
“Point being, do you agree that if the CB sets rates too high, the. Treasury can lower them via taxation, fixing the CBs mistake?”
In the model yes. Because you just replace r with r(1-t), where t is the tax rate on interest from the central bank, and set t such that r(1-t)=n. But that’s identical to just lowering r. And this only works because of the representative agent setup in the model. If people were different, there would be private borrowing and lending too, and taxes on interest income would cause welfare losses by distorting private lending and borrowing.
Well, as long as you believe that fiscal policy can undo the mistakes of the CB, preventing the recession without causing inter-generational transfers, I am happy.
Nick,
I don’t think this example works. If you try to solve for the interest rate path, there is no solution.
“Here is a second example, where all future cohorts have lower lifetime utility, even though their lifetime consumption stays at 200:
Same as the first example, except the government only borrows 50, and then taxes all future generations to pay the interest on the debt, but leaves the debt unchanged at 50 forever. So all future cohorts consume 50 when young and 150 when old. But they have a utility function U=consumption when young x consumption when old. So their lifetime utility will be 50×150, which is less than 100×100.”
The first generation with CyCo utility needs to get a return of 100 to lend 50 apples when young (the interest rate must be 100%. Why? Because 50200 = 100100 (consumption young)(consumption old). If it’s not clear look at the FOCs. So to lend 50 apples, they need to get a transfer of 100 when old. 50 to pay of principle and 50 to pay off interest. You said, use taxes to pay the interest. Fine, so the next generation has 50 apples left to buy government debt. The government needs to raise 50 to roll over the debt. What interest can they offer? They have to offer an infinitely high interest rate, because the next generation only has 50 apples left and giving up all 50 will leave them with a utility of zero no matter how much they get to eat when old.
The old generation knows it will never get paid back, so it wouldn’t buy 50 apples worth of government debt. My conjecture is that you can’t get the first generation to buy debt without increasing their lifetime consumption, if they have concave utility. [unless the future is valued more than the present]
rsj: ahem. You know that’s not what it means. It means the fiscal authorities taxing the interest rate that the Bank of Canada pays on reserves. It’s just monetary policy, with a different name.
Charlie: Nope. Cohort A consumes 100 when young, and 150 when old. The government borrows 50, then gives them 50. It is exactly as if the government gave them a bond for 50 apples.
Nick,
I’m talking about what you’d call cohort B. The buyer of the bonds. Think about it. They need a return to buy the bonds.
Generation A is better off, 150*100, surely you weren’t talking about them being worse off.
If you don’t believe me, tell me the interest rate on the bonds.
Charlie: OK. I thought you were talking about cohort A. But you were talking about cohort B, who consume 50 when young and 150 when old. So in equilibrium for cohort B, (1+r)=(MUwhen young/MUwhen old) will be 150/50, or r=200% right? (I don’t trust my arithmetic.) No worries, just stick a lump sum tax on them. The government can afford to pay any interest rate it likes, if it gets the revenue from lump sum taxes.
And (1+r) for cohort A will be 150/100, or r=50%.
rsj: ahem. You know that’s not what it means.
No, no, and NO. But I think this point illustrates why you don’t believe in a fiscal theory of the price level. You really believe that the government comes and confiscates your chickens for taxes.
It does not.
The government merely marks down your money holdings. That’s it. It’s just a monetary transaction, and that is how the public views it. And when the government sends out benefit checks, it is not giving anyone chickens, either. It is merely increasing their deposit holdings. Another monetary transaction.
Fiscal policy happens with monetary transactions vis-a-vis the private sector. All monetary adjustments that can affect interest rates, the price level, etc. No chickens are harmed in the tax collection process. So fiscal policy can accomplish everything that monetary policy can do plus other, more targeted things that monetary policy can not do, such as breaking the zero bound, effective transfers of nominal income, etc. What it can do in the real sense is more complicated, but this is fiscal policy.
Plus, the Giants won.
Plus, the debt incurred by the government is nominal in nature and not real. No one knows what the real debt will be (that also depends on future fiscal policy). There is no real government budget constraint, there is only a nominal GBC. And before you chime in with “if the CB does its job then the nominal GBC is a real GBC”, I would point out that many are calling for above average inflation during the recovery, which means that we don’t really know what the real burden of debt will be by looking at current nominal interest rates.
Nick,
“The government can afford to pay any interest rate it likes, if it gets the revenue from lump sum taxes.”
No, unfortunately there is a resource constraint, so the government cannot pay any interest rate. Also, the tax rule will be in the FOCs in equilibrium. There is no uncertainty in this problem. So the agent knows he will pay a lump sum tax when old, which will change the required interest rate. You have to solve for prices given the tax rule.
For the interest rate, with no taxes when old only taxes on the young, generation B needs to get 100 apples for the 50 they give up. So if call the first 50 interest and the second 50 repayment of principle, then the interest rate is 100%
If you think about optimality:
max Co*Cy
Cy + b = 100
Co = 100 + (1+r)b
FOC:
Co = Cy(1+r)
100 + (1+r)b = (100-b)(1+r)
Solving for b with some algebra it appears you get:
b = 50r / (1+r)
I thought I could get that generation B to lend, but I think I had an algebra mistake. It looks like the interest rate needs to be infinite to get them to lend 50 apples. (set b = 50 and solve)
It will be hard to do a lump sum tax of infinity, no?
Nick,
You picked the consumption stream you wanted and then solved for the interest rate using the FOC, but that consumption stream isn’t optimal. At that interest rate, the agents would prefer to lend 33 and a third apples. You actually have to make it optimal for them to pick that consumption stream by picking the interest rate.