Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:

Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.

Then, Domar describes the merits of a budget deficit:

By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.

All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.

Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:

Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...

On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.

The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:

Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.

The article concludes with a comment on how to best address the “debt problem”:

The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?

As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.

Austerity in Canada: Then and Now

Canada's economic accounts for the third quarter of 2012 were released last week.  They show a very weak quarter.  Real gross domestic product barely stayed positive, growing by a mere 0.1 percent (see chart 1).  The details can be found here, courtesy of Statistics Canada (click on charts to expand).

Chart 1 Real GDP growth, quarterly % change

Many reasons have been given to explain the economy's weak performance, including the slowdown in China, the fiscal and financial situation in Europe, as well as tepid growth in the US during the summer months.

Of course, as usual, no one is pointing to the fact that Canada is currently undergoing its second most important (i.e., longest and sharpest) bout of public sector austerity in half a century.  One would think that commentators would highlight this reality in their analyses.

As you can see from the chart below, real (consolidated) government expenditure (excluding transfers) has been in decline since the fourth quarter of 2010.  Historically, such a decline in real government spending has only occurred once: during the period of fiscal restraint of the mid-1990s.

Chart 2: Real government expenditures, Source: Statistics Canada and author's calculations

The reason why commentators don't think of austerity as the potential cause of the current weak performance is that Canadians live under the illusion that government spending cuts have little or no impact on the economy.  This stems from the fact that the fiscal austerity put forth during the 1990s gave Canadians (and especially their political leaders) the false impression that cuts in government spending generally help to boost the economy.

Visually, this is how most commentators interpret Canada's experience with austerity in the 1990s (note: I'm not seeking to show a correlation between the two series. I'm simply overlapping both sets of data on a common timeline):

Chart 3: The vanishing deficit and the road to surpluses, Source: Statistics Canada

The standard view holds that fiscal austerity during the 1990s helped to shrink the deficit, thus enabling Canada to run a series of budgetary surpluses throughout the early- to mid- 2000s.  Also, this view holds that fiscal austerity played a crucial role in helping Canada recover from the recession of the early 1990s and contributed to Canada's strong economic performance during the period from the mid-1990s until the financial crisis. 

The problem with this interpretation is that it completely disregards the fact that the Canadian economy during the mid-1990s was impacted by a massive increase in demand stemming from the domestic household and external sectors.  Consider the following charts showing that, as fiscal austerity was undertaken, net borrowing by both the household and external sector exploded in Canada during that period:

Chart 3: Household sector falls into net financial deficit, Source: Statistics Canada and author's calculations

Chart 4: Increased foreign demand to the rescue, Source: Statistics Canada and author's calculations

Net borrowing is the difference between a sector's total spending and income.  It is a key indicator of the demand generated by any sector of the economy. 

Supported by a much easier monetary policy and falling exchanging rate (a consequence of US President Clinton's desire to "have a strong dollar"), the increased net borrowing generated by these two sectors was effective in offsetting the decline in net borrowing of the government sector caused by fiscal austerity.

The increase in net borrowing by the household sector between the mid-1990s and the mid-2000s was unprecedented.  Between 1995 and 2007, net borrowing by the household sector increased by close to 10 percent of GDP (see arrow going down).  As for net borrowing of the foreign sector, it increased by approximately five percent of GDP.  Combined, this additional demand was more than sufficient to offset the decline in demand caused by fiscal austerity.

Today, unlike in the 1990s, the household sector is seeking to reduce its level of borrowing.  And the foreign sector, due to the strength of the Canadian dollar and the weakness of the world economy as a result of global austerity, cannot be a significant source of demand at this time.*

As a result, any attempt by Canada's policymakers to balance the budget in such a context is self-defeating and actually exacerbating the problem given that it is taking away purchasing power from households and firms.  And, as we are witnessing now, it is taking its toll and slowing GDP growth as a consequence.

Economist James Tobin said it best several years ago:

Deficit reduction is not an end in itself. It's rationale is to improve productivity, real wages and living standards of our children and their children. If the measures to cut deficits actually diminish GDP raise unemployment, and reduce future-oriented activities of government, business and households, they do not achieve the goals that are their raison-d'être; rather, they retard them. This perverse result is likely if deficit reduction measures are introduced while the economy is as weak and as constrained by effective demand as it is now.

It's time to think more clearly about these issues.  What "worked" in the past need not be the appropriate course of action today.  The Canadian economy now is not like the one that existed back then.  It's time to move forward.  Trying to relive the "success" of the 1990s will only make matters worse. 

Update:

Chart 2 should be entitled "Real consolidated government expenditures (all levels of government) (millions of chained 2002 dollars)". The title and headings in charts 3, 4 and 5 are accurate.  All data comprises expenditures on goods and services, as well as on capital formation. They exclude transfers.


*  The critical point to remember is that, as I've explained before, the government deficit cannot be reduced in isolation from the other sectors of the economy.  Public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports.  The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

In other words, any reduction in government spending or tax increase has a direct impact on the financial position of the private sector.  To believe otherwise is wishful thinking.  If external demand and/or increased demand from another domestic sector (households or businesses) are not high enough to offset the demand shortfall created by reduced government expenditures, continued attempts at fiscal austerity will impose additional deflationary pressure on the economy.

Reference

Tobin, J., "Thinking straight about fiscal stimulus and deficit reduction", Challenge, March 1, 1993

Old Keynesian themes in Modern Monetary Theory

Readers of this blog know I'm generally supportive of the views espoused by proponents of Modern Monetary Theory (MMT). The reasons are fairly simple. First, MMT considers unemployment to be an important problem that must be quickly and effectively addressed by the government authorities.  I agree with that.  Also, MMT makes a good case on the important role of fiscal policy in ensuring stable and equitable economic growth.  Again, I agree with that.

But there is another reason I'm generally in agreement with MMT on many issues.  This has to do with the fact that MMT builds on some pretty solid economic thinking, much of which was well understood and accepted by earlier generations of Keynesian economists.  As someone who has a lot of respect for and who finds much insight from this earlier Keynesian tradition, I'm quite pleased to see MMT, a more recent school of thought, disseminate these views.

I was reminded of some of these - let's call them - "Old Keynesian" tenets in a recent blog post by Paul Krugman, in which he discusses a trifecta of issues relating to (1) the benefits of monetary sovereignty (i.e., where a nation issues and uses its own currency), (2) the debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance and (3) the recent controversy regarding the potentially expansionary consequences of a "loss of confidence" in US government bonds by international investors .

The first of these views concerns monetary sovereignty, a central MMT theme.  This was also a well understood concept by earlier Keynesian economists.  For instance, monetary sovereignty was a key aspect highlighted in the work of economist Robert Eisner, who brilliantly described in his book The Misunderstood Economy (1994:74) why the US greatly benefits from being a currency issuing nation:

[One] point that is widely misunderstood or unrecognized is that this debt, relatively small as it is, is all owed in its own currency, US dollars.  We pay interest and principal in US dollars.  And our Treasury and Federal Reserve can always create all the dollars we need.  One may object that such money creation or the monetization of the interest-bearing debt may have undesirable consequences, particularly greater inflationary pressure.  But it may also have the desirable effect of stimulating the US economy if that is in order. In any event, the fact that US debt held by foreigners is virtually all denominated in US dollars rules out the possibility of unvoluntary default on US government obligations.

We are not in the position of many third world or other debtor nations that sadly had obligations in foreign currencies, frequently the US dollars.  The only way they could service their debt was to obtain foreign currencies. [...]

The "world's greatest debtor nation" gave the American public visions of the US going bankrupt.  Since the debt was essentially in our currency, however, this made no sense.  We could "print" out own money to pay it off or, in more sophisticated fashion, have the Federal Reserve create the money. (1994:74)

Several other Keynesian economists also held similar views, including economist Lorie Tarshis who emphasized this point in Elements of Economics (1947), the first Keynesian textbook to be published in the US.

Secondly, concerning the ever-lasting debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance, MMT considers that the latter should be viewed as more inflationary than the former since the interest payments paid by government on its debt results in a greater expansion in the money supply (in the long run) than if the deficit is financed by money creation.

On this point, it may be instructive to recall that economists Alan Blinder and Robert Solow demonstrated long ago that the "potency" of deficit spending via money creation or bond issuance is not strictly related to the manner of financing.  In fact, Blinder and Solow demonstrate in "Analytical Foundations of Public Finance" (1974) that deficit spending financed via issuance of bonds has under normal, steady-state equilibrium conditions a greater fiscal multiplier than deficit spending via monetary financing in the long run:

When we correct an oversight committed by almost all previous users of the government budget constraint, a still more odd result emerges.  The error has been to ignore the fact that interest payments on outstanding government bonds are another expenditure item in the budgetary accounts. [...]

Under a policy of strict monetary financing, [in a stable system, the long-run government expenditure multiplier is simply the reciprocal of the marginal propensity to tax].  But the issuance of new bonds means a greater multiplier in the long run. (1974:50). (original emphasis)

Finally, as for Krugman's contention that a loss of confidence in US government bonds by investors may have potentially expansionary consequences for the US economy, economist Bill Vickrey presented a similar argument in his article entitled "Fifteen Fatal Fallacies of Financial Fundamentalism" (1996).  On whether a sell-off of US government bonds by foreign investors would have a detrimental effect on the US economy, Vickrey suggested the following:

It is not intended that the domestic government debt should be held in any large quantity by foreigners.  But should foreigners wish to liquidate holdings of this debt or any other domestic assets, they can only do so as a whole by generating an export surplus, easing the domestic unemployment problem, releasing assets to supply the domestic demand, and making it possible to get along with smaller deficits and a less rapidly growing government debt.  The same thing happens if domestic investors turn to investing in foreign assets, thereby reducing their drain on the domestic asset supply.

All that to say that, in my opinion, both Paul Krugman and proponents of MMT stand on solid ground regarding these issues.

References

Blinder, Alan and Robert Solow, "Analytical Foundations of Fiscal Policy," in A. S. Blinder, et. al., The Economics of Public Finance, The Brookings Institution, 1974, pp. 3-115.

Eisner, Robert, The Misunderstood Economy: What counts and how to count it, Boston: HBSP, 1994.

Tarshis, Lorie, The Elements of Economics, New York: Houghton Mifflin, 1947.

Vickrey, William. "Fifteen fallacies of financial fundamentalism: A disquisition on demand-side economies", Proceedings of the National Academy of Sciences of the United States of America, Vol. 95, No. 3, February 1998, pp. 1340-1347.

The Federal Reserve staff on the evolution of US household net worth and related financial flows during the last decade

The Federal Reserve released an informative discussion paper this week that presents background on the Integrated Macroeconomics Accounts (IMAs) of the US.  The IMAs is a long-term interagency project between the Fed and the Bureau of Economic Analysis aimed at linking saving, capital accumulation, investment in financial assets and balance sheet data within an integrated framework using consistent definitions, classifications, and accounting conventions.

In the IMAs, each of the sectors of the economy is depicted according to a consistent set of statistical accounts: the current account (production and distribution of income accounts), and the accumulation accounts (capital, financial, other volume changes, and revaluation accounts).  These accounts allow one to trace the factors leading to changes in the net worth position on the balance sheet of each sector.

The paper contains lots of useful information for those interested in the analysis of national income and flow of funds accounts.

As a way to help demonstrate the usefulness of the IMAs, the authors of the paper have included a section describing the evolution of household net worth and its components during the last decade, thus enabling the reader to understand some of the underlying causes and subsequent effects of the recent financial crisis. 

As you read the excerpt below, keep in mind the following basic rule of thumb: a key indicator of the demand generated by any sector of the economy is its net borrowing (i.e., the difference between its total spending and income).

Uses of the IMAs

The recent financial crisis has vividly shown that analyzing the change in net worth and its composition is critical to understanding the health, risks, and prospects of an economic sector.  Net worth is a broad measure of the wealth of a sector, often used in conjunction with other variables, such as income and interest rates, to study variables such as consumption and saving.

The IMAs enable one to analyze net worth and its composition, clarifying how the current balance sheet position came about by distinguishing between saving, borrowing, holding gains or losses, and other changes in volume.  As an example, we can look at the IMAs for the household and [Non-Profit Institutions Serving Households] sector.  In the first half of the last decade, the household sector shifted from being a major lending sector to a major borrowing sector, rivaled only as a borrower by the federal government sector. It was at this same time that the rest of the world sector became the predominant lending sector.

At the same time, household net worth surged rapidly and the ratio of household net worth to disposable personal income reached record levels (chart 1 -- click on chart to expand).  This surge was caused not by elevated savings, but by sizable capital gains both on housing wealth and on stock-market wealth (chart 2).

Chart 1

Chart 2

Indeed, the ratio of both housing wealth and stock market wealth to disposable personal income surged to historically unprecedented levels (chart 3).  Not surprisingly, household debt also ballooned.  The ratio of household debt to disposable personal income surged from around 90 percent at the beginning of the decade to an all-time high of around 130 percent in the middle of 2007 (chart 4).

Chart 3

Chart 4

This ratio dropped to 111 percent by the end of 2011 as consumers borrowed less and as a significant amount of mortgage debt was written off. [...] [T]he household sector shifted back to being a major net lender in 2008.

Net borrowing by the federal government, on the other hand, ballooned to over $1.3 trillion in both 2009 and 2010. In 2009, the rest of the world sector was a significant lender, along with the financial business sector. The nonfinancial corporate business sector, traditionally a net borrower, became a net lender in 2009, as capital expenditures remained relatively low and retained earnings elevated (Cagetti et al, 2012:6-8).

Reference

Cagetti, M., Elizabeth Ball Holmquist, Lisa Lynn, Susan Hume, McIntosh and David Wasshausen, The Integrated Macroeconomic Accounts of the United States, 2012-81, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.

Bernanke on the Fed's policy of paying interest on reserves

Chairman Bernanke gave a good speech yesterday in which he indicated being encouraged by recent improvements in the US housing sector. Specifically, Bernanke explained that residential investment "will be a source of economic growth and new jobs during the next couple of years". However, he expressed concern regarding both the fiscal drag that will result from the phasing out of some federal stimulus spending and the risks that the situation in Europe pose to the US economy.

From a policy standpoint, another interesting statement by Bernanke came during the Q&As that followed his speech when Bernanke indicated that reducing the rate of interest paid on reserves by the Fed would have little stimulative effect on bank lending. (For more details, see Joe Weisenthal of Business Insider)

In the Q&A he hit on other interesting points, such as the issue of the Fed paying interest on excess reserves (IOER), a payment that's commonly said to be an inducement for the banks to do nothing, and just leave money at the bank. Bernanke's angle is that eliminating IOER to zero would barely stimulate any lending, but that having zero rates could cause mechanical issues in the market, and that keeping IOER allows for an easily tool to tighten policy in the future, simply by raising it.

Read more: http://www.businessinsider.com/ben-bernanke-the-economic-recovery-and-economic-policy-2012-11#ixzz2CzcOFAUA

Bernanke's angle is that eliminating IOER to zero would barely stimulate any lending, but that having zero rates could cause mechanical issues in the market, and that keeping IOER allows for an easily tool to tighten policy in the future, simply by raising it.

Read more: http://www.businessinsider.com/ben-bernanke-the-economic-recovery-and-economic-policy-2012-11#ixzz2CzciBTjO

This is actually significant seeing as Bernanke suggested in the past that one of the options that the Fed has to entice banks to lend is to reduce the rate of interest paid on reserves. Here is an excerpt from his testimony before Congress in July of last year:

...we have a number of ways in which we could act to ease financial conditions further. [...] The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally.

Recall that since December 2008 when the Fed started paying interest on reserves, the Fed's instrument has been effectively its asset portfolio. The policy of paying interest on reserves is a policy tool used to support the active use of this instrument. 

Read more: http://www.businessinsider.com/ben-bernanke-the-economic-recovery-and-economic-policy-2012-11#ixzz2Cuiiae2u

next year the drag from federal fiscal policy on GDP growth will outweigh the positive effects on growth from fiscal expansion at the state and local level.

Read more: http://www.businessinsider.com/ben-bernanke-the-economic-recovery-and-economic-policy-2012-11#ixzz2Cuiiae2u

next year the drag from federal fiscal policy on GDP growth will outweigh the positive effects on growth from fiscal expansion at the state and local level.

Read more: http://www.businessinsider.com/ben-bernanke-the-economic-recovery-and-economic-policy-2012-11#ixzz2Cuiiae2u

Bill Vickrey and Alan Blinder on the burden of the national debt

A colleague asked me today if I thought the national debt was a burden imposed on future generations.  No doubt my colleague has been following the debate of late on that issue. Anyway, in my opinion, anyone who argues that the national debt is a burden on future generations has to take into consideration the views put forth by the late economist and Bank of Sweden Nobel laureate Bill Vickrey.  According to Prof. Vickrey, the notion that government debt is a burden imposed on future generations is a false worry.  In Prof. Vickrey's own words:

...[I]n generational terms, the debt is the means whereby the present working cohorts are enabled to earn more by fuller employment and invest in the increased supply of assets, of which the debt is a part, so as to provide for their own old age. In this way the children and grandchildren are relieved of the burden of providing for the retirement of the preceding generations, whether on a personal basis or through government programs.

This fallacy is another example of zero-sum thinking that ignores the possibility of increased employment and expanded output. While it is still true that the goods consumed by retirees will have to be produced by the contemporary working population, the increased government debt will enable more of these goods to be exchanged for assets rather than transferred through the tax-benefit mechanism.

Also, in regard to the notion that deficits represent "sinful profligate spending at the expense of future generations who will be left with a smaller endowment of invested capital", Prof. Vickrey considered such an idea a fallacy stemming from a false analogy to borrowing by individuals.  Again, according to Prof. Vickrey,

[c]urrent reality is almost the exact opposite. Deficits add to the net disposable income of individuals, to the extent that government disbursements that constitute income to recipients exceed that abstracted from disposable income in taxes, fees, and other charges. This added purchasing power, when spent, provides markets for private production, inducing producers to invest in additional plant capacity, which will form part of the real heritage left to the future. This is in addition to whatever public investment takes place in infrastructure, education, research, and the like. Larger deficits, sufficient to recycle savings out of a growing gross domestic product in excess of what can be recycled by profit-seeking private investment, are not an economic sin but an economic necessity. Deficits in excess of a gap growing as a result of the maximum feasible growth in real output might indeed cause problems, but we are nowhere near that level.

Finally, it's also important to mention that, as economist Alan Blinder has pointed out in the past, the majority of government bonds in the US have a maturity period of about a decade:

...in my view, most of the debate is beside the point because, in the real world, the bonds that will be issued to cover deficits will almost always mature in less than 10 years, a time frame within which most of today's taxpayers will still be around to pay the bills.  So intergenerational aspects of present-value budget constraints are mostly irrelevant. (2004:19) (emphasis added)

References

Blinder, Alan."The Case Against the Case Against Discretionary Fiscal Policy" CEPS Working Paper No. 100, June 2004.

Vickrey, William. "Fifteen fallacies of financial fundamentalism: A disquisition on demand-side economies", Proceedings of the National Academy of Sciences of the United States of America, Vol. 95, No. 3, February 1998, pp. 1340-1347.

Hyperinflation in Weimar Germany: New Perspective on the “German View” using a Post-Keynesian Flow of Funds Framework

By Joseph Laliberté

Some of this material will be used for a future publication. Comments most welcome.

The “quantity theory explanation” and the “German view” are two schools of thought found in the literature to explain hyperinflation in Weimar Germany.

The quantity theory explanation emphasizes the role of fiscal deficits as the root cause of hyperinflation episode (Câmara and Vernengo, p. 1):

According to the quantity theory of money the origins of any inflationary process are to be found in irresponsible fiscal policies of governments. Budget deficits lead to the rise of a supply in money, and consequently higher prices. The solution to an inflationary process is to restore the principles of sound money either by reducing expenditure or raising revenues.

Or in the words of Kiguel (1989):

Hyperinflation, understood in this paper as a process of accelerating inflation, in fact occurs because governments have unsustainably large budget deficits...A correction of the fiscal imbalance has been crucial for stopping hyperinflation. This factor is well documented in the works of Yeager (1981), Sargent (1982), and Webb (1986) on the hyperinflation episodes in the central European countries during the 1920s and by Sachs (1987) on the more recent Bolivian episode.

There are many variants within the school of thought known as the Quantity Theory of Money. One major irritant from a post Keynesian standpoint is the notion that the money supply is exogenous and determined by the central bank. In general, proponents of the quantity theory explanation contend that although the government deficit may be the starting point of hyperinflationary episode, the key triggering factor of elevated inflation is to be found in the monetisation of this deficit by monetary authority. We will leave this last point aside for the purpose of this analysis and simply note the quantity theory focus on very large fiscal deficit as a key factor in accelerating inflation.

In opposition to the quantity theory explanation, German economists in the Republic of Weimar long contended that the imbalance created by the Treaty of Versailles in Germany's current account was the chief cause of hyperinflation. The balance of payment explanation, also called the “German view” in the literature, was in fact so prevalent in Weimar Germany, particularly at the Reichbank itself, that it was considered an official position (Laidler and Stadler, 1998, footnote 4). The lead proponent of the balance of payment explanation was Karl Helfferich, a German politician and economist, who was successively Secretary for the Treasury and Secretary of the Interior of the German Empire during WWI, and who wrote a book on money in 1927 (taken from Laidler and Stadler, 1998, p. 820):

First came the depreciation of the German currency by the overburdening of Germany with international liabilities and by the French policy of violence. Thence followed a rise in prices of all imported commodities. This led to a general rise in prices and wages, which in turn lead to a greater demand for currency by the public and by the financial authorities of the Reich; and finally, the greater calls upon the Reichbank from the public and the financial administration of the Reich led to an increase in the note issue.

Economists from other western nations have perhaps always looked with high suspicion to the “German view” because of its perceived political motive. Indeed, it was highly convenient for the German political class to blame hyperinflation on the Treaty of Versailles. Further, it did not help that Karl Helfferich himself was a German hawk during WWI and was responsible for a financial policy that contends that the cost of the war should be financed by borrowing rather than by fresh taxation (in other words, he was an interested party). These factors may explain why the balance of payment explanation as the root cause of hyperinflation has never been particularly popular among academics outside of Germany.

The objective of this analysis is to demonstrate using a post-Keynesian flow of funds analytical framework that, in conformity with the “Germany view”, the terms of reparations included in the Treaty of Versailles set the conditions for hyperinflation in Weimar Germany. Also, it seeks to show that hyperinflation in Weimar Germany is fully consistent with the existence of significant and on-going imbalances in both the current account and the fiscal situation.

After WWI, Germany was off the gold standard and on a floating exchange rate vis-à-vis other currencies such as the gold-pegged U.S. dollar. The Treaty of Versaille imposed heavy penalty on Germany relative to the size of its economy; by some estimates, reparations represented 20 times the total average German coal yearly output before the War, or nearly four times the average value of U.S., English or German annual exports before the war.

The Treaty of Versailles imposed two types of reparations on Germany: reparations payable in gold and reparations payable in real goods. It should be noted that the two types of reparations amount to the same thing: Germany was out of gold-denominated securities at end of WWI (due chiefly to its chronic current account deficit during the war itself, see here, p. 698), therefore the only way for Germany to obtain gold-pegged foreign currencies was through the exports of goods via the current account (or sales of assets abroad via the capital account).  We will assume therefore for the purpose of this analysis that all reparation was payable in real goods ("in kind" reparations). We have for Weimar Germany, the following standard flow of funds equation before reparations in period 0: 

1)      (G₀ - T₀) - (S₀ - I₀) = (M₀ - X₀)

Assuming the economy is at full capacity at a given price level P, and that E₀ is the equilibrium exchange between the German mark and the US gold-pegged dollar at which X₀=M₀, we have in period 0 (assuming the exchange rate is at E₀): [i]

2)      (G₀ - T₀) - (S₀ - I₀) = 0

The State was responsible for reparations, and paid for it using German marks. Therefore, reparations without a corresponding amount of new taxes directly increase Weimar Germany’s fiscal deficit. It should be noted that the price the German governments had to pay to entice German exporters to sell to the German government for German marks rather than export to foreign countries for U.S. gold-pegged dollars is a direct function of the prevailing exchange rate.  Denoting by Q the quantity of reparations in kind, we can define V₀ as the nominal value of reparations under Versailles denominated in German mark in year 0:

3)      V₀ = E₀*P*Q

The increase in budget deficit in year 0 therefore corresponds to V₀.  Substituting in the flow of funds of equation, we have:

4)      ((G₀ + V₀) - T₀) - (S₀ - I₀) = (M₀ - (X₀ - V₀))

Since M₀ = X₀, we now have the current account in a deficit by the amount of nominal reparations V₀.  So equation 4 could be simplified to:

5)      ((G₀ + V₀) - T₀) - (S₀ - I₀) = V₀

The current account, now in deficit, causes a reduction in the exchange.  Note: ΔE₁ is the change in the exchange rate.  It is to be interpreted as "the increase in % in the number of German mark you obtain from 1 US gold-pegged dollar". 

Thus we have the change in the exchange rate in period 1 which is a function of the nominal value of reparations denominated in German mark in period 0:

6)      ΔE₁ = f (V₀)

We also have:

7)      E₁ = (1 + ΔE₁)*E₀

Using equation 7, we can derive the following equation: 

8)      V₁ = (1 + ΔE₁)*E₀*P*Q

Combining equations 8 and 3, we obtain:

9)      (V₁ / V₀) - 1 = ΔE₁

Equation 9 says that the increase in nominal reparations denominated in German mark in period 1 relative to period 0 corresponds exactly to the depreciation of the exchange rate, itself caused by the current account deficit resulting from reparations payments in period 0 as shown above.  Re-arranging equation 9:

10)      V₁ = V₀*(1 + ΔE₁)

Pursuing with the same logic, nominal reparations denominated in German Mark in period 2 will be:

11)       V₂ = V₀*(1 + ΔE₁)*(ΔE₂ + 1)  

In period n, we will have:

12)       V_n = V₀*(1 + ΔE₁)*(1 + ΔE₂)*(1 + ΔE₃)* ... *(1 + ΔE_n) 

And so on and so forth.  Assuming a constant impact in percentage on the exchange rate (constant elasticity), we can simplify the above equation to:

13)       V_n  = V₀ (1 + ΔE)ⁿ

Substituting this equation in period n flow of funds equation, we have

14)       ((G_n+ (V₀ (1 + ΔE)ⁿ)) - T_n) - (S_n - I_n) = (V₀ (1 + ΔE)ⁿ)

Assuming n tends toward infinity, we are left with (denominated in German mark) an infinite nominal amount of reparations, as well as an infinite budget deficit coupled with an infinite current account deficit. Moreover, the value of the German mark relative to other currencies will tend toward zero. Reparations therefore had the effects of triggering a vicious cycle of ever-increasing current account deficit and ever-increasing fiscal deficit in Weimar Germany.

The very tendency to approach equilibrium in the current account through a decrease in the exchange rate was undermined by the ever-increasing nominal value of reparations denominated in German marks, which was itself caused by the decrease in exchange rate. In all likelihood, a country caught in this kind of cycle will eventually face a vicious inflation spiral unless it can afford politically to impose new taxes on its population in order to “confiscate” domestic consumption to pay for reparations. [ii]

Therefore, based on this analysis, the root cause of hyperinflation in Weimar Germany are to be found in the conditions as set out in the Treaty of Versailles regarding reparations.  Seen from a flow of funds perspective, the “German View” is therefore fully consistent with the existence of significant imbalance in both the current account and the fiscal situation.  

[i] These assumptions are made for simplification purpose. Altering them would not ultimately change the result of the analysis.

[ii] Clearly, the Weimar government could not afford politically to impose new taxes on its population. For example, Ladislaus Bortkiewicz, an economist in Weimar Germany, contended that the extreme fragility of Germany’s socio-political situation after WWI may have made inflation the most appropriate policy response (Laidler and Stadler, 1998, p.828).

References

Alcino Câmara and Matias Vernengo, The German Balance of Payment School and the Latin American Neostructuralists,  http://acd.ufrj.br/~coopegrid/pdfs/german%20balance%20of%20payment%20school.pdf

David E. Laidler and George W. Stadler, "Explanations of the the Weimar Republic’s Hyperinflation: Some Neglected Contributions in Contemporary German Literature", Journal of Money, Credit and Banking (Nov. 1998), pp. 816-831. http://www.jstor.org/stable/2601130

Miguel A. Kiguel, "Budget Deficits, Stability, and the Monetary Dynamics of Hyperinflation", Journal of Money, Credit and Banking, Vol. 21, No. 2 (May, 1989), pp. 148-157
http://www.jstor.org/stable/1992365

Federal Reserve Bulletin, ISSUED BY THE FEDERAL RESERVE BOARD AT WASHINGTON, various years, see for example: http://fraser.stlouisfed.org/docs/publications/FRB/1920s/frb_061923.pdf

Mythologies: Money and hyperinflation, http://rabble.ca/blogs/bloggers/progressive-economics-forum/2011/08/mythologies-money-and-hyperinflation

Thomas J. Sargent, "The Ends of Four Big Inflations", in: Inflation: Causes and Effects, University of Chicago Press (1982) http://www.nber.org/chapters/c11452.pdf