It is odd how ideas, thought and reading evolve over the course of a day. I started off early this morning reading Nick Rowe’s post on structural deficits in the Eurozone and assorted news stories on the European crisis. I then began working in my office and while shuffling a few books on my desk came across my copy of First Principles of Public Finance (1936) by Antonio De Viti De Marco. The book was given to me a number of years ago by Norman Bonsor at Lakehead when he retired and I had started reading it several weeks ago given that I was looking for something different as I began preparing for next term’s intro lecture for my public finance course. De Marco was part of the “Italian school” and had a focus on institutions and political economy that made him (and I suppose the Italian School) a precursor to public choice. As Europe struggles with its fiscal crisis and trying to rein in deficits, it may be instructive to consider a few passages from De Marco’s First Principles to gain some perspective on the European fiscal mind.
“The deviations from the principle of maximum economic advantage which are due to political factors increase the price that tax-payers are called upon to pay for the production of public services: but they do not alter the fact that the State tends to specialize in the production of a given category of goods, just as private enterprise does. It is precisely this fact that shows the error of treating the phenomena of Public Finance as if they were dissociated from Private Economics. In fact they form an integral part of the general organism of production, exchange and consumption of goods.”
As a result, the Italians and probably the Europeans in general (but not les anglais) are probably more sensitive than North Americans to the idea that tackling a deficit and associated debt is not just a simple cost-cutting exercise with short-term spillover effects and adjustments. The spill-over is not just in terms of budget reductions that lead to cuts in entitlements or unemployed civil servants but can fundamentally redefine the role of the state as well as affect private sector activity in terms of the services it obtains from the public sector whether those services are financial regulation or clean water and street lighting.
The view of public debt in his chapter on The Theory of Public Loans also bears the marks of this analysis. It would appear that high amounts of public debt were not necessarily viewed as negative by De Marco particularly if they were incurred for capital expenditures – at least that is my interpretation based on a reading of the chapter. Again, he writes (p.395-396):
“The extraordinary levy can consist only of present goods; this is axiomatic. The useful effects of the expenditure, on the other hand, usually concern future generations. In the future, the heirs and future generations will receive from their ancestors a budget which, on the liability side, is depreciated by the amount of the extraordinary levy, and, on the asset side, is increased by the utility of the expenditure incurred. The State, say, has used a billion to build a railroad system; future generations will inherit a billion less in private goods, but will receive the system of completed railroads….In the light of these considerations, there is no basis for the old, but still widespread, opinion that a loan, unlike an extraordinary tax on property, makes it possible to shift a part of public expenditure to future generations. On the contrary, in every case the heirs either receive a patrimony which is lessened by an amount equal to the capital sum involved or are held responsible for the continuing payment of the corresponding amount of interest…”
If this type of thinking and analysis has underscored the European approach to public finance and the acquisition of debt, then it is not hard to see it facilitating the acquisition of ever larger debt to GDP ratios. It makes perfect sense. The difficulty I suppose is when the justification is applied not to capital projects that bequeath assets but to current spending on pensions and transfers. While incurring deficits to spending education and health could be justified as “bequeathing” a human capital asset to future generations, incurring them to fund more generous current consumption spending is not as easily justified. When De Marco wrote, the post-war welfare state had yet to come about and much government spending was on tangible goods and capital. Politically, if all deficits can be portrayed as investments in the future, then it becomes much harder to bring about the fiscal discipline to restore the public finances. I think the Europeans are struggling with a fundamental rethink of what the role of public finances and the state are in the economy. When the Europeans talk about a “structural deficit”, what exactly will it mean?
De Marco sounds fairly sensible to me. There are two arguments (I'm aware of) for why government investment should be financed by borrowing rather than by current taxes: intergenerational equity; tax rate smoothing (to minimise the present value of deadweight costs of taxation).
Posted by: Nick Rowe | December 11, 2011 at 07:22 PM
"intergenerational equity"
Or "parents deciding that the kids owe them!" Everywhere you look, an agency problem. Why can't we just pay for the kids *we* decided to have. And then pay for our own retirement later.
Posted by: K | December 11, 2011 at 08:09 PM
It's contracting with toddlers! *Actually* stealing candy from a baby! And the courts let us get away with it :-)))
Posted by: K | December 11, 2011 at 08:15 PM
K: Because the kids benefit from government investment. Sure, there's an agency problem there but we can hardly wait 'till the kids are 18 to ask them if they would like to learn to read. But who knows, maybe science can engineer humans to mature in 6 months and feature a USB port (Firewire for the iKids) so we can just download the PhD.
Posted by: Patrick | December 11, 2011 at 10:49 PM
Oh my. Of course that should be upload. Unforgivable for a computer geek.
Posted by: Patrick | December 11, 2011 at 11:13 PM
Patrick: "Because the kids benefit from government investment."
And the parents benefit from having kids. They sure aren't having them for the kids' sake. You raise them and if you do a really good job and you are lucky then they will help you out in your old age. But you don't contract with them.
"Teach your children well" - CSNY
Posted by: K | December 11, 2011 at 11:59 PM
There are two arguments (I'm aware of) for why government investment should be financed by borrowing rather than by current taxes: intergenerational equity; tax rate smoothing (to minimise the present value of deadweight costs of taxation).
What about the case where the interest rate on the debt is lower than the GDP growth rate? You could see it as a special case of tax rate smoothing (since the tax base is proportional to GDP), but it's convenient to take this as a special case.
Also, the tax-rate argument applies to current-account spending as well as investment. (Granted, investment might pay for itself if it raises future GDP enough. But this too is subsumed by the former argument.) If there's a rationale or restrcting borrowing to investment spending, it is about public choice considerations, not economics ones.
Posted by: anon | December 12, 2011 at 04:17 AM
K: so? It's not the benefit derived from having kids at issue. It's the benefit of government investment.
Posted by: Patrick | December 12, 2011 at 07:54 AM
anon: yep. I forgot about the interest rate lower than GDP growth case. And yep, the tax rate smoothing argument also applies for any other case (not just investment) where desired expenditure might be temporarily high, or GDP temporarily low. Wars and earthquakes, etc.
Posted by: Nick Rowe | December 12, 2011 at 08:10 AM
Nick, is there a case for the Keynesian argument for budget deficits and surpluses, i.e. managing velocity of money when the monetary authority is not pursuing a sensible target? It seems that the smoothing-wrt-GDP argument subsumes it to some extent, but this could be wrong e.g. if the benefit of expenditure correlates with GDP, or any other considerations.
Regardless, a recent paper by Greg Mankiw and Matthew Weinzierl ("An exploration of optimal stabilization policy") argues that investment subsidies can be used to manage velocity at much lower welfare cost.
Posted by: anon | December 12, 2011 at 08:56 AM
Italy's birth rate is too low to replace their population as it is, so creating further disincentive to have children seems like poor public policy.
Posted by: Andrew F | December 12, 2011 at 11:03 AM
anon: here's an old post I did, arguing for what would look like "keynesian" fiscal policy from very orthodox micro grounds, even if monetary policy can do all the AD stabilisation that's needed:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/06/monetary-and-fiscal-policy-ought-normally-move-together.html
Posted by: Nick Rowe | December 12, 2011 at 01:13 PM
Livio:
"As a result, the Italians and probably the Europeans in general (but not les anglais) are probably more sensitive than North Americans to the idea that tackling a deficit and associated debt is not just a simple cost-cutting exercise with short-term spillover effects and adjustments."
I began my studies in the 70's with a bunch of older european-trained profs. As the years went on, my University expanded fast and hired a gang of american-trained young uns. And the perspective in public finance courses changed in the way you suggest. Years ago, I was still teaching my Intro Macro pups that public debt didn't matter that much as you inherited both sides of the balance sheet. But it disappeared from the textbooks and my younger colleagues in the dept. had more and more trouble with the course outline. I still teach it but I feel so old..( but right)
Posted by: Jacques René Giguère | December 12, 2011 at 02:37 PM
Jacques:
Well, for all we know that concept of debt will cycle back into vogue at some point. It does make alot of sense at least for capital spending.
Posted by: Livio Di Matteo | December 12, 2011 at 06:09 PM
“there is no basis for the old, but still widespread, opinion that a loan, unlike an extraordinary tax on property, makes it possible to shift a part of public expenditure to future generations”. Quite right: though there is actually an exception to this rule: where a country borrows from abroad. In this case, the obligation to repay the loan can be dumped on future generations, as was pointed out by R.A.Musgrave in the American Economic Review in 1939: “‘The Nature of Budgetary Balance and the Case for the Capital Budget’. (I.e. I don’t agree with Nick’s first comment above).
“Politically, if all deficits can be portrayed as investments in the future, then it becomes much harder to bring about the fiscal discipline to restore the public finances.” The idea that government borrowing is justified if the relevant funds are invested is an appealing “common sense” argument. However, the argument does not actually hold much water. That is, it makes more sense to fund public investment from tax rather than borrowing, as was shown by Kirsten Kellerman in her paper in the European Journal of Political Economy (2007): “Debt financing of public investment….”.
When the Europeans talk about a “structural deficit”, what exactly will it mean?” The Reuters or Wiki definition will do me. The Financial Times Lexicon definition is similar, but is self-contradictory in some respects. I’m trying to get them to change it.
Posted by: Ralph Musgrave | December 13, 2011 at 01:43 AM
Ralph, Jacques: It *is* possible to shift the burden onto future generations.
Ignore capital, ignore foreigners, and assume lump sum taxes only, for simplicity.
There are two cases:
1. Barro Ricardian Equivalence. The old *give* their bonds to their kids. No burden on future generations. They inherit both the tax liabilities and they inherit the bonds (for free).
2. Buchanan Samuelson. The old *sell* their bonds to their kids. There is a burden on future generations. They inherits the tax liabilities, but *pay for* the bonds they "inherit".
The trouble with Old Keynesians is that they wanted it both ways. They assumed "Bonds are net wealth" (2) when it came to arguing that fiscal policy increases AD. But they assumed "Bonds are not net wealth" (1) when it came to the burden of the debt.
But I sort of agree with Jacques, that there was this very *silent* shift in beliefs in economics, sometime around 1980's, where we went from assuming debt is not a burden to assuming it is a burden. Almost as though we were too embarrassed, as a profession, to discuss our change of beliefs.
Posted by: Nick Rowe | December 13, 2011 at 07:16 AM
Patrick: I don't see the moral distinction between goods we provide individually (food, shelter) and collectively (healthcare, education) to our children. If it's OK to stick them with the bill for the latter, why not the former? Why can't I *lend* them money for room and board, and sue them in ten years if necessary to collect?
Posted by: K | December 13, 2011 at 08:19 AM
"it's OK to stick them with the bill for the latter, why not the former? Why can't I *lend* them money for room and board, and sue them in ten years if necessary to collect?"
You can, I believe that traditional method of financing retirement is to blow all your money on your kids, then show up on their front door and tell them that they'll be caring for you for the rest of their lives. Granted, that's a moral or ethical obligation of your kids (at least in traditional societies) rather than a legal one, but probably no less binding for that.
Posted by: Bob Smith | December 13, 2011 at 08:37 AM
Nick, Buchanan Samuelson is new to me and got me thinking. As regards very wealthy bond owners selling bonds to their kids, that just doesn’t happen, seems to me.
A more realistic scenario is that some bond holders sell their bonds to fund their retirement (which is what pension funds do, I suppose). Here, bond prices will drop and interest rates will rise. But this is a zero sum game for aged bond holders isn’t it, because aged bond holders who DON’T SELL, see the value of their bonds drop?
As regards kids, if they see a drop in bond prices as being an easy way of acquiring investment income (e.g. to funding their own retirement) and if the kids worked extra hours to acquire the bonds, then Buchanan Samuelson would work. But the kids could react by working FEWER hours and/or acquiring fewer bonds on the grounds that fewer bonds appear to be needed to fund a given standard of living in retirement.
This is getting too complicated for me!
Posted by: Ralph Musgrave | December 13, 2011 at 12:41 PM
Ralph: if the old generation sells their bonds (to their own or someone else's kids) then in return they get the real goods that the kids have produced. That's an intergenerational transfer.
Simplest thought-experiment is helicopter bonds. Generation A is given the bonds as a transfer. Hold taxes constant, and issue new bonds to pay interest on the old. A sells bonds to B, which sells to C, etc., then unlucky generation X gets a tax increase to retire the bonds plus accumulated interest, which is like having the bonds vacuumed (reverse helicoptered) out of their pockets. It's a wealth transfer from generation A from generation X.
This is how the "ignorant unlearned Man-in-the-street" thinks about debt. And it's basically right, unless you use the debt to finance schools for the kids so there's an offsetting investment, or if Barro-Ricardo is right, and people do their own offsetting transfers.
IIRC (I'm not sure I do) Abba Lerner never figured this out in Functional finance. Not sure if the MMTers ever figured it out. (Hides under desk.)
Posted by: Nick Rowe | December 13, 2011 at 12:59 PM
Typo: Should be: "It's a wealth transfer TO generation A from generation X."
Posted by: Nick Rowe | December 13, 2011 at 01:02 PM