Three myths about Johnson’s Social Care package

Most of the controversy around the extra spending for the NHS and social care announced last week focused on the higher rates for national insurance. As Rachel Cunliffe explained here, national insurance contributions are a tax just like income tax or VAT. The misconception that they are payments into some pot of money that you get back later helps explain why this was the tax of choice for Johnson, although the fact that it is not as progressive as income tax (excluding, in particular, rent or interest income) probably helped too.

I'm not going to talk about why national insurance is a very bad way to fund this additional spending because that has been covered elsewhere. However my first myth is that this unfairness has something about ‘generation wars’. When the post war Labour government introduced the state pension in 1946 I don’t know whether anyone said that because money was being taken from the young to give to the old (true) it was unfair on the younger generation, but if they had it would have been nonsense. It is difficult to get your head around, but with that kind of scheme, the old at the time it starts gain a huge amount, but there is no corresponding loser if the scheme continues forever. Some things are about generational transfer (like higher house prices), but schemes where the young will benefit when they are old are not. [1] The reason to oppose the use of national insurance is on normal equity grounds considering who benefits, rather than anything intergenerational.

The second myth I want to talk about is that this package shows that this government is not Thatcherite, or Osbornite, but instead favours a bigger state (and therefore it is more left wing). This myth is believed by a number of Tory MPs, some journalists (the Telegraph’s editor even called it the triumph of socialism) and some on the left. The reality is that it shows no such thing. Instead it is just bowing to the inevitable consequence of having a state funded health service.

The fact of life that few journalists are prepared to admit, and many Tory MPs pretend not to understand, is that in economies such as ours the share of health spending in GDP rises over time. This is something I have talked about for some time, ever since Osborne pretended that he was ‘protecting the NHS’ which journalists parroted. Here, for example, is a post from 2015 that shows a graph of the share of NHS spending in GDP rising from 3% of GDP in the 1950s to over 7% in the 2010s.

There are a number of reasons for this. As our incomes rise our wish to spend money on our health rises faster than our income, while our spending on food (for example) rises less. Doctors are finding better ways (or sometimes ways that didn’t exist previously) of treating us, which often seems to involve expensive drugs or capital equipment. But perhaps most important of all, we are on average living longer but the age our bodies start needing attention has not been rising so rapidly. This point applies to social care as well as the NHS. 

The inevitable consequence is that taxes need to rise to match this rising spending. [2] This was masked for a long time by an opposing trend: falling defence spending as a share of GDP. That however came to an end certainly by the turn of the century, which is why the Blair/Brown government increased national insurance to get the NHS to a reasonable level of operation. In contrast Cameron/Osborne were able to run the NHS into the ground again not just because they ran a right wing, small state government, but because they used the false excuse of a runaway government deficit which most of the media and the public believed and because their squeeze began from a fairly good position.

This chart, of how many cancer cases were treated within the target number of days, shows what happened clearly.

This chart is one of many that show a gradually deteriorating health service since 2010: see here for more information.

This deterioration has stepped up substantially in 2020 because of the COVID pandemic. No government, whether left or right, could have failed to react to this, if it wants to survive in office. So Johnson had to put additional resources into the NHS to clear the backlog created by COVID, and that is what the higher national insurance increase is initially about. It does not make him left wing, it does not raise the scope of the state (which is what really matters politically), and it certainly doesn’t herald a victory for socialism.

At this point we do need to ask whether permanently higher taxes make sense for what is a temporary problem - clearing the COVID backlog of cases. Just as most of the costs of COVID have been paid for with borrowing, why not this? It makes no macroeconomic sense to raise taxes now to cover transitional spending. The obvious answer to this puzzle is that nothing has changed since Osborne, in that we still have a Chancellor who is distorting economic policy just so he will meet some arbitrary deficit targets. This, in turn, is why it is so inaccurate to describe this as a left wing, big state government. Talk to those in local authorities, or in criminal justice, to see that Sunak (whatever Johnson’s wishes) continues to be a small state Chancellor.

But there might be another reason why the government chose to permanently raise taxes? This brings us to myth number three, which is that this package is about improving the quality of social care, even in the longer run. In the short term most of the money raised by the new tax will go to the NHS. What is left for social care will have to cover the cost of reducing the amount the elderly need to pay for their care (but not their living costs). As the IFS says, this aspect has not been costed by the government, but “can be expected to be several billion pounds a year.” Not much if any will be left over to improve the quality of care for the next three years.

Thus the IFS writes

“While the precise path for spending – and hence for the availability and quality of care – is unclear, it is clear that the extra funding will not be sufficient to reverse the cuts in the numbers receiving care seen during the 2010s. Thus, while more people will become entitled to financial support as a result of the reforms planned, many people with care needs not considered severe enough will continue to miss out.”

Even the cap on personal social care costs will not necessarily prevent some people having to sell their homes. If your only asset is a £200,000 flat or house you still have to find the 86,000 that is the cap on payments. The government responds by talking about a growing insurance market, but that market is small at present for obvious reasons (adverse selection) and that will not change much with these plans.

What will happen in the longer term, once the pandemic backlog has been dealt with? Here we have to come back to the state of waiting lists before COVID. The NHS does not just need money to catch up with the backlog caused by COVID, it needs money to stop (and even reverse) the deterioration in waiting times that began under austerity.

There are other pressures on NHS budgets too. One is pay. It is not sustainable to keep funding the NHS by decreasing the real value of nurses’ pay. Another is privatisation. The bill currently going through parliament gives ministers the power to circumvent normal procurement rules (competitive tendering), and their past actions suggest they favour giving contracts to private sector friends rather than allowing the NHS to do work in-house. Whatever these private sector companies may claim, that means higher cost to the public sector to fund the profits these companies need to make. [3]

The risk therefore is that after three years not much, if any, of the money created by the national insurance tax increase will end up in social care. As Graham Atkins of the Institute for Government says, “There is a risk that the funding for the NHS to tackle backlogs goes into the baseline NHS budget and the funding never ends up going to local authorities to reform social care.” This risk will be intensified if the government continues to squeeze local authority budgets, which in the short term at least seems likely to happen as Sunak tries to meet his deficit targets.

If higher taxes were really for social care, then it would have made sense to give the NHS temporary money to cover costs arising from the pandemic by borrowing, and direct the funds from higher taxes to social care immediately. Better still delay the tax rise but increase funding straight away to give the economy the boost it clearly needs. One of the reasons this didn't happen is that the NHS needs more money on a permanent basis, and Johnson is a Prime Minister who knows further deterioration in NHS waiting times beyond 2019 levels will risk losing power. Thus the tax increase says very little about the ideology of this government, and instead reflects the continuing desire of Conservative Prime Ministers to retain power. .

[1] The young could lose a bit if they could do better saving themselves and then investing in social care insurance, but when that insurance is scarce and expensive because of adverse selection it seems unlikely.

[2] This is a red flag to twitter MMT, who will say you could borrow or create money instead. But doing so year after year will overheat the economy, so if we are talking about several decades it’s not a very helpful remark. I talk about the immediate short run below.

[3] The usual counterpoint to this is that the private sector have more of an interest in improving efficiency. While that may be true in some areas, it seems highly unlikely for the NHS. The inefficiencies in the current NHS largely stem from a lack of public sector investment.

The dangers of pluralism in economics: the case of MMT

MMT (Modern Monetary Theory) is a ‘school of thought’ in economics, by which I mean that it deliberately sets itself apart from the mainstream. I like a lot about MMT as a set of ideas. On the key issue of whether monetary or fiscal policy should be used as the main stabilising tool, although I go with the mainstream in looking to monetary policy outwith the lower bound, I think that issue should always be kept open, and too many mainstream economists just presume that monetary policy must be better. I am also attracted to the idea of some version of a Job Guarantee type scheme, and the mainstream has often failed to recognise the amount of autonomy the banking system has to create demand. I could go on but you get the idea. As I result, I have tried probably more than most mainstream economists to engage with MMT ideas.

As far as I can see there is nothing in MMT that cannot be presented using standard mainstream tools. But I also know that the microfoundations hegemony in mainstream macro excludes many, like MMT economists, who would prefer to do macro in different ways. I dislike the microfoundations hegemony for reasons I have set out elsewhere. For that reason I cannot argue that MMT, or any other school of thought, should be part of the mainstream, because right now it would be impossible because of the microfoundations hegemony. [1]

Having said all that, I think MMT sometimes demonstrates many of the dangers of a school of thought. It tends to be antagonistic to the mainstream, and some (not all) of its leading lights give their followers the idea that the only truth is to be found within MMT, and everything the mainstream says has to be wrong. That proposition is so absurd but I can understand why it can be believed. It was a long time ago, but I was told as a student that neoclassical economics was fundamentally flawed, and would soon be replaced in some kind of Kuhnian revolution. I know how easy it is to follow your political instincts and thereby miss out on so much important and useful knowledge.

It is very difficult not to come across MMT followers (MMTers) if you write a blog on macroeconomics. Most recently this happened when I wrote this on Trump’s tax cuts. Now unusually this post examined how to discuss these tax cuts split into two parts: one which followed the mainstream view where monetary policy controlled inflation, and another that described an MMT view where fiscal policy controls inflation.

My post was criticised by some MMTers on twitter. Not because I had got the MMT part wrong, but because I had argued in the mainstream part that a deficit generated by a tax cut could alter the intergenerational distribution of income. Now this idea is standard, but it can confuse, because you cannot transfer real resources (output) through time in a closed economy. I show how it can be done in an overlapping generations framework here. It is much easier to see how it can happen in an individual open economy, because a generation can consume overseas goods as well as domestically produced goods.

If that all seems a bit abstract, it is also important. I have argued in the past that one of Margaret Thatcher’s failures was to give taxes from the North Sea back to consumers (who spent rather than saved them) instead of following Norway in creating a sovereign wealth fund. Subsequent generations have therefore been deprived of the benefits of North Sea oil. By giving tax cuts funded by borrowing, governments can do the opposite of creating a sovereign wealth fund: future generations inherit more government debt which they have to service.

Those MMTers criticising my blog said such intergenerational transfer was impossible. I tried the best I could to explain why it was possible, but the responses I got ranged from intelligent denialism to simple insults along the lines that I was neoliberal, I didn’t care about the working class and so on.

I’m used to that kind of interchange as a result of Brexit. But there was an important difference here. I was not attacking MMT, but outlining how things work in a mainstream view. So I was not attacking their school or their politics. They had no reason to be defensive. But it was clear to some that I was the enemy simply because I was not an MMTer. This very tribal attitude reflects one of the dangers of plurality in economics. Another is language. MMTers have their own way of describing things, so if you say something like a ‘tax financed increase in government spending’ you are jumped on: according to MMT tax never finances spending, but follows it, or something like that. I don’t mean to make fun, and I can see what they are trying to do, but talking separate languages is a key problem when you have different schools of thought, particularly if you insist that only your language is the right language.

Another problem is that schools of thought also tend to be political. As a result, to use Paul Romer’s phrase, all too often scientific discourse is replaced by political discourse. To some of these MMTers because I was a mainstream economist I had to be neoliberal, as if those two things had to go together. The idea that deficits could redistribute income between generations moved from being an economic statement to a political one. Presenting models that showed how it could happen meant those models had to be unrealistic, without specifying why that lack of realism mattered to the issue in hand.

It is a shame, because these MMTers are clearly interested in economics because of their political interest, so I would love them to be discussing both mainstream as well as MMT ideas. I probably spent too much time on twitter with them as a result. Those that tell them the mainstream is neoliberal and a waste of time are in my view almost criminal because that attitude leads to such a waste of enthusiasm and interest.

It does not have to be like this. I have had plenty of good discussions with MMT academics and some supporters which I have found interesting. They have been courteous and not aggressive. But not all the leading lights in MMT encourage these things. Such as those who write

“Wren-Lewis just should stick to Twitter. He seems to like that. It would save us the time reading the other stuff.”

He wrote that, and worse still which I will not repeat, because he is angry that Labour have adopted a fiscal rule based on my own work with Jonathan Portes rather than MMT’s ideas. Actually I didn’t enjoy the conversations he is referring to at all, and I should have stopped much earlier because it was a waste of time, but as I said above it is a shame to see people who have closed themselves off to so much interesting and, for them, politically useful knowledge.

As I said, I do not blame anyone being in a macroeconomic school of thought because the current mainstream is exclusionary. Many MMTers are open and my discussions with them have been interesting for me at least. But unfortunately some in MMT appear to want to make it a kind of cult, where only MMT sees the truth and everything in the mainstream is neoliberal and wrong. They attract followers because of their politics, but then they turn their followers into converts with closed minds. Which I think is a real shame and completely unnecessary, because MMT is strong enough to stand on its own feet and encourage open minded thinking, not dogma.

[1] I do not think that is the only aspect of the mainstream that excludes other schools. There is too little room in mainstream journals to discuss policy or history in a discursive, holistic way. I happen to like the way most mainstream economists use models to discuss issues, but sometimes it is useful to make sure we are not abstracting from what is really important.

Does public investment have to pay for itself?

A key distinction between Labour’s new fiscal rule and Osborne’s fiscal charter is that the former allows borrowing for investment. When supporters of the fiscal charter treat borrowing as if it was inherently sinful (‘Labour will borrow forever’) it is natural to remind them that firms often borrow to invest and grow, and consumers invariably borrow if they buy a house. We also note that public investment can enhance economic growth. But this can lead to a confusion about whether such investment has to ‘pay for itself’.

When a firm borrows to invest, it hopes to make enough profits to pay back the borrowing. There may be forms of public investment which could raise future GDP (and therefore income and spending) such that eventually taxes rise by enough to pay at least the interest on the borrowing that made the investment possible, or even start paying back the borrowing itself. But there are two other important reasons why it makes sense to borrow to invest.

The first involves intergenerational equity. Suppose we have a public investment project which significantly enhances the quality of life, but there is no pecuniary benefit: GDP does not rise. So taxes will have to rise at some point to pay for that borrowing. But who should pay those taxes? When we are talking about investments that are long-lived, the obvious answer is those that benefit from the investment, which means future generations as well as the current generation. That can happen if investment is paid for by borrowing rather than raising current taxes.

This helps answer a point that is often raised, which is what should count as public investment and what should not. With this reasoning it makes sense to borrow whenever the social benefits of public spending are long lasting. When the benefits are short lived, spending should be paid for by higher taxes. So the relevant metric for what should count as investment in this context is who benefits most. While paying doctors or teachers more may have some knock on benefits for the future, the main beneficiary will be today’s doctors or teachers. The benefits of new schools and hospitals are longer lasting. 

The second reason for using borrowing to pay for investment is if the increase in investment is a one-off. As taxes are distortionary at the margin, it makes sense to smooth those taxes over time. Once again, that can be achieved using borrowing.  

If a lot of public investment does not pay for itself, wouldn’t borrowing only to invest mean that debt just went on increasing and increasing? What matters here is the debt to GDP ratio. If you want to keep that ratio constant, and you always run a zero current balance, then that tells you how much investment you can do. The numbers are fairly simple to work out. If the economy grows in nominal terms by 4.5% on average, and debt is 80% of GDP, net investment could be around 3.5% of GDP to keep the debt to GDP ratio constant. Osborne plans net investment over this parliament averaging 1.6% of GDP.

This leads to one final, important point. You cannot have separate goals for all three of debt to GDP, the current balance, and public investment. In Labour’s new rule, the commitment to reduce borrowing as a share of trend GDP over the lifetime of a parliament, coupled with the zero current balance target, puts an upper limit on the amount of investment the government could do. Whether that is a sensible upper limit in economic or political terms, and what you do if it is not, I will leave as an exercise for the reader.

The burden of government debt, again

Here is an attempt to clear up some of the confusion that still exists on this issue.

1) Government debt can be used to redistribute income to current generations from future generations, even if the aggregate level of consumption in each period remains the same. Proof by example: see here (or many similar proofs from Nick Rowe - his latest post on this is here).

Note: I think people get confused because although the first part of the proposition seems intuitive (if the government cuts taxes and pays for this by borrowing, surely those receiving the tax cut could spend it on themselves and be better off as a result), the ‘even if’ part seems wrong (if we are taking from the future to give to the present, current consumption must rise and future consumption fall). Those who have worked with OLG models, like Roger Farmer, find it easier to work through the logic as to how this is possible.

2) The size of government debt is not a good indicator of any burden. It is possible that government debt is positive, but there has been no attempt at intergenerational transfer. Proof 1: taxes on the young are cut, and the young save all the tax cut by holding the extra debt. Proof 2: borrowing for a capital project that benefits current and all future generations equally.

Note: This is important, as Noah Smith notes in this post. The size of government debt is not equal to the ‘burden’ on future generations. Indeed, positive debt is compatible with there being no burden at all.

3) There are probably much more important mechanisms going on right now that are transferring consumption from the future to the present: in some countries rising house prices, and climate change. No proof, just an opinion.

Note: despite this, if you think your grandchildren will have such a wonderful life compared to yours because of technological progress, you might not be too bothered. It is also worth remarking how potentially inconsistent it is to argue that we have to reduce debt now for the sake of future generations, and at the same time argue that it is too costly to take action now to mitigate climate change. 

4) Even if no intergenerational transfer is involved, high government debt could reduce future consumption for two quite plausible reasons: productive capital may be crowded out, and the tax required to pay the interest on the debt is distortionary (i.e. reduces output below optimal level). Proof: countless papers in the literature.

Note: I think it is wrong to describe both mechanisms as model specific, because you have to make quite extreme assumptions to avoid them. It is for this reason that I worry about high government debt in the long term. I have not heard anything to convince me that either mechanism is unimportant, or of any countervailing mechanism. (The need for safe assets could argue for high gross government debt, but not net debt, where the difference could be a large sovereign wealth fund.)

5) None of these arguments justify austerity at the Zero Lower Bound. Proof: countless posts by various people, including myself.

Note: For example, crowding out happens through high real interest rates, which are hardly a current problem. Nor is scarcity of labour arising from tax distortions.

Final thought. Think about government debt as a way of providing intergenerational insurance against negative demand shocks. When those shocks happen, the state pays out by cutting taxes (say) and increasing its debt. In normal times taxes rise again and the debt is gradually reduced. In this case allowing debt to rise following one of these shocks is no burden.  

Redistribution between generations

I ought to start a series on common macroeconomic misunderstandings. (I do not watch zombie films.) One would be that the central bank’s balance sheet normally matters, although this nice comment on my last post does the job pretty well. Here is one that crops up fairly regularly - that government debt does not involve redistribution between generations. The misunderstanding here is obvious once you see that generations overlap.

Take a really simple example. Suppose the amount of goods produced each period in the economy is always 100. Now if each period was the life of a generation, and generations did not overlap, then obviously each generation gets 100, and there can be no redistribution between them. But in real life generations do overlap.

So instead let each period involve two generations: the old and young. Suppose each produced 50 goods. But in one period, call it period T, the government decides that the young should pay 10 goods into a pension scheme, and the old should get that pension at T, even though they contributed nothing when young. In other words, the young pay the old. A fanciful idea? No, it is called an unfunded pension scheme, and it is how the state pension works in the UK. As a result of the scheme, the old at T get 60 goods, and the young only 40, of the 100 produced in period T. The old at T are clear winners. Who loses? Not the young at T if the scheme continues, because they get 60 when old (and assume for simplicity that people do not care when they get goods). The losers are the generation who are old in the period the scheme stops. Say that is period T+10, when the young get to keep their 50, but the old who only got 40 when young only get 50 when old. So we have a clear redistribution from the old in period T+10 to the old in period T. Yet output in period T and T+10 is unchanged at 100.

That example did not involve any debt, but I started with it because it shows so clearly how you can have redistribution between generations even if output is unchanged. To bring in debt, suppose government taxes both the old and young by 10 each period, and transforms this 20 into public goods. So each generation has a lifetime consumption of 80 of private goods.

Now in period T the government says that the young need pay no taxes, but will instead give 10 goods in exchange for a paper asset - government debt - that can be redeemed next period for 10 goods. In period T nothing changes, except that the young now have this asset. In period T+1 this allows them (the now old) to consume 50 private goods rather than 40: the 40 it produces less tax and the 10 it now gets from the government by selling the debt. Their total consumption of private goods has increased from 80 to 90. How does the government obtain these 10 to give the now old? It says to the young: either you pay 20 rather than 10 in taxes, or you can buy this government debt for 10. As people only care about their total consumption, the young obviously buy the debt. They now consume 30 in private goods in T+1, but 50 in T+2 when they sell their debt, which gets us back to the original 80 in total lifetime consumption.

This process continues until period T+10, say, when the government refuses to give the young the choice of buying debt, and just raises an extra 10 in taxes on the young. So the debt disappears, but the young are worse off, as they only have 30 of private goods to consume this period. Their total lifetime consumption of private goods is 70. We have a clear redistribution of 10 from the young in period T+10 to the young in period T enacted by the government issuing debt in period T.

If you are thinking that these redistributions need not occur if the debt is never repaid or the pension scheme never wound up, then we need to get a bit more realistic and bring in interest rates and growth (and the famous r<>g relationship), which these posts of mine (and these at least as good posts from Nick Rowe) discuss. But the idea with this post is to get across in a very simple way how redistribution between generations can work because generations overlap.

Unfunded pension schemes and intergenerational equity

Government debt and the burden on future generations

The Burden of Government Debt

Nick Rowe

How time travel is possible,

The burden of the (bad monetary policy) on future generations

Annoying Anti-Fiscal Stimulus Arguments Nos. 3 and 4

For numbers 1 and 2, see this post.

Number 3. We must reduce the size of the state.

This argument is often there but unstated, because to say it explicitly involves a deception. Instead it sometimes goes by the euphemism of ‘structural’ or ‘supply side’ reform. (No, I’m not saying there are no genuinely useful structural reforms out there, but just what some people mean when they use this term.) But as those making the case for austerity get more desperate, I have seen this argument a few times recently.

It involves a deception, because reducing the size of the state has nothing in principle to do with austerity and stimulus. I personally have no strong views about what the size of the state should be: some things are clearly done better by the private sector, while others are done better by the state, and how this eventually pans out for the aggregate I have no idea. But this has almost nothing to do with the need to increase demand when interest rates are at the zero lower bound. The deception comes when austerity mainly involves cutting spending (as in the UK), because it is anticipated that it will be very easy to cut taxes later on once austerity is over.

When I say it has almost nothing to do with stimulating demand, this is why I say almost. A long established and theoretically robust method of stimulating demand is a balanced budget fiscal expansion, where you temporarily increase government spending by temporarily raising taxes. However as it need involve nothing more than bringing investment projects forward in time (e.g. repairing roads and schools before they completely fall apart), it is not really increasing the size of the state. The idea that what is temporary is bound to become permanent does not stand up.

4. We must think of the children

This is annoying not because it is wrong in principle. Instead it is wrong because it either ignores who suffers the costs of austerity, or because it is not genuine. The argument that is right in principle is that, by increasing debt, we are ceteris paribus redistributing money from future generations to the current generation. There may be a complete offset if that increase in debt avoids hysteresis effects (or enables investment with beneficial supply side effects). Yet even leaving that aside, there are often very good reasons to redistribute income. When a country suffers a natural disaster, both governments and individuals freely give money to help those involved. We can think about the recession as a similar disaster.

If that does not convince you, ask who is bearing the brunt of this recession. All around the world, youth unemployment has risen by more than unemployment in general. If you asked those who cannot find a job after leaving school or college whether they would be willing to pay higher future taxes in order to get a job today, what do you think their answer would be?

Why do I suspect that this argument is sometimes not genuine? Because some of those who make this case also argue against measures to tackle climate change. Now even if you are sceptical about the science, the potential costs of you being wrong and 98% of scientists being right are so great that if you really cared about future generations you would support measures to reduce carbon emissions. (See Martin Wolf here or Martin Weitzman here.) So when, for example, a recent Wall Street Journal article argued that “we need an exclusive focus on supply-side reform [reducing the size of the state] to promote growth. Luxuries such as family-friendly employment legislation or green initiatives such as the carbon taxes are no longer affordable in the age of austerity” you know something is not right. The biggest risk to the well being of future generations right now is climate change, so what is the point of increasing future growth if the cost is doing nothing to reduce that risk. Of course that combination might make sense if you only care about what happens in the next few decades, but if that is your view then don’t tell me we should avoid a short run increase in debt for the sake of future generations. 

Teaching graduate macro

For teachers and students of economics

Noah Smith has a depressing look at the reaction of some graduate students to the macro they are taught. He links this to the ‘war’ between freshwater and saltwater visions of macro, and any disconnect between what is taught and the real world is bound to be more acute with the former. Particularly today, courses that attach New Keynesian theory to the end of the programme - and in some cases (through accident or design) end up not teaching it at all - are just asking for trouble. Even in more normal times, isn’t it a good idea to give students some idea of what central banks think they are doing? - they might just want a job in one!

However, even if you put this ideological problem to one side, I think there is a difficulty for anyone teaching graduate macro, which is rather different from anything encountered teaching at the undergraduate level. At the masters level it is just logical to delay teaching New Keynesian economics until some way into the course. As is frequently said, New Keynesian theory is an elaboration of the RBC construct, so all that needs to be done first. To take the example of Oxford’s MPhil, we do the Ramsey model, RBC, OLG, growth theory, and the flex price open economy all before New Keynesian economics, and it makes sense to do it this way.

Now this would not be a problem if this other stuff was as obviously interesting and relevant as Keynesian economics is today. However I fear that it is often not presented as such. Take growth theory for example. Now in principle this is all about why some countries are rich and some poor, which should be attention grabbing. But if in practice it amounts to discussing whether the speed of catch up is consistent with the Solow model, it can appear rather irrelevant. With the Ramsey model, I suspect the question of whether the allocation is optimal was not quite what students really wanted to know when they started the course. And if you do not teach the RBC model as the way to explain the business cycle, there is not that much to get excited about.

The problem of lack of motivation is compounded by something that I think those teaching micro often fail to appreciate. Today graduate macro is intrinsically harder than micro. In terms of the techniques involved it is probably no more or less difficult, but what in my experience students find really hard is that everything we teach fits together. Yet until you have done everything it is difficult to understand why we choose to focus on some model features to discuss some issues, but on other aspects of the macroeconomy when talking about different issues. Motivation is useful when the subject is challenging.

Luckily I think recent events, and specifically the debates over how quickly to reduce government debt, have come to the rescue. I mentioned in a footnote to a recent post how this year I was experimenting with starting the macro course with the two-period OLG model, instead of first developing the Ramsey model. This has a straightforward advantage, which is that students are familiar with the two-period consumption model from their undergraduate training, so we do not have to hit them with Hamiltonians quite so soon. However I think the main plus is that it allows us to focus on government debt and intergenerational equity right at the beginning of the course. There is an obvious interest among students in debt and intergenerational equity, but the crowding out effects of government debt on capital and therefore output in the simple two-period OLG model (with no wage income in the second period) are also dramatic. Almost certainly overstated as well, but better to start here than with a model where government debt does not matter at all! I can even bring in recent blog debates.

We will see at the end of the year whether this turned out to be a good idea. Even if it is, I am still searching for the equivalent motivation when presenting the basic ideas behind flex price new open economy macro. What determines international competitiveness, its relationship to PPP, non-traded goods and home bias are all things students should know about, but I’m not sure it really grabs their attention. Any ideas will be gratefully received.

Discounting Ethics in Macroeconomics

For macroeconomists (and perhaps philosophers)

In the Ramsey model (aka the representative agent model, the infinite life model, or what Romer calls the Ramsey-Cass-Koopmans model), agents care about their children’s utility as if it was their own. However, because they are impatient, they discount their children’s utility as they do their own. They therefore act as if they live forever. When teaching this [1] we say that the decentralized equilibrium is identical to the allocation that would be chosen by a benevolent social planner, who maximizes the utility of the representative agent.

When we teach the OLG model, we normally describe this model as involving agents who do not care about their children.[2] We note that the decentralized equilibrium would only be equal to the optimal allocation by chance. This is often done by showing that it differs from the golden rule allocation (the allocation that maximises steady state consumption), but some texts (e.g. Blanchard and Fischer) note that it would also differ from an allocation where the social planner showed some impatience over the utility of the unborn. In either case it is assumed that a benevolent social planner would put some value on the utility of the unborn.

It strikes me that the treatment of the two models is inconsistent. The claim about the Ramsey allocation involves an ethical assumption, which is that we allow the current generation to value the utility of the unborn. The benevolent social planner takes that valuation. Putting it another way, the benevolent social planner only maximizes the utility of the current generation, and makes no independent judgment about the utility of the unborn. Textbooks do not usually put it that way, but it seems to me this has to be what is being assumed.[3]

If we applied the same ethical judgment in the OLG model, where agents were entirely selfish, then the benevolent social planner should aim for an allocation which attempted to exploit the unborn as much as possible for the benefit of current generations. They should not be using a social welfare function which gives any weight to the utility of the unborn, and certainly not be thinking about the golden rule allocation. Instead, they should reflect the preferences of the living generations.

No one as far as I know tries to do this, presumably because it appears morally abhorrent. We want to overrule the selfish preferences of OLG agents. However, why is this acceptable in an OLG context, but not acceptable for agents in the Ramsey model?  If Ramsey agents had impatience (a rate of time preference) of 5% pa, then they are giving the utility of their children a weight of between 0.35 and 0.2 compared to their utility today. That is not so different from a weight of zero.

This point is clearer still if we look at the Blanchard/Yaari Model of Perpetual Youth, where agents do not care about their children but face a constant probability of death. A social planner that maximized the utility of the current living generations would discount at the same rate individuals do: impatience plus the probability of death. However I have not seen any papers that do this. Calvo and Obstfeld take a utilitarian perspective, and explicitly note that there is no necessary connection between the rate (if any) that the social planner uses to discount generations and the personal rate of time preference (with or without the probability of death). Once again, why is this distinction made in the context of this particular OLG model, but not when we look at the Ramsey set up where agents do care about their children?

It seems to me that if macroeconomists want to be consistent[4] they need to do one of two things. If they want to continue to insist that a benevolent social planner should use the personal rate of time preference of the current generation to discount future generations, then they should also make the social planner ignore the utility of the unborn in OLG models where agents are assumed not to care about future generations. They should also be transparent about the ethical assumptions they are making in the Ramsey case. (The potential double meaning in my title was deliberate). Alternatively, if they do not want to adopt this ethical position, they need to allow the rate at which the social planner discounts future generations (if any) to differ from individuals impatience in the Ramsey set-up as well as OLG models.[5] I have my own view on which is the better choice, but the point of this post is to suggest that at the moment macroeconomists are collectively just being inconsistent.

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[1] This post reflects the masters teaching I have just completed. I used to follow Romer in teaching the Ramsey model first, and then the OLG model. This year I have experimented with the reverse order (in the spirit of Obstfeld and Rogoff), which has helped highlight the issue I discuss here.

[2]This is crucial. If we described OLG as involving agents who would like to give Barro bequests but for some reason could not do, then my inconsistency argument does not apply.

[3] Future generations would only be happy with this if they gave the utility of their parents a much higher weight than their own. Somehow I do not think this is very realistic.

[4] The only grounds to be inconsistent would be that agents who give a weight to their children of zero should be treated differently than those that give it a non-zero weight. I cannot see what philosophical argument could be used to justify this, but I am not a philosopher.

[5] This is what the Stern Review on climate change does. 

Austerity, debt burdens and hypocrisy

After the weekend march against UK austerity, I saw a government minister on the TV justifying their fiscal plans. One of the arguments he used was that it was necessary for the sake of our children. In these circumstances I can quite understand the urge to dismiss such arguments as invalid. Part of this urge comes from knowing that, in many cases, the argument about debt being a burden on future generations represents simple hypocrisy.

How do I know this? Because often exactly the same people championing austerity also argue that we cannot take action to reduce future climate change because the current costs will be too great. The UK government’s spin was that it would be the greenest government ever, but its policy is quite the opposite. The Republican Party in the US also resists any action to reduce climate change because of the current costs of doing so (at least when they are not denying climate change exists). The connection? Both issues involve trading off costs to the current generation (austerity, measures to reduce climate change) with costs to future generations (higher taxes, climate change itself). If you really believe that we must reduce debt right now (rather than after the economy has recovered) because of the impact debt will have on future generations, then you should also be doing everything you can right now to reduce carbon emissions.

But just because some of those who use the ‘we are doing it for our children’ argument to justify today’s austerity are doing so hypocritically does not mean the argument is wrong. I will not go over why it is not wrong again, except to stress a point I do not think I have made forcefully enough before. Arguments which look at the distributional implications of permanently higher government debt (debt incurred but never repaid), and then ponder whether real interest rates will or will not be higher than the growth rate, are analytically convenient but practically irrelevant. There are many strong reasons, which have nothing to do with intergenerational equity, why it would be foolish to not try and reduce the high levels of government debt we currently have when the economy recovers, and so additional debt issued today will need to be repaid (and not just financed) at some point in the not too distant future.

However, although concerns about intergenerational equity are valid, they are unlikely to be critical to the austerity debate. Probably most major economic issues involve some element of redistribution, and in practice the device of compensating the losers is not an option. Take monetary policy, for example. We currently have low real interest rates, which benefits some but harms others. Do we let the fact that savers are worse off as a result of this policy hinder the central bank from keeping interest rates low? Of course not.

In the case of reducing debt today through austerity, there are other factors which have distributional consequences going in the other direction. To the extent that we have austerity through lower investment in infrastructure or education, it is the young more than the old that will be hurt by this policy. As important, high unemployment among the young today can have lasting effects (pdf, HT TC) on their welfare, and their children's welfare, as this study (pdf) shows. More generally, if DeLong and Summers are right that the hysteresis effects of austerity today are significant, then an entire future generation may be worse off as a result.

So it is not that ‘burden of debt’ arguments are wrong, but that they are just not that important in the context of the current austerity debate. The welfare loss to future generations of delaying debt reduction by ten years is small relative to the massive loss of resources and welfare caused by austerity today. If we are worried about future generations, a far cheaper way of helping them is to take action to mitigate the impact of climate change. 

The Burden of Government Debt

The recent ‘exchange’ on this topic (see Nick Rowe here, here, here and here, and apparently on the other side Dean Baker, Brad DeLong, Paul Krugman and Noah Smith) may just have confused many, so here is my attempt to unconfuse. I’m doing this because (a) the issue is tricky (as I know from my own experience) (b) I’ve written about this before (c) I happen to be teaching this stuff right now (d) Nick Rowe needs some support (although no help). Bottom line: government debt can be a burden on future generations (the current generation can use it to take resources from future generations) even if there is no impact on future output, but it is also likely to reduce future output, so we really should worry about the size of government debt in the longer term. But none of these worries applies when the economy is demand constrained, as it is right now.

There are a number of ways that the current generation can exploit (take resources away from) future generations, and paying themselves using the device of government issuing debt is one. This can happen because generations overlap, and even if there is no impact on future output. Take the most basic example. At any point in time there are two generations: old and young. Only the young work and they produce 2000. They plan to save 1000 for their retirement, so consuming 1000 in each period of their two period lives. (Ignore interest payments for simplicity.) Now the old at time T get a gift of 100 from the government, paid for by issuing debt to the young. Suppose the young cut their consumption to 900 to purchase this debt. The old at T are better off by 100, and consume 1100 at T. The gift effectively comes from the young at T, but as the young bought an asset, they may think they will be OK at T+1, when they sell that asset and have consumption that period of 1100. The government then pays back its borrowing at T+1 by taxing the now (at T+1) old by 100. The T+1 old do indeed get their money back by selling the asset, but they are also taxed, so their consumption is 1000 in T+1, not 1100 as they had hoped. The economy at T+1 produces and consumes as much as it would have without this temporary creation of government debt, but the sum of consumption in both periods of the old in T+1 is 1900, while the sum of consumption in both periods of the old at T in 2100. It is as if the young just paid the old 100 at T, which is what would happen in a one-off unfunded social security scheme.

Now have the debt paid back at T+2 rather than T+1. The young at T, who are the old at T+1, are indifferent: they consume 900 at T and 1100 at T+1. The young at T+1 buy the debt from the old at T+1, and consume 900. It is when they become old at T+2 that they are worse off, when taxes rise to pay back the debt. If we call ‘society’ at some date the combination of the two generations living at that date, then we can say society at T is better off and society at T+2 worse off. But what if the debt is never repaid? I have misgivings about the relevance of this thought experiment (see here), but for what it is worth the standard result is that future generations get exploited if the real interest rate is greater than the rate of growth of the economy. However, no exploitation need occur if the debt is used not to increase the consumption of the old, but to invest in assets that future generations can benefit from (see here).

All this assumes that there is no impact on what society can produce. But that is not a realistic assumption. In the example above I just assumed that the young would be happy to postpone 100 of consumption to buy some government debt. But suppose instead they were not, and substituted that debt for 100 of their 1000 saving for their retirement. If that saving was in the form of productive capital, then the government debt ‘crowds out’ that capital. Now one for one crowding out like that is probably too extreme, but I think there are good reasons to believe that some crowding out occurs when investment in capital is governed by the availability of savings. This effect occurs not because government debt is in any sense necessarily bad – you can get exactly the same effect from investment in housing depending on who inherits houses. Indeed, if society has too much capital (which is theoretically possible), having government debt crowd out capital would be a good thing. However the balance of evidence is that society probably has too little rather than too much productive capital, which means we should be concerned about the long run impact of government debt.

Need this have any relevance to the debate on stimulus versus austerity? Absolutely not: indeed quite the reverse. No sensible person is arguing that current increases in debt should be permanent – instead they should be reversed, gradually, once the economy recovers. Until the economy recovers, investment is being held back by lack of demand, not a lack of savings, so the crowding out issue does not arise. I think you could make a good case that, by stifling the economy today through austerity, you are damaging productive capacity in the future. So in the current circumstances it is austerity, not increasing debt, which is harming future generations.

Unfunded pension schemes and intergenerational equity

                In two earlier posts (here and here) I looked at issues involving debt and intergenerational equity. The second attracted a lot of interesting comments. Some had difficulty with the idea of debt as a burden, and I think one way to help here is to look at pension schemes. (I hope to return to other comments later.)

                When I talk about intergenerational equity to students, I go through all the ways that the current generation is exploiting future generations, like climate change, rising house prices, and rising government debt. I also say that of course the older generation could just get the younger generation to pay them directly. I then reveal, to the surprise of some, that that is exactly what happens in many countries because these countries run unfunded pension schemes.

                An unfunded scheme is where the working generation pays social security contributions, and that money goes straight into paying the pensions of the old, rather than buying some kind of asset (hence unfunded). When the scheme starts, the current old receive a windfall: a pension without having contributed anything. The young pay contributions, but then receive a pension when they get old from the new younger generation. So the older generation when the scheme starts are clearly winners, but are there any losers? The answer depends on two things.

                The first is whether the scheme ever stops. If it stops, the young in the period beforehand are clear losers. They paid contributions (which went straight to the then old), but get nothing when they get old. Obviously the scheme is a huge burden on this ‘final generation’. However if the scheme goes on forever, there is no last generation, so there is no loser on that account.

The second issue is whether those who are forced to save by contributing to the pension lose out because they could have done better saving for themselves. That in turn depends on whether the rate of interest (r) is greater than the rate of growth (g). Those who contribute to the pension scheme get back more than they put in because of economic growth. The income of the young as a whole will be higher either because of technical progress which raises income per head (assuming contributions are a fixed proportion of income), or because there are more of them which raises the number of heads. In either case the current young generation contributes more than the old did when they were young, so the old benefit from that extra money. However if they had saved themselves their return would be the rate of interest. So if r>g, each generation of young lose out a bit by being forced to save in a way that produces a return equal to g rather than r.

All that is happening here is that money is passing from one group to another, with the government acting as an intermediary. Society is ‘paying itself’. But this statement says nothing about intergenerational equity. Suppose the scheme only lasted one period. Money passes from the young to the old, but it would be absurd to say that this implied that the young were not losing out.

Those who read this earlier post will see the parallel with the case of government debt. With pensions the young get an implicit promise that they will receive their money back with a return equal to g, whereas those that buy debt get an explicit note saying they will get their money back with some rate of interest r. The implicit/explicit thing is not crucial here – after all the government can default! The key difference is that, if people are to buy the debt voluntarily, they get a return equal to the return on other forms of saving (=r). If r>g, taxes have to rise to make up the difference between the two when debt is issued.

An unfunded pension scheme has the same macroeconomic costs that I discussed before in relation to government debt. In particular, if the young save at least part of their pension this way, they will save less in productive capital, and if the amount of capital in the economy as a whole is less than the optimal level, this will be an important cost. In addition, to the extent that the contributions act like an income tax, it can distort work effort.

Does this mean that an unfunded pension scheme is a bad idea? You can see why it might be introduced even if it was a bad idea – its introduction is great for the current old, so they will always vote for it. There are two potentially important benefits, if the alternative is funded private schemes. First, it takes away a lot of the uncertainty in funded schemes. If you buy your private pension when the stock market is high, and retire when it is low, you could lose out in a big way. You might also want insurance against labour income risk. (See, for example, this paper by David Miles.) Second, it provides a safety net for those who were misguided enough not to contribute to a private pension. (For a useful reference on pension issues, see Oxford Review of Economic Policy Vol 22, No1, Spring 2006.)

                I think this nicely illustrates why intergenerational equity can never be the overriding concern when it comes to issues involving government debt or unfunded pension schemes. There are many other factors to consider that may be more important. If it was decided that the costs of unfunded pension schemes exceeded the benefits (or, more realistically, that the balance should move to funded schemes), then the generations involved in any transition would almost certainly lose out. They would become like the final generation in my discussion above. That issue of intergenerational equity should be important in any decision, but it should never be the only consideration.