The 30 years non-war over the debt burden. Plus Samuelsonian NGDP bonds.

I thought we all had this debt burden stuff sorted out 30 years ago. Obviously we didn't.

We should have had a bigger argument about it 30 years ago, which would have sorted it all out. But we didn't. Maybe because we spent all our time arguing about other stuff 30 years ago, and didn't have time to argue about this stuff as well. Or maybe because most of us were too embarrassed to mention we had totally changed our minds on this, and that the views we used to say were uneducated views were in fact right after all. So we silently changed our beliefs, and tried to forget we had ever believed anything different. But not all of us noticed this change in beliefs, and still thought everybody else believed what we all used to. So now we are re-fighting the old ground we should have fought properly 30 years ago.

There are 4 possible positions to take on the debt. One of them doesn't make sense; the other 3 do. Which of those 3 is right is an empirical question.

Here are the 4 positions. I gave each one a name. I made up the quotes.

1. Abba Lerner. 'The national debt is not a first-order burden on future generations. We owe it to ourselves. The sum of the IOU's must equal the sum of the UOMe's. You can't make real goods and services travel back in time, out of the mouths of our grandkids and into our mouths. The possible second-order exceptions are: if we owe it to foreigners; the disincentive effects of distortionary future taxes; the lower marginal product of future labour if the future capital stock is smaller.'

2. James Buchanan/uneducated person on the street. 'The national debt is a burden on future generations of taxpayers. Foreigners are basically irrelevant. Any second order effects of distortionary taxes and lower capital stock are over and above that first order effects of the taxes themselves.'

3. Robert Barro/Ricardian Equivalence. 'The national debt is not a burden on future taxpayers (except for the deadweight costs of distortionary taxation) but only because ordinary people take steps to fully offset the burden on future generations by increasing private saving to offset government dissaving and increasing bequests to their heirs to offset the debt burden.'

4. Samuelson 1958. 'If the rate of interest on government bonds is forever less than the growth rate of the economy, the government can run a sustainable Ponzi finance of deficits, where it rolls over the debt plus interest forever and never needs to increase taxes, so there is no burden on future generations.'

I personally was taught 1 as an undergraduate. And I believed in 1 until about 1980, when I spent some time reading Buchanan and Barro arguing with each other. And I worked 4 into my own beliefs soon after.

And now, I believe 1 is false. The truth is some sort of mixture of 2,3, and 4. What precise mixture of 2,3,4 is true is an empirical question. My prior is one third-one third-one third.

Until last week, I thought that almost every macroeconomist had now realised that 1 was false. And I wrote a post arguing 1 is false. My post was triggered by Paul Krugman's recent post, which I interpret as saying that 1 is true. Paul wrote two later posts too, which I interpret as also saying that 1 is true.

Many other bloggers have now waded into this debate. Good! Finally (I was scared we were going to keep on ignoring this question)! Bill Woolsey. Greg Mankiw. Don Boudreaux. Karl Smith. Daniel Kuehn. Jim Hamilton. Noah Smith. (I must have missed some. Sorry.)

And look, just because deficits have costs doesn't mean we shouldn't do them. Like a lot of things, deficits have benefits too, and sometimes the benefits are bigger than the costs. But we shouldn't ignore those costs, just because we think the benefits are bigger than the costs.

And what we need to do more work on is this: we know Samuelson is right, if we know for sure that the interest rate on bonds is less than the growth rate of GDP forever. That is a sufficient condition for Samuelson being right, but I rather doubt it's a necessary condition. What if the interest rate will probably be less than the growth rate part of the time for a rather long time? Could Samuelson still be right, or at least partly right?

I really wish I could get my head around that question, but I can't. My hunch is that NGDP bonds would play a role in the solution, because a bond indexed to nominal GDP would resolve the uncertainty of whether the interest rate would be above or below the growth rate of GDP. And if we got the duration of those NGDP bonds right, we ought to be able to get around the problem of r being sometimes greater and sometimes less than g. Somehow, it just must be possible to eat the Samuelsonian free lunch, even if it's only a temporary and uncertain free lunch. And NGDP bonds just must be the way to eat it, somehow.

And if I could only get my head around that question, I might come up with something that would make both Scott Sumner and the MMT guys very happy indeed. Which would be neat. Plus, as a side-benefit to making both those guys happy, it might be very good for the poor ignorant uneducated slob on the street too.

But my brain just can't figure it out, yet. Maybe some of you younger, keener, brighter, people could work on this?

Comments

[Anonymous]

What about the current case, where interest rates on bonds were below the growth rate, until it reversed (Greece, Spain, Italy, etc). In this case the debts looks sustainable precisely because of 4, but after the interest rates grew above growth rates, the speed of disaster was unpredictably quick. Thoughts?

[Nick Rowe]

Anonymous: the Eurozone countries are a little but different, because they can't print money and act as lenders of last resort to themselves. That means they can get stuck in a bad equilibrium where there's a "run" on their bonds in much the same way there can be a run on a bank. The danger for "printers" like Japan, US, UK, etc., is a bit different. When/if the recession ends, and desired saving and investment return to normal, what will happen to the equilibrium real interest rate? My guess is that it will rise. If it rises above the long-term real GDP growth rate, those countries will have to increase taxes to avoid a snowballing debt/GDP ratio.

If it weren't for the political incompetence, I wouldn't worry much about the US. But Japan has a rather high debt/GDP ratio.

NGDP bonds could, I think, fix this problem. They would act more like equity than debt.

But I don't understand this issue as well as I wish I did.

[Robillard]

Well Anonymous, I guess we can say that 4 holds true... until it doesn't hold true anymore. Of course, it is conditional on the interest rate staying below the nominal growth rate of the economy. In the case of Greece, investors really got alarmed about its debt situation when it was revealed that the Greek government had been systematically understating the amount of its borrowing. When the borrowing figures were revised upwards, there were no corresponding upward revisions to nominal economic growth. So it really was the case that deficit-funded government spending led to less GDP growth than previously stated.

Sometimes I wonder if there is a conventional economics (not involving behavioural economics) explanation for why investors seem to swing from confidence to hysteria and back over time. Keynes seemed to resort a kluge by referring to "animal spirits". I realize that the current surge in peripheral European government bond yields can be partially rationally attributed to the need for European banks to deleverage in order to meet heightened capital requirements, which has become of a bit of a vicious cycle. Are investors and their intermediaries, such as banks, supposed to be rational economic actors? Or is there some kind of confidence explanation that can only be explained by behavioural economics and psychology?

[Jonathan M.F. Catalán]

But, wouldn't you agree that the relevance of this debate really revolves around the more crucial question: whether the accumulation of debt (i.e. government spending) positively contributes to economic growth? (Not just positively contributes, but does so in a way that is superior to any other possible alternative given a certain set of conditions.)

[Nick Rowe]

Jonathan: Yep. If the government can find an investment that has a rate of return above the interest rate on bonds, then it should do it. The benefits of the investment exceed the costs of the debt. Net plus for future taxpayers.

[Bob Smith]

Jonathan,

I think what's interesting about that is that the question of whether the deficit increases growth has different relevance for different scenarios.

For example, if you accept 1, then it doesn't really matter if deficits increase growth, since they don't (allegedly) impose any cost. Same for 3 (because of Ricardian equivalence).

On the other hand, if you believe 2, then the possible benefit of a deficit is relevant to determining the net benefit of that deficit.

Finally, in 4, samuelson essentially incorporates the benefit of the deficit into the no-ponzi condition. Essentially this is a generalization of (1) and (2), if the deficit increases growth such that ponzi finance is feasible, you end up in 1. If not, you end up in 2.

[Steve Roth]

Damn you're good.

Thanks from your friendly neighborhood poor ignorant uneducated slob on the street.

"I really wish I could get my head around that question, but I can't. ... something that would make both Scott Sumner and the MMT guys very happy indeed"

Where's Steve Randy Waldman when we need him? You out there Steve?

[Martin]

Nick, the stock market seems a clear candidate for that with an 6-8% return a year. Hell, even corporate bonds do pretty well. The trouble however is that this kind of 'socialization of investment' will not work. The government is not risking its own resources, the return is conditional on people selecting those stocks and bonds with their own resources at risk. And if, you cannot imagine the government to do that successfully why would you expect them to pick investment projects with a higher return outside a market setting?

What my point is, is that looking for investment opportunities that exceed the interest rate on its bond is not the job of the government and cannot be its job. Thinking about the accumulation of debt in terms of rate of return on investment seems simply wrong to me.

Regarding your original question: "What if the interest rate will probably be less than the growth rate part of the time for a rather long time? Could Samuelson still be right, or at least partly right?"

I would frame it in terms of NGDP * (1 + r_t)^t >= B * (1 + i_t)^t, where NGDP is NGDP, r_t is the growth rate of nominal spending at time t, B is the government debt and i is the rate on government debt at time t. So what you're asking essentially is how would the path of r_t have to be relative to i_t for Samuelson to be still right? Is this what you're asking? If so, I am not sure whether you can prove it, but you certainly should be able to run simulations of different scenario's. You could probably reduce the simulations by making a model that relates i to r and to NGDP and B.

[Determinant]

I attended a chat by Dr. Torben Drewes of Trent University, a macroeconomist, given to a local business gathering. He argued, in simple but clear terms, for [1]. However [1] depends on government debt being treated as akin to money in that it has no default risk. You can manage this if you print your own money but it does require work.

[4]is actually a corollary of [1], [4] relates to the interest burden and [1] relates to principal. [4] is actually of wider application because it's the justification for defined-benefit pensions. Classically (prior to 1990) government employee pensions were invested in government bonds or simply noted as an obligation to be financed, such as the Federal Government's Superannuation Account for Public Service pensions. Private sector pensions were financed on the assumption that the growth rate of the economy was greater than the government prime bond rate and therefore DB pensions weren't a direct burden for the private sector either.

The trouble is that we have managed to work ourselves into cases where either [1] or [4] don't hold for a few years and then we panic.

[Nick Rowe]

Bob Smith: "Same for 3 (because of Ricardian equivalence)."

Minor disagreement there. Barro would say that the government should go ahead with the investment, but it doesn't make any difference whether it is financed by taxes or by deficits.

Steve: Thanks! (Yeah, the "poor uneducated slob on the street" bit was supposed to be ironical.)

Steve Randy Waldman might take a good crack at it. I keep trying to figure it out, then I find myself thinking about NGDP perpetuities whose value exceeds infinity, getting muddled, and giving up.

[JeffreyY]

Matt Yglesias gave an interesting defense of Krugman's position: http://www.slate.com/blogs/moneybox/2012/01/01/why_debt_doesn_t_burden.html

Krugman's argument for #1 may be that #2 only tells half the story: "The national debt is a burden on future generations of taxpayers. … But it is also a blessing to future generations of bondholders, and the two cancel out."

I don't understand why Krugman ignores the distributional effects. If bondholders are on average wealthier than the uneducated person on the street, then #2 is still right when you look at important subsets of the country. Maybe he assumes that taxation will be progressive enough to offset the difference?

[Nick Rowe]

Martin: Yep, if the government started running a stock mutual fund, I'm not sure how well it would do, and for how long the interest rate on government bonds would be less than the returns on its portfolio. Plus, this would be a leveraged bet on the stock market with the taxpayer taking the residual risk. Would that residual risk be properly priced? Hmmm.

"Is this what you're asking?"

I don't know. It's one of those cases where if I could formulate the question properly it should be easily solvable. Or, if I already knew the answer, I would be able to formulate the question properly. I'm just not clear enough on either question or answer to say.

Determinant: Torben will not be alone. My late colleague TK Rymes, an unreconstructed Keynesian, always believed 1. (And he would sometimes joke, just to tease "What's posterity ever done for me?"

I think that 1 and 4 are very different. 4 says the government never needs to increase taxes, and that's why it's not a burden. 1 says it doesn't matter whether the government does or does not need to increase taxes, because it's never a burden in either case.

JeffreyY: Thanks for the Matt Yglesias link. Oh dear. Matt's not getting it either. I wonder if Matt has read my post?

[W. Peden]

"If the rate of interest on government bonds is forever less than the growth rate of the economy"

Is that the nominal or real growth rate?

[geerussell]

In point number one should the made up quote be "unless it is denominated in a foreign currency" rather than "unless we owe it to foreigners"?

What I've read of Lerner and others of that lineage down to current MMT'ers indicates a stance that how the debt is denominated is the determining factor, not who holds the bonds.

[Normand Leblanc]

If 1 or 4 is true then why are we paying taxes. Let's print (borrow) everything... Hmmm, our american friends are borrowing close to 50 cents for each dollar spent by the gov. This is pretty close to our defunct Social Credit Party's theory.

If we follow that strategy, at one point in the future, even with all IOU issued by Canadian banks or the BoC (no outside debt), the market will lower the value of our C$ causing price inflation and eventually we will have to stop printing/borrowing or our money will be worthless. The drop in value of our C$ would most likely trigger a raise in interest rates meaning that Samuelson's condition no.4 would not be met.

If I'm wrong then I just can't see why the ECB is not printing more without all those governments having to cut expenses to reduce their deficit.

[Jacques René Giguère]

Nick:"if the government started running a stock mutual fund".
It runs something much simpler and much better, the ultimate index fund aka taxing GDP.
It is more stable than interest rates and thus bond valuations ( including the not-a-burden-corporate ones), much more stable than corporate profits and avoid the wild girations in animal spirits that affect stock prices. There aren't any of the random distributionnal effects from one individual having to sell or buy at momentarily out of whack prices. And it avoid commissions paid to the parasitic brokering services. Maybe slightly OT but Determinant opened the wedge...

[Nick Rowe]

W Peden: Either: nominal interest rate and growth rate of nominal GDP; or real interest rate and growth rate of real GDP. Same thing either way.

geerussell: there are times when it matters, like in the Eurozone right now. If there's a "run" on government bonds, or if you need to loosen monetary policy in a recession, or if you want insurance against shocks, then it is much better to borrow in your own currency. But a government which borrows in its own currency still faces a budget constraint (unless 4 is true). You can inflate away the debt with a surprise inflation. But anticipated inflation simply means the nominal interest rate rises one-for-one with the inflation rate, and so printing money doesn't help you pay down the debt. (There is a limit to the real seigniorage revenue from printing money).

Normand: If 4 is true we should not be paying taxes at the margin. We should cut taxes, and increase the debt, until the interest rate rises to just equal the growth rate of GDP.

Given the ECB faces a disinflationary recession, the ECB should be printing more money.

Jacques: I think that's on topic. I don't quite follow you though.

[Liquidationist]

Even if the government can borrow forever at an interest rate less that the rate of GDP growth it doesn't mean that it should be allowed to. Given a limited pool of savings then in a free market the borrowers who are prepared to bid up the interest rate to the highest level based on their current valuation of how that money should be spent will be the ones who get access to a share of it. The government will always be in a position to outbid the private sector because of its ability to tax and print money to pay future interest.

I would like to suggest the following to make sure that the government only borrows when it is optimal to do so:

1. make taxation optional
2. make currency creation open to anyone

This will ensure that when the government borrows money it is competing fairly with private borrowers.

[Nick Rowe]

Liquidationist: You might like this old post of mine:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/do-we-need-a-bubble.html

[Determinant]

Governments that borrow in their own currency have an unfair advantage: they can't default for lack of funds, but they can generate inflation. Therefore they have less credit risk than private businesses by structure.

Finance is sooo much easier when you operate the tax office, the central bank and the printing press.

All you need is a helicopter and away you go.

[Jacques René Giguère]

Nick: I was following Determinant's point "4]is actually a corollary of [1], [4] relates to the interest burden and [1] relates to principal. [4] is actually of wider application because it's the justification for defined-benefit pensions".

[Liquidationist]

That's an interesting article but I don't really get why there is a bubble involved. It seems to me its just a combination of altruism and self-interest that make the interest rate 0% rather than infinity. If there was a government in the picture I think there is a good chance it would inflate the money supply and reduce the value of the money savings needed to make the model work.

In any case if there was a bubble and it burst don't the Market Monetarists know how to fix that ?

[Martin]

Nick:

"Would that residual risk be properly priced? Hmmm."

I have a hunch and my reasoning is as followed:

1. Opportunity cost is the cost to the decision maker of the foregone alternative at the time of the choice.
2. If the market is perfectly competitive the opportunity cost is equal to the price.

So the price of the residual risk depends on the utility function and expectation of the decision maker and on the market structure where the risk is priced.

Assuming benevolence, the question becomes one of expectations and market structure. In the case of the EMH the risk will be properly priced and the decision maker will know what to expect. The question then is, is the presence of government on the market consistent with the EMH? I think it is not and this has to do with how capital is raised by the government: through taxation. Because of this, the decision maker can never know what the opportunity cost is to the tax payer and therefore the risk can never be properly priced.

"I don't know. It's one of those cases where if I could formulate the question properly it should be easily solvable. Or, if I already knew the answer, I would be able to formulate the question properly. I'm just not clear enough on either question or answer to say."

Would it help to assume that there is some value of (B * (1+i_t)^t)/(NGDP * (1+r_t)^t) that will make a mess of things and you want r_t and i_t to be such that that value is never reached at any time t?

[J.V. Dubois]

Nick: First, thanks for excellent post and for stirring this debate that I find more and more at the root of differences between various schools of thought about the response to the crisis.

However as for your post, I still think that Aba Lerner position is right. First thing is – how do you define “burden” and “income”? If we define burden as anything that decreases the ability of future generations to produce and income as the sum of the things they produce (and sell), then clearly position 1 is right (ignoring disincentive and distortion effects of taxation). This is the key.

So generally speaking it is not government spending that is a burden, but neglect of investment and giving up on capital formation for the sake of consumption. For example imagine a fictive state where its government has a policy that says that 30% of GDP must be in investment. And if private sector does not deliver, then government will start “spending” on infrastructure, basic research and other forms of investment to reach this ratio. Such society is clearly committed to build up the wealth to be used by their children - even if this additional investment spending is financed by deficits.

What you were saying with overlapping generations model and all that is completely different question. Imagine no growth and infinite number of generations – the worst case scenario you get is that one “winner” generation gets to consume twice or several times the product of some future generation (based on how many generations do overlap). And as a “loser” there is this future generation that in turn does not get to consume anything, it will only produce. And this is it. The effect of debt cannot get any worse - unless it somehow decreases the ability of future generations to produce – like distorting incentives, destroying capital etc. That is what I believe Paul and other people suggest. This effect is something completely else from what “ignorant uneducated slob on the street” probably thinks.

Compare this effect with the power of compound interest accruing from investment and accumulation of capital. Actually if you add growth of the overall wealth into equation, this intergeneration redistribution effect will be even lower – and it will become zero – or positive if Samuelson condition (growth above interest) applies.

[Martin]

- Speculative answer -

Also, we know that r has to be bounded, it can never be more than the value beyond which it is expected that inflation will accelerate. For accelerating inflation will result in an excess demand for money.

Assuming that i_t =< r_t for a stable path of nominal GDP and r_t can be chosen by the monetary authority, where i_t = r_t for risk-neutrality and i_t < r_t for risk-aversion, you'd have to pick an r_t close enough to r_t that results in accelerating inflation as that maximizes the r_t - i_t with risk-averseness. With risk-neutrality you can't do this at all I think.

Now I am assuming that the choice of r_t does not affect the ability of market participants to plan for the future and that it does not create any sorts of distortions affecting supply.

[J.V. Dubois]

Another two notes on Samuelson position. The first and obvious one is that this condition may be stable even if interest on debt exceeds the rate of growth - given that you start with smaller debt. If you for example start with 100 production, 50 debt, 2% growth and 3% interest - you still end up with surplus production of 0,5 above interest. So to restate the condition, debt is sustainable if absolute production increase is more than absolute interest payments

However the less obvious thing is, that even if we acknowledge the validity of this position it will not pass morally as per Nick's overlapping generation post. We still end up burdening our children. Why? Because the first generation that eats this free lunch will deprive some future generation from eating the same lunch. And the "free" lunch gets greater and greater over time as the economy grows.

So now we are getting really into philosophical ground. Is it really a burden for our children if we are the first generation that eats that free lunch? Even if we know that it is tabu and that last 1000 generations did not do it? What if every generation would keep this tabu and just let that free lunch grow? Can we even speak about the free lunch anymore? Are we making our children poorer by being the first generation that creates such tabu, prohibiting all the future generations to eat that lunch? Or it can get even better. Let's say that we know that every generation there exist a chance - albeit a tiny one - that this tabu will be broken. Is it still amoral for us to eat that lunch, when we know for sure that some future of the infinite generations will eat it anyhow? So from the position of total well-being of all our future children it does not matter if the free lunch gets eaten now or 1000 generations later? What if there is a chance that the game may not be stable because we do not know the long-term growth of product? Would anything change if everybody believes that there is a free lunch with all other arguments valid as per stable example?

[JKH]

Nick,

“I think that 1 and 4 are very different. 4 says the government never needs to increase taxes, and that's why it's not a burden. 1 says it doesn't matter whether the government does or does not need to increase taxes, because it's never a burden in either case.’

So, do you disagree with number one because it contends that taxes if necessary are still not a burden?

And was your point in the apple sequence in your original post to prove that taxes if necessary must be a burden?

Is this point controversial?

Is it the central point you were originally making?

[Nick Rowe]

Determinant: "Finance is sooo much easier when you operate the tax office, the central bank and the printing press."

Yep. Easier, but not trivially easy. Somebody has to pay fro stuff, eventually.

Jacques: I was following Determinant's point "4]is actually a corollary of [1], [4] relates to the interest burden and [1] relates to principal. [4] is actually of wider application because it's the justification for defined-benefit pensions"."

1 and 4 both relate to the principal plus the interest burden. 1. says the taxes to cover principal+interest don't create a burden. 4 says there never need to be taxes to pay principal+interest.

It should be PAYGO pensions, not defined benefit. The defined benefit/defined contribution distinction only matters under uncertainty. In this case what matters is the funded/unfunded distinction. 4 was indeed originally used as the rationale for an unfunded (PAYGO) US SS system.

Liquidationist: Sorry, you lost me.

Martin: "Because of this, the decision maker can never know what the opportunity cost is to the tax payer and therefore the risk can never be properly priced."

Aha!

"Would it help to assume that there is some value of (B * (1+i_t)^t)/(NGDP * (1+r_t)^t) that will make a mess of things and you want r_t and i_t to be such that that value is never reached at any time t?"

Yes/no. In the simple case, where i and g are constant, when you write down the one-period government budget constraint, then lead it forward one period, substitute in, repeat ad infinitum, you get the Long Run Government Budget Constraint:
Existing debt + PV(Government spending) = PV(Taxes) + limit as t goes to infinity of debt at time t/(1+i)^t

("PV" means "Present Value")

You then use L'Hopital's theorem to say whether that last term goes to zero or infinity in the limit. If the growth rate is less than the rate of interest, it must go to zero in the limit, and you are in the world of 2 or 3. Otherwise, you are in the world of 4.

[Liquidationist]

I was actually commenting on your earlier article on the Samuelson paper that you pointed me to.

[Nick Rowe]

JV: Thanks!

"However as for your post, I still think that Aba Lerner position is right. First thing is – how do you define “burden” and “income”? If we define burden as anything that decreases the ability of future generations to produce and income as the sum of the things they produce (and sell), then clearly position 1 is right (ignoring disincentive and distortion effects of taxation). This is the key."

That is indeed the key. I define "burden" as "lifetime consumption", or, more precisely, "lifetime utility from that consumption".

Go back to the model in my first post. You will see that output is exogenous. Every time period, and every cohort, has exactly the same exogenous output. But cohort C has lower lifetime consumption and utility as a result of the debt.

"The first and obvious one is that this condition may be stable even if interest on debt exceeds the rate of growth - given that you start with smaller debt."

That's not obvious to me. I would say it's wrong. However small the existing debt/GDP ratio, if you simply rollover the debt+interest, the debt/gdp ratio will grow without limit, and eventually be impossible to rollover any more.

"However the less obvious thing is, that even if we acknowledge the validity of this position it will not pass morally as per Nick's overlapping generation post. We still end up burdening our children. Why? Because the first generation that eats this free lunch will deprive some future generation from eating the same lunch. And the "free" lunch gets greater and greater over time as the economy grows."

Oooh! Very interesting point! I wonder how we could share that free lunch across all generations, fairly/equally?

JKH: I answer an emphatic "Yes!" to each of your four questions. We are on the same page.

[Account Deleted]

NGDP bonds or bonds pegged directly to taxation collections?

[Nick Rowe]

Prakash: Good question. I was implicitly assuming that taxes, or taxation capacity, was closely proxied by GDP. Bonds pegged to tax collection would be very much like equity, rather than debt. (I think this is also related to tax farming in the olden days??) But they would have a big moral hazard problem, I think.

[Bob Murphy]

Master Rowe, you have struck again with your apple example. Until I read that, I was firmly in Camp #1. In fact I was getting ready to write a blistering defense of Krugman against Boudreaux's scurrilous attacks, until (fortunately) I read your post and my worldview collapsed.

Incidentally, do you know why I used to think #1? Because as a young pup I read Ludwig von Mises say somewhere that it was silly when people said deficit finance allowed the cost of World War I (?) to be foisted onto future generations. Mises pointed out that the real resources used for munitions came out of present alternative uses. I thought that was a brilliant insight and cherished it.

[Nick Rowe]

Bob: Wow! A totally unexpected and very welcome convert!

This just shows how wrong I was, in my estimation of what other economists believed. I had thought that all Austrians would line up with James Buchanan, like Don Boudreax. (It's very funny, and also very good for the soul, to think of you writing to defend PK against DB!)

Is James Buchanan seen as sort of semi-Austrian? I ask out of ignorance.

I don't remember von Mises saying that. (Which says something about my memory, and nothing about what von Mises said.)

Von Mises was perfectly correct in saying that. (IIRC, Keynes said the same thing in "How to Pay for the War"?). But the next question is: what cohort of people had lower lifetime consumption as a result of those real resources being used for munitions instead of private consumption (and/or investment)? If those resources were borrowed from the current cohort, then they had lower consumption during the war, but higher consumption after the war, when they sold their bonds to the next generation. If those resources were instead taxed from the current cohort, they had lower consumption during the war and the same consumption after the war. And if Mises failed to ask that next question, he said something correct and important, but left out something equally correct and important.

[K]

Nick: Bonds paying NGDP should settle the issue. Either they would pay NGDP flat (sustainable, I guess) or they would pay NGDP plus a spread (unsustainable) or minus a spread (sustainable). Ignoring the outlook for deep liquidity traps (ZLB => NGDP *plus* spread), my mind isn't really made up how they would trade. I find it helps to ignore long term bonds, and just imagine a market made up exclusively of short term instruments: T-Bills, real T-Bills, or NGDP "bills". Then we need to think about how risk averse investors would discount the notes vs other capital assets in a world with inflation/consumption basket price risk. And perhaps we need more that one agent to get an endogenous paradox of thrift? Something like a 2-agent Consumption CAPM might be a good place to start. Still thinking about it...

[Bob Murphy]

Nick, well, right, I try to defend Krugman when I think it's appropriate, because I want to establish my street cred for when I go for his jugular.

A lot of Austrians revere Buchanan, especially (for lack of a better term) the Hayekian wing of the Austrians. In contrast, a lot of Rothbardians hate his stuff about constitutions etc. because they think he was just coming up with non sequiturs to justify a State.

[Nick Rowe]

K: we are on the same page, I think. I was imagining they would pay NGDP minus an epsilon spread, so it stays just barely inside the sustainable frontier. But I think they would need to be perpetuities to ensure there was never a rollover risk of refinancing at higher market rates. And then I did the PV calculation, and they came up infinitely valued. And then I gave up because I realised I was getting muddled somewhere.

[K]

Nick: You need to discount at the risk free rate plus risk premium for NGDP risk. That's why I suggested an asset pricing framework like the CCAPM: to compute the value of that risk premium. The bonds would have to pay a coupon rate of NGDP plus a spread equal to the risk premium. The payments would be discounted by the same rate thus making the bonds par. I think that such bonds (assuming no default risk and ignoring the ZLB) would trade with zero spread since holding them would give the investor a fixed claim on a fraction of total NGDP and I don't see why investors would either seek or be adverse to holding that risk compared to a real-return bond.

But still, I want a model. In the limit of huge debt/GDP (e.g. 100X) it ought to be possible to do something back-of-the-envelope. Basically my feeling is that in that limit the risk of swinging between inflation/deflation due to small changes in risk free rate vs expected return of capital assets ought to raise general risk and therefore market risk premium in general which would skew our choices toward consumption and away from investment, which ought to slow growth, lower rates and raise expected returns on capital assets (all from risk premium *not* improved outlook). So definitely bad for the economy, but I don't see why we would get a relative shift in NGDP growth compared to T-Bill rates so no obvious impact on debt sustainability and no obvious limit to debt/GDP.

Awhile ago we (you and I) had a debate over the meaning of "crowding out" which we didn't settle. I think this clarifies it for me. High levels of government debt *crowds out* real assets, raising risk premia, i.e. returns over risk-free rate which shifts the economy toward consumption, lowering growth rates and therewith the policy rate. This is how, in an economy with an endogenous central bank, high government debt levels lead to low government bond yields.

[JKH]

Nick,

Here is the accounting analysis I referred to earlier.

INTRODUCTION

As preamble, the “we owe it to ourselves” argument works only for assumed refinancing of outstanding debt with more debt. It doesn’t work for the case of the assumed repayment of debt with taxes. That’s pretty much what your original post demonstrates. Krugman’s point is OK if you assume there is no need to pay off debt with taxes. But I don’t think he justifies that assumption in any great way. His argument is about the nature of the liquidity issue in the assumed refinancing of debt – not the nature of the liquidity issue in the assumed repayment of debt with taxes.

The fact that “we owe it to ourselves” may be helpful in refinancing debt, all things considered, but it is not pertinent to Nick’s argument, which demonstrates the net burden effect of paying off debt with taxes. Conversely, the mere demonstration that the assumed repayment of taxes constitutes a burden on future generations does not prove there is a requirement for taxes - the calculation of the tax burden under assumed taxation is not in itself a justification for taxation. Finally, the fact that most of the debt is held domestically has little to do with any argument as to whether or not it should be paid off with taxes (see the addendum).

Summarizing what follows, the burden of paying off debt with taxes is due to the fact that in accounting terms this amounts to an equity for debt swap, because taxes in effect represent an equity infusion from the private sector into government. (The fact that no equity security is issued in the case of government is beside the point.)

So the most important question is whether or not the debt will be paid off with taxes. If the answer is yes, it is a burden along the lines of your original post. If the answer is no, it is not a burden. The tax question is the primary one; the burden flows from that. Conversely, Nick, your proof that the debt is a burden depends entirely on your assumption that it will be paid off with taxes. And to demonstrate the burden effect, it doesn’t directly matter what the argument for the tax assumption is. It only matters that there is a tax assumption.

The burden is the tax.

No tax, no burden.

I’ve attempted a presentation of your original problem, using my own form of sectoral/generational balance sheet accounting. I believe it reinforces the correctness of your presentation using reasonably pure accounting logic, for both monetary and apple economies:

..................................

ACCOUNTING PROOF OF NICK’S APPLE MODEL OF THE DEBT BURDEN

(Note: I’ve expressed everything in asset, liability, and equity type accounting entries here, but to keep things manageable, I’ve done this verbally, without attempting to present T accounts. It should be easy enough for the reader to mirror the verbal description with T account construction as you go along.)

So, split the world into two sectors – the government in question, and non-government (the rest of the world).

G and G’

You can assume for simplicity, for now, that it’s a closed economy, and there are no external complications (see the addendum for foreign ownership of bonds). Nevertheless, I’ll stick with the G’ notation for the sake of generality, prior to looking at the special case of foreign ownership of bonds in the addendum.

I’m going to use “cash”, “bonds”, and “tax” throughout, but just substitute apples for cash, apple bonds for bonds, and apple tax for tax, throughout, and it works quite well for an apple economy.

Here is the sequence in accounting terms:

a) G borrows for the first time. Its marginal balance sheet change now consists of cash and bonds (apples and apple bonds). G is long cash (asset) and short bonds (liability).

b) Conversely, the marginal G’ balance sheet change consists of bonds (an asset) and a cash liability. Off the top, this cash liability entry and its interpretation are critical. What we’re looking at here is a balance sheet effect at the margin. So when we say the marginal balance sheet change of G’ includes a cash liability, it means that the gross asset cash position of G’ is now reduced or “shorter” than what it would have been without G borrowing. So a short cash position at the margin reflects the draining of cash as an asset from the rest of the G’ balance sheet as it exists outside of this particular transaction.

c) IN ADDITION to the opening G’ long bond, short cash balance sheet change, there is a second balance sheet adjustment. This results from the initial government transfer of the cash that was raised by the bond issue. I.e. the cash transfer is a transfer of the initial G cash position to G’:

The opening marginal balance sheet change of G was long cash, short bonds. Following the transfer of cash to G’, G’s marginal position now gets adjusted to a net short bond position. (Complete, pure accounting would show equity as a left hand entry, not normally done in government accounting. Left hand equity is actually a negative equity position, which is logically correct here. But I won’t get into that to avoid the terminological complication. Let’s just say the G balance sheet has moved from long cash, short bonds to a net short bond position.)

Correspondingly, the G’ balance sheet now gets the cash from the transfer. The marginal balance sheet change from the cash transfer (alone) is long cash, equity. Here, the equity entry is conventional right hand side. It is positive equity in the conventional balance sheet accounting sense.

Therefore, the total cumulative marginal G’ balance sheet now has 4 entries – long bonds, short cash; long cash, equity. Consolidating that, the final cumulative marginal G’ balance sheet position at this stage is then long bonds, equity.

(BTW this position of long bonds, equity corresponds to the usual MMT designation of “net financial assets” at the margin, which is the general MMT accounting result associated with government deficit spending (or transfer). But nothing here by way of accounting presentation actually “depends” on MMT. It’s just accounting. That correspondence is only for the information of those interested in the connection.)

d) Now we can sequence G’ into time/generational G’ cohorts. Call them G’1, G’2, etc.

e) So the G’1 opening change, in total, is long bonds, equity.

f) At the transition point, G’1 sells its bonds to G’2.

g) The resulting G’1 balance sheet change is long cash, equity.

h) The resulting G’2 balance sheet change is long bonds, short cash. (The short cash position is interpreted exactly the same as it was at the beginning for G’1.)

i) Next, G’2 sells its bonds to G’3

j) The resulting G’2 balance sheet change is long cash, short cash.

Netting, the consolidated G’2 balance sheet position at the margin is then zero/zero.

k) The resulting G’3 balance sheet change is long bonds, short cash. (Again, the short cash position is interpreted exactly the same as it was for G’1 and G’2, at the stage where they also bought the same bonds.)

l) Finally, the government taxes G’3 to pay off the bonds.

m) The tax on its own has a marginal balance sheet presentation. The first step is to record the G’3 tax bill, prior to G’3 actually paying that bill. The marginal tax bill entry therefore is that of a G’3 net tax liability (short taxes). G’3 owes taxes, simply because the government says so.

n) Taking that tax liability entry into account, and adding to the position that already existed, the cumulative marginal balance sheet change of G’3 is now:

G’3 is long bonds with two different liabilities, each in the same quantity as the bonds - short cash, and short taxes.

o) G’3 now pays the taxes. Its long bond position is used to pay off the tax liability. (There are intra-G’3 bond for cash transactions etc. in order to get the cash to pay the tax, but those transactions are secondary).

p) So the G’3 long bond position nets out against its tax liability, and the resulting final cumulative marginal balance position of G’3 is net short cash.

q) That net short cash position alone is interpreted similarly as in the earlier cases. It can be viewed as G’3 ending up with that much less cash than it otherwise already had elsewhere on its total balance sheet.

r) Putting everything together then, the burden effect Nick identified in his example shows up here effectively, as position q) funding position g), through time and generations.

s) That is, the net benefit to the first cohort (the cohort receiving the transfer) is its marginal long cash, equity position as explained in g).

t) And the net cost to the final cohort (the cohort paying the tax) is its marginal short cash position (a liability, with negative equity at least implicit on the left hand side, if you will) as explained in q).

u) So the first cohort’s long cash position becomes the burden of the last cohort in the form of the last cohort’s short cash position.

v) Now replace cash with apples, bonds with apple bonds, and tax with apple tax, and that’s Nick’s example in balance sheet accounting terms.

w) The apple burden that is quite evident in Nick’s model therefore can be reflected in apple accounting. And the corresponding burden in a monetary economy as depicted more directly in the accounting above consists of the loss of the final generation’s cash and corresponding equity, by taxation, at the margin. But there is such a burden only because such a tax is assumed.

x) In relating apple accounting to monetary accounting, note that assets and liabilities (including tax) can all be depicted in either apple or money terms. Also, the balance sheet entry of equity (conventionally positive equity if a positive number on the right hand side; negative equity if a positive number on the left hand side) is the net result of assets and liabilities, depicted in either apple or money terms.

 
ADDENDUM REGARDING FOREIGN OWNERSHIP OF BONDS

We defined G’ at the outset as “non-government”

This general definition applies to each of the cohorts as well, G’1, G’2, and G’3. Initially, we assumed a closed economy for simplicity, so G’ was actually describing the domestic private sector. Now we extend this to the full original meaning of “non-government”, which allows for a foreign sector as well. So let’s take the case where the foreign sector buys the government bonds.

The key point here involves step n) from above:

“Taking that tax liability entry into account, and adding to the position that already existed, the cumulative marginal balance sheet position of G’3 is now:

G’3 is long bonds with two different liabilities, each in the same quantity as the bonds - short cash, and short taxes.”

So let’s assume now that G’3 does include both the domestic sector and the foreign sector and that it is the foreign sector component that has bought the bonds. And let’s suppose for simplicity that they’ve bought all of the bonds.

The first thing to recognize is that when the foreign sector buys the bonds, it creates a marginal accounting entry for itself of long bonds, short cash. This is exactly the same marginal entry as was the case when we assumed it was the domestic sector that bought the bonds.

The second thing is that this idea of marginal balance sheet effect is something that is relative to a “ceteris paribus” balance sheet otherwise. So in this case, we must think about what the balance sheet of the foreign sector itself looked like before it bought these bonds. And the pertinent thing to look at there is the nature of the pre-existing gross and net international investment position of the domestic sector interfacing with the foreign sector.

For example, suppose the domestic sector had run up a cumulative current account deficit exactly equal to the quantity of bonds purchased by the foreign sector. The foreign sector would have a corresponding cumulative current account surplus against the domestic sector. This means that the foreign sector would have been long cash to begin with (or equivalently, could have swapped its pre-existing net foreign asset position into cash). That means it uses its pre-existing cash to buy the bonds. We described the marginal balance sheet effect of the bond purchase as long bonds, short cash. Combining this with a pre-existing foreign long cash, equity position, the result of the bond purchase is a foreign balance sheet of long bonds, equity. And note that the accounting equity here corresponds to the fact that a foreign sector cumulative current account surplus is in fact a component of its collective national accounts cumulative saving, and saving is essentially equivalent to accounting equity.

As a second example, suppose the domestic sector had run a cumulative balanced current account with the foreign sector. The marginal balance sheet effect of the foreign sector bond purchase again is long bonds, short cash. There is no pre-existing foreign net asset position with the domestic sector, cash or otherwise. However, there is still a gross balance sheet position. And it is still the case that the marginal result of the bond purchase is a marginal foreign balance sheet change of long bonds, short cash. For example, the foreign sector may buy domestic bonds by simultaneously incurring some sort of liability against the domestic sector. This corresponds to a gross capital account outflow from the foreign sector (bond purchase) matched by a gross capital account inflow to the foreign sector (e.g. foreign borrowing from a domestic bank).

So all of that gets pretty complicated; i.e. the effect on the foreign sector balance sheet of the foreign sector buying domestic government bonds can get complicated.

But here’s the important point. Whatever that effect is, it arises from a pre-existing balance sheet condition that is characterized most generally in the starting point for the net and gross international investment position of either side against the other.

And that starting point has NOTHING to do directly with the fact that the domestic government has issued bonds. It has EVERYTHING to do with such matters as cumulative current account deficits and/or gross international capital flows.

And whatever that starting international position is, the fact remains that regardless of that starting position, the marginal balance sheet effect of the foreign sector buying government bonds is a marginal balance sheet entry of long bonds, short cash – the very same entry that was the case for the closed economy domestic sector purchase described earlier.

Now, returning to the main issue, remember that we are assuming G’3, the final cohort, now includes those foreigners that have bought all of the bonds. And their marginal balance sheet position as described above is long bonds, short cash.

So we come to the tax burden.

Let’s assume that the government levies the tax to pay off the bonds entirely on the domestic sector, and that the foreign bond holders escape free of any direct effect of the tax that is levied to pay off the bonds.

Remember point n) above, which describes the marginal balance sheet position of the full cohort G’3:

G’3 is long bonds with two different liabilities, each in the same quantity as the bonds - short cash, and short taxes.”

This still applies. But there is now a decomposition of this position into domestic and foreign components.

The foreign component is long bonds, short cash as described above.

The domestic component is now short taxes alone.

So what happens is that the government taxes the domestic sector to pay off the bonds. It then uses those tax proceeds to pay the foreign owners of the bonds. And the foreign owners of the bonds use that to pay off their short cash position. All of this is happening at the margin, ceteris paribus. And ALL of this is quite feasible through the mechanism of gross and/or net international capital flows. It’s the financial market.

So the net result of all of that for the final cohort is as follows:

The foreign sector part of the cohort ends up flat. Its cumulative marginal balance sheet position is zero, zero.

The domestic sector ends up short taxes.

When the domestic sector goes to pay down its tax liability, it basically swaps the tax liability for a cash liability (e.g. by borrowing the cash to pay the tax or by running down its cash position otherwise).

And the end net result for the domestic sector is EXACTLY the same as it was for the closed economy.

Now substitute apples for cash, and everything will still work.

The key point in all of this is that the starting balance sheet position is the basis for the final net apple or net cash effect on everybody. For example, it could be the case that the foreign sector started out with a net apple asset against the domestic sector, as the result of a current account apple surplus with the domestic sector. So it buys the bonds with pre-existing, domestically produced apples that it received through current account. And it gets paid back with apples that the domestic government got when it taxed the domestic sector at the other end. But that pre-existing balance sheet position, including the current account accumulation of apples by the foreign sector, has NOTHING to do directly with a government bond issue. Similarly, a pre-existing foreign sector gross international apple position, even without any net current account impact whatsoever, may also be the original source of foreign sector payment of apples for bonds. But that starting position as well has nothing to do directly with the issuance of bonds by the domestic government. And so on. So this entire issue of domestic versus foreign needs to be separated out, when considering the specific issue of burden in the form of a tax burden at the end of the whole process. And I think that’s where Krugman may be wrong, and Nick is right.

[Nick Rowe]

JKH: "And the end net result for the domestic sector is EXACTLY the same as it was for the closed economy."

BINGO! Yes!

[Nick Rowe]

JKH: "So the most important question is whether or not the debt will be paid off with taxes. If the answer is yes, it is a burden along the lines of your original post. If the answer is no, it is not a burden. The tax question is the primary one; the burden flows from that."

Yes! And in #4, since there is no need for future tax increases, there is no burden.

Minor quibble 1: a default on the debt would be equivalent to a tax on the bondholders, and would create a burden.

Minor quibble 2: and if future taxes are increased, not to pay off the debt, but just to pay the interest on the debt, then there is a burden, but it's spread out over all future generations.

[James Oswald]

I was wondering if you saw my updated post here. I think it might help you to think of the real instead of the nominal side for awhile. When are real productive resources used up?

If it really is possible to consume more now at the expense of people later, why not do it as much as we can? If I convinced everyone that the singularity would happen in 30 years, would it be possible to double everyone's real consumption today by issuing a ton of 30 year bonds? People in 30 years will be infinitely wealthy so they won't mind. If it's not possible, why not?

[Ralph Musgrave]

I find JKH’s laberinthine accounting unnecessary. It stikes me as obvious that Nick is right in saying (as per his original apple analogy) that IF youngsters in each generation transfer real wealth or spending power to oldies, then a real burden is passed down the generations (assuming a closed economy).

It is also true that this phenomenon actually happens with pension schemes, funded or un-funded. In both cases, youngsters effectively support oldies.

Next point is that absent government bonds, people would simply find alternative ways to fund their pensions: perhaps using other assets or perhaps making more use of un-funded schemes.

Thus the $64k question is whether people are induced to INCREASE their pension provision when government runs up extra debt, and I don’t see there being much of an effect here.

My conclusion: when government of country X incurs debt, or extra debt, there is little or no increased burden on future generations. Though if a significant portion of the extra debt is bought by foreigners (and assuming there is no singnificant increase in foreign debt bought by residents of country X) then to that extent, there will be a burden on future generations.

[JKH]

Nick,

“Minor quibble 1: a default on the debt would be equivalent to a tax on the bondholders, and would create a burden.”

Agreed, viewed as an isolated effect.

What I said was that debt repayment with tax is equivalent to default without tax.

Same difference.

“Minor quibble 2: and if future taxes are increased, not to pay off the debt, but just to pay the interest on the debt, then there is a burden, but it's spread out over all future generations.”

Agreed.

[JKH]

Nick P.S.

The Model

You have a (performing) bond asset.
You incur a tax liability.
You pay the tax with the bond (effectively, i.e. after swapping it for cash).
Net zero.

Default Interpretation 1 (JKH)

You have a defaulted bond asset.
That is equivalent to no asset.
You have no tax liability.
Net zero.

Default Interpretation 2 (Nick)

You have a defaulted bond asset.
That is equivalent to a performing bond that is taxed away in kind.
Both are equivalent to no asset.
Net zero.

[Adam]

I guess I read Krugman as implying #4, but avoiding stating it in politically unpalatable terms.

[Reverend Moon]

I can create a model in which debt is never ever a burden. It's a distributional, intertemporal blessing. The only change I have to make to your model is to assume that the younger cohort is unable to consume or chooses to save a portion of their apples, works with money too. I don't even need to assume growth. And it's not a ponzi scheme. If I want to save apples for the future but can't store them what is the interest rate (hint it's not 10%)? Works forever or until someone decides they want to let apples spoil.

Or am I missing something?
In all your examples the same number of apples are consumed every year. It's the number of apples produced. Plus for consistency sake shouldn't the final cohort tax the next cohort as was the case previously in which case cohort C refuses to buy the bonds so they are taxed to pay B and they in turn tax cohort D and so on.

Otherwise all you've shown is that if you buy a bond that defaults you lose money. Happens with or without government bonds taxes or whatever.

A rolling loan gathers no loss. (therefore not a burden)
That which cannot go on forever won't. (10% interest rates in a no growth economy)

Took me a while to understand the point you're trying to make, probably still don't, other than you can create a model world in which debt must be paid by the people who bought the bonds. Sucks to be them. Sounds like they're the greater fool generation.

I probably just don't understand.
Happy new year Nick good luck in 2012 WCI

[Nick Rowe]

Reverend Moon: Your model is a version of #4. The real interest rate in your model (if people want to save apples for the future, but can't) would be negative, and so less than the growth rate of the economy, even if the economy was stationary.

In my model cohort D could pay the tax, instead of cohort C. No real difference, except D rather than C bears the burden.

Adam: "I guess I read Krugman as implying #4, but avoiding stating it in politically unpalatable terms."

Maybe, but then why does he keep talking about the disincentive effects of future taxes being a burden on future generations?

Ralph: JKH's accounting served (for me) as a check on my intuition that it really made no difference to my argument whether we assumed an open or closed economy.

"Next point is that absent government bonds, people would simply find alternative ways to fund their pensions: perhaps using other assets or perhaps making more use of un-funded schemes."

OK. Assume that apples can be stored, and that A was originally planning to store apples for its retirement. Then the government gives A the bonds, so A eats 100 more apples immediately because they can save they bonds instead. And B also saves the bonds rather than storing apples. But this makes no difference to the rest of my story. C still has to pay taxes to retire the bonds, so C has lower lifetime consumption.

[Nick Rowe]

K @1.33. My brain isn't really up to following you, I'm afraid. But your comment has fired some (possibly random) thoughts in my brain, that may or may not lead somewhere.

[Paul Rogers]

Nick wrote: "something that would make both Scott Sumner and the MMT guys very happy indeed. Which would be neat. Plus, as a side-benefit to making both those guys happy, it might be very good for the poor ignorant uneducated slob on the street too."

Funny, that. :)

[Reverend Moon]

No not so much. I'm saying that in your model there is no growth therefore all any one is talking about is how their output is distributed. Of course it's possible to distribute the apples unfairly. In your model there would exist an optimum distribution of apples that maximizes overall apple consumption over their life time and that is how they would be distributed most likely since everyone is the same. It makes no sense to contemplate a world where one generation thinks they can fleece another in a world where nothing changes. Rolling over principal and interest until they have everything without anybody figuring out what's going on requires irrational agents. The opposite of what's assumed in economics. You created a simple world everyone eats only apples, makes only apples and it's the same number of apples every period but they're too stupid to figure out the simple world they live in. The concept of compound interest doesn't exist in the world you've created. The only thing that does make sense in your model is communism.

[James Oswald]

@Bob Murphy: Noooo! Don't forsake Mises, he was right.

[wh10]

Thanks to Nick, JKH et al for all this.

I need to read JKH's whole accounting post, but based on a skim, I think I entirely agree with JKH and thus Nick here- *if* the tax occurs, *then it is a burden.* Of course.

But isn't the more interesting issue *when* taxes are needed to pay back the debt? This is the problem I had with Nick's original post. At first, it seemed like Nick was saying always and eventually. But then there was the full employment clarification.

But is full employment a sufficiently defined condition? If the economy reaches full employment and the govt continues to spend, the debt can still be funded without a tax (****and doesn't that trigger JKH's 'no tax, no burden' condition??****), but the result is inflation. And you can only call inflation like a tax at the *individual level* *depending on your assumptions* of how the net financial assets from the deficit spending are distributed throughout the economy (and assuming it's not so inflationary we're in hyperinflation land and the economy ceases to exist). From an accounting perspective of the macroeconomy, the impact of a deficit here remains wholly different from a tax, since the former remains a net add of NFA and the latter a subtraction.

JKH, I'd be really interested to hear your opinion here. The whole reason I posted all that finance stuff from Fullwiler in the other thread was to show that the debt can always be funded, without a tax, and not at market determined prices but where the Fed sets interest rates. And that's because the Fed makes credit infinitely available at the price (interest rate) it has full power in determining. I think Nick thinks interest rates on govt debt are ultimately market determined, and that if inflation goes up or is expected to go up, the interest rate on govt debt necessarily has to go up. I think the latter will only occur if the Fed raises interest rates. But in any case, a tax isn't theoretically necessarily, and inflation remains the only issue. And so when is that a burden?

To reassert, there are a lot of assumptions that have to be made here, so one should be careful about which side they pick here regarding whether or not govt debt is a burden- it depends.

[JKH]

wh10

I'll reflect a bit on your comment, but this may be of some help for starters:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/01/matt-yglesias-and-spilt-milk.html?cid=6a00d83451688169e20162ff0558cc970d#comment-6a00d83451688169e20162ff0558cc970d

[wh10]

Thanks JKH. If I could add, it seemed your initial response to my concerns in Nick's original post invoked the MMT view that the govt could always pay off the debt with an overdraft from the Fed (assuming IOR at target) in order to quell others' concerns of debt repayment/solvency. But I think we can still show 'monetization' is never necessary (even if MMTers say it's a false dichotomy from debt issuance) and that the market will always take on the debt at Fed determined prices. I think there are two components to this: the availability of credit at Fed determined prices and the finance stuff I posted from Fullwiler. It also seems to be an extension of the same conversation we we're having regarding Fullwiler's strong to weak forms = bond issuance is also possible at whatever interest rate the Fed wants.

[JKH]

The issue here is not the normative one of whether or not a fiat currency issuing government should ever run or need every run a surplus.

The issue is the positive one of whether or not an actual event in which taxes are used to pay down debt (i.e. a budget surplus) constitutes a burden for the generation that pays the taxes.

Nick’s model (and my accounting for it) shows it does, unless the generation that pays the taxes inherited the bonds from the previous one.

[JKH]

wh10,

"it seemed your initial response to my concerns in Nick's original post invoked the MMT view that the govt could always pay off the debt with an overdraft from the Fed (assuming IOR at target) in order to quell others' concerns of debt repayment/solvency."

sure, but that's not the issue here, see previous

"I think we can still show 'monetization' is never necessary"

to a point, perhaps to a very high probability point, but never say never - the ultimate insurance is the threat of being able to print and it's there if its ever actually needed in dire circumstances - agreed though that to the degree its a credible threat, it almost certainly won't have to be used

If my responses seem contradictory in total, can you link to my comment that you reference - I really do think it's a separate issue though

[wh10]

To reiterate and for people to mull over since we've presumably moved passed the 'if tax, then burden' proof and are now on to 'if debt can always be issued and at what price':

"First, there are these things called primary dealers, who can borrow at the repo rate and fix their costs for any maturity in forwards and buy any Tsy issue that goes above the borrowing costs. And the repo rate--created out of thin air with just a previously issued security as collateral--always arbitrages with the overnight target rate.

Second, there are these things called hedge funds--like 100s of Warren Moslers--who can (and in the case of Mosler, have and will continue to) borrow at LIBOR and fix this rate at any maturity in swaps or forwards. And LIBOR arbitrages at the overnight target rate, while eurodollars are created out of thin air like any bank loan.

Third, if the public doesn't want to hold bonds, there are these things called banks that offer these things called time deposits, and the public can hold these and earn interest at virtually any maturity. And then the bank can hold a Tsy and earn a spread, or it can hold interest earning reserve balances and earn a spread.

These don't work nearly as well for countries for which there is any significant risk of default (Greece), but that's another story and perfectly consistent with MMT.."

In fact, now that I recall our conversation that spanned heteconomist, winterspeak etc, it seems we're in a similar situation here. In the Eurozone, where mkts perceive default risk given the restrictions on the ECB, we agreed it all comes down to the issue of the interest rate on the debt, and that it could be resolved by the ECB if those restrictions were removed. Even though I am proposing different circumstances here (deficit spending at full employment leading to inflation, but no restrictions on the CB), isn't it effectively the same? The mkts might not perceive default risk, but the interest rate is still a lever of the Fed's, despite inflation and Nick's claims that interest rates on the debt would have to rise... no? And would purchasing in the secondary mkt even be theoretically necessary?

[wh10]

'The issue is the positive one of whether or not an actual event in which taxes are used to pay down debt (i.e. a budget surplus) constitutes a burden for the generation that pays the taxes.

Nick’s model (and my accounting for it) shows it does, unless the generation that pays the taxes inherited the bonds from the previous one."

Agreed. I am asking about a different issue, the normative issue.

"If my responses seem contradictory in total, can you link to my comment that you reference - I really do think it's a separate issue though"

Sorry- we might not be connecting. Agreed - it is a different issue (see above :)). I am not asserting contradiction, just wanting to explore the other normative issue. Specifically the issue of deficit spending at full employment, with inflation, and if debt can continue to be sold and in accordance with FFRs, which the Fed sets where it wants.

Agreed on 'never say never.' My thinking is more theoretical (semi-strong, strong), but we can allow the possibility of the CB stepping in, as in our discussions at heteconomist, winterspeak, etc.

[JKH]

wh10,

that's all interesting stuff, but once again it's not the issue relating to Nick's model

I agree that a fiat currency issuing government can force any deficit it wants into the monetary system - one way or another - including central bank shenanigans to buy bonds through what are essentially understood forward contracts with dealers and many other permutations

The issue being discussed here (once again) is IF the government taxes to pay down debt (or the cumulative deficit), is there a net generational burden? Nick's model shows there is.

[JKH]

OK. We agree it's a separate issue. Good.

The issue you're interested in is quite massive in its potential operational complexity. I need to take a break for a bit.

[wh10]

Right (once again) I just wanted to move beyond the positive issue (which I am in agreement with- always thought it was obvious) to the normative.

And it's relevant here, because if we are going to evaluate the truthiness of Nick's 1-4 above, then we have to understand the normative. Nick also continues to write generalized statements that imply normative issues like "If the government runs a deficit now, there is a cost to future taxpayers" (http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/01/matt-yglesias-and-spilt-milk.html?cid=6a00d83451688169e20162ff0558cc970d#comment-6a00d83451688169e20162ff0558cc970d).

[wh10]

Sorry - looks like we were posting before we saw each other's most recent comments.

[JKH]

"And it's relevant here, because if we are going to evaluate the truthiness of Nick's 1-4 above, then we have to understand the normative. Nick also continues to write generalized statements that imply normative issues like "If the government runs a deficit now, there is a cost to future taxpayers"

Now that I haven't been tracking, but its a fair check.

I've only taken Nick's model at face value and demonstrated by accounting I think that its totally correct at face value - i.e. as a positive type proposition. And I asked a few questions of Nick at the outset to confirm what I think was his concern that not everybody agreed with it as a positive type proposition. And BTW I'm having the same type of discussion with Ramanan on the international side.

That said, I think Nick is pretty comfortable with the BASIC model in which i less than g means sustainable deficit financing.

Now I'm breaking.

[rsj]

How would the generation inheriting the tax burden *not* receive the bonds? In a discreet two-generation set up, that isn't even possible, is it? As long as the bonds are outstanding, someone must have them. Assuming that they are not burned (i.e. repudiated), they will be inherited by the next generation, unless the previous generation decides to pay them off, in which case the tax burden goes away, too.

All of this is really just a fence-post error -- an assumption that the older generation does not pay taxes, and that only the younger generation pays taxes. This isn't a good assumption to make given continuous overlapping generations. In a binary model, you need the population of old = population of young, so old would be about 37 until death, and young would be 0-37 (37 is the median age). Do you really want to go and argue that everyone stops paying taxes after the age of 37? If anything, you would model this as the young paying no taxes, and the old paying both taxes and receiving benefits, hence the "fence-post" error.

If you make the assumption that everyone pays taxes until they die, then you get Krugman's conclusion that it all boils down to distribution.

Whoever is receiving more in income that arises both directly and indirectly from the government spending than they are paying in taxes is benefitting and has the opportunity to consume more, and whomever receives less is not and has their consumption curtailed. In aggregate, the indirect benefits of stabilization are a net positive, so there is a net positive aggregate gain from most forms of government deficit spending. That aggregate gain may not result in a specific gain to each individual. The wealthy certainly gain in that they are receiving concentrated levels of interest income, far more than they pay in taxes. The young and the poor gain in that they receive benefits and are either receiving an education and not working or their wages are lower. The middle class -- it depends on whether the result of stabilization policy support enough gains in output versus the tax burden. But it all boils down to distribution and multipliers, not a binary "old" versus "young".

[JKH]

As a model, those who pay the final tax to fund the bond maturity can’t be the same ones as those who received the original expenditure benefit. A long time period is required to achieve full separation between those two populations – decades obviously.

Relative to that full separation scenario, the population of those who in fact both received the original benefit and paid the final tax starts to increase (from a starting point of zero) and increases as a subset of the total population who paid the final tax, as the time period between the original benefit and the final tax is made shorter and approaches zero.

It’s a starting point model.

[rsj]

"As a model, those who pay the final tax to fund the bond maturity can’t be the same ones as those who received the original expenditure benefit. "

Agreed. Which is why you should not use "generational accounting" to discuss government tax burdens.

The numbers don't work out that way.

So you move to something else -- rich versus poor, disabled versus abled, etc.

And you make the clear case whether the transfer is justified on economic and welfare grounds or whether it is not.

You do not talk about "passing debts to your children" or else you will mislead, because if you try to separate by age, you find that the extremely old and the extremely young receive far more in benefits than they pay in taxes, and everyone else receives a bit less -- depending on your starting assumptions about the impact of government deficit spending on total income. So you can't model this as the young paying for the old, since that's not what we see. If you must boil it down to only two generations, then it must be that only the older generation pays taxes and the younger generation only receives benefits (e.g. education, infrastructure).

But here, I am making a quantitive argument, that Nick's qualitative argument is so far from reality as to not be a good starting point for discussion of government debt burdens. It is anti-pedagogical in that it gives you the wrong intuition, and the math is also unhelpful, as uni-directional inter-temporal transfers are not a good way to get a handle on what is going on.

[JKH]

“It is anti-pedagogical in that it gives you the wrong intuition”

I understand your point(s).

Try this as an alternative way of looking at it, in addition to what you've outlined:

Suppose you take a more abstract view of what a “generation” is. Consider that the situation in the model requires a budget surplus – i.e. debt can only be paid down with the taxes that constitute a marginal budget surplus. Then consider that governments tend to run surpluses only periodically, and that surplus periods are sometimes separated by quite extended deficit periods (really generalizing here).

Then, for a given surplus period, define the “generation” that corresponds to it as the population of taxpayers that fund that budget surplus.

Then it’s the case that you can identity such populations of taxpayers over time who do incur taxes at the margin and incur a burden relative to those the population that benefited from the deficits that preceded that surplus period.

Those populations may be overlapping, but their difference is still defined on the basis of time separation.

[rsj]

My argument is not that having too little or too high of a debt burden causes no changes in consumption, but that the changes hit all generations that happen to be alive at that time roughly equally.

The Ricardian approach assumes aggregate income is constant, and moreover that the debt and repayment obligations are real, rather than nominal. I.e. when the parents tighten their belts, the kids go on a shopping spree. But that is not what we see, even to first order. When the parents tighten their belts, so do the kids, and when the parents receive more disposable income, then so do the kids.

Now, if you start talking about smaller cohorts -- not two cohorts, but, say, 20, cohorts, then you can easily see aggregate transfers occurring from one cohort to another without an overall reduction in aggregate income. But with just two cohorts, if 50% of the population reduces their consumption, then this will cause a general recession and everyone's income will decline. However, as soon as you add many cohorts, then unless you are talking about very targeted tax burdens only borne by a specific group, you are not going to see a correlation between generation #19 transferring real resources to everyone else and a change in the overall government tax burden when generation #19 is alive.

So this approach is fundamentally the wrong approach. The government debt burden should always be viewed as a purely nominal quantity, that while it may affect many things when it is at the "wrong" level, is going to hit both the young and the old in the same direction via changes in aggregate output, not relative changes in a generation's share. In that sense, you are right, if we have too little debt now, we can be dooming future generations to less consumption if they are mired in a prolonged slump, and if we have too much debt now, then there may be a period of future austerity that dooms everyone to too little consumption as well. But the mechanisms behind that are not going to be ones of generational accounting as outlined here.

[David Khoo]

The crux of the issue is the definition of "generation". Rowe defines it as a cohort of individuals born at a certain time (of the same age), while Krugman defines it as a cohort of individuals alive at a certain time (of different ages). It is obvious that debt can redistribute real resources from the cohort of individuals born in 1990 to those born in 1950, but it is impossible for debt owed between the individuals alive in 1950 to (in and of itself) affect the total real resources available to those alive later in 1990.

[JKH]

“It is obvious that debt can redistribute real resources from the cohort of individuals born in 1990 to those born in 1950, but it is impossible for debt owed between the individuals alive in 1950 to (in and of itself) affect the total real resources available to those alive later in 1990.”

The model is true in a generalized way and more.

If the government levies a broadly based surtax 40 years from now to pay down a deficit that was incurred today, the average date of birth of those who pay the tax will be later in time than the average date of birth of those who receive the benefit of today’s transfer.

Both monetary and incremental real resources are transferred to those who receive the benefit of the deficit today (e.g. transfer). And both monetary and decremental real resources are transferred away from those who pay the tax 40 years from now. That assumes that the transfer today causes an equal increase in aggregate demand and GDP, and the tax 40 years from now causes a equal decrease in aggregate demand and GDP, compared to the counterfactuals of no transfer and no tax respectively – i.e. it assumes transfer and tax multipliers of one. Different multiplier assumptions can adjust from there.

If you substitute “population with an average date of birth” for generation, the model is true in a more general sense than Nick’s discrete generational specification. It is a future cohort that incurs the burden that is the cost of the benefit to today’s cohort, even though the cohorts thus defined may be intersecting.

Furthermore, if the difference between the two average dates of birth is a sufficiently long period of time such that the two cohorts are non-intersecting, the model is true outright as per Nick’s specs.

The relationship between today’s deficit and the future surplus is perfectly unambiguous if budgets are balanced in all other years. Otherwise, there is potential ambiguity in exactly “which” year’s deficit and debt is being paid down by that future surplus - unless specified by assumption of association, which Nick’s version does in effect.

[JKH]

Can somebody with Herculean computer skills turn off these damn italics?

Perhaps with a comment directed to that purpose?

[rsj]

trying to turn off italics.

"That assumes that the transfer today causes an equal increase in aggregate demand and GDP, and the tax 40 years from now causes a equal decrease in aggregate demand and GDP"

OK, that is a heterodox position. if you read Barro's paper, the argument is that changes in debt can neither increase nor decrease total output. "Aggregate demand" has no meaning in a model in which production = income and all transactions occur as barter (e.g. Barro's model).

Going further with this heterodox argument -- which is not a standard intergenerational transfer argument -- leads to the conclusion that increases in aggregate demand and output today due to expansionary fiscal policy may result in future decreases in aggregate demand due to contractionary fiscal policy or other side effects of carrying a large debt burden (e.g. inflation, since we are rejecting the standard view, we might as well think about a fiscal theory of the price level).

I think it's a reasonable argument to make, but not all the argument that was made in this post. And the key difference is that the expansion today affects *all* people living today -- e.g. all generations still alive. And the contraction in 50 years affects *all* generations alive in 50 years.

So this is not really an argument about inter-generational transfers, even though some generations alive today will not be alive in 50 years. This is a different, heterodox argument, about the effects of nominal income flows on real output, and has nothing to do with IOUs for apples.

[JKH]

"and has nothing to do with IOUs for apples"

Not sure about that, but I think I understand all the rest.

Pls note I qualified "generational" by modifying it to include any population separated by time and actuarial change - with the pure case being sufficient time separation to admit the conventionally defined distinction between generations.

E.g. the qualified definition would in theory define the "next generation" mathematically as the current population minus one death or plus one birth, etc. As time passes, the overlap between current and next generations diminishes.

[JKH]

"As time passes, the overlap between current and next generations diminishes."

closer to intended meaning:

"As the time that separates two different, specified "generations" (modified definition) expands, the overlap between the two diminishes"

[Michael Carroll]

I went back and read the first post.

My big question is where the 10 extra apples cohort A ate came from?

The government didn't give it to Cohort A it only gave IOUs plus the original 100 apples back.

Which means it has to come from Cohort B.

I'd argue that if Cohort B knows there is never growth in the economy, they would discount the price of the IOU to 100. They would NOT pay 110 apples. They don't give a damn about the loss of present value of one part of Cohort A to another part of Cohort A. That is Cohort A's problem and there is no debt burden on Cohort B or any other future cohort. There are always 1000 apples for each generation and a 100-Apple piece of paper that circulates like fiat money.

Your example only works if the interest rate is fixed and arbitrary or if there is no knowledge of prevailing growth rates to price interest rates.

[Nick Rowe]

rsj: "How would the generation inheriting the tax burden *not* receive the bonds? In a discreet two-generation set up, that isn't even possible, is it? As long as the bonds are outstanding, someone must have them. Assuming that they are not burned (i.e. repudiated), they will be inherited by the next generation, unless the previous generation decides to pay them off, in which case the tax burden goes away, too."

When you say "receive" and "inherit" the bonds, that can mean either of two things: they inherit them as a free gift from the previous generation (#3 Ricardian Equivalence); or they buy the bonds from the previous generation (#2Buchanan). It makes a very big difference.

[Michael Carroll]

Pretty sure, Nick Rowe's example is wrong.

The assumptions that:

1) growth = 0

and

2) interest rates are > 0

Are mutually exclusive.

(words 'real', 'average' & 'long term' omitted for clarity).

[K]

Michael: "The assumptions that: 1) growth = 0 and 2) interest rates are > 0 Are mutually exclusive."

I'm pretty assure that Nick is assuming that growth is whatever it is and that rates are something higher. But whatever, makes no difference. I am, however, very interested in how you would derive your claim, or the more general claim that asymptotically rates must be less than or equal to nominal growth.

[Michael Carroll]

K,

My claim is only about the example given. But in that example, the issue is that if there is no prospect of REAL growth why would any claim to be able to pay REAL interest in the long run even be credible? If its not credible (and it isn't) the market would set the real interest rate to a level that is credible.

The only artifact then is present value, but...

Although I live in a world where I can risk my present value ("lend"):

A) as a favor,
B) to exploit through obligation, or
C) to gain additional return.

In Nick's Example, when Cohort A lends money to the government possibilities B and C do not exist. B is treason and as far as C, in the aggregate there is never a possibility of change in the rate of return. Since you can't reasonably profit from lending the government money, how could lending to the gov't have any meaning besides doing it a favor? You could never be compensated for your loss of present value (except through a sense of citizenship).

[Nick Rowe]

Michael: the rate of interest in a simple OLG model like mine will depend on two things: individuals' rate of time preference; what proportion of their endowment individuals receive when young and when old.

If they have very high rates of time preference, and if most of their endowment comes when they are old, the equilibrium interest rate will be very high, because everyone will want to borrow to consume more when young. I can make the equilibrium rate of interest as high as I want by playing with those two assumptions.

[Michael Carroll]

Nick,

OK I can see that, but it seems that only assumes that the debt sale only factors in what sellers want to get paid and not what prospect they actually have of getting paid.

Again I think the example breaks down in a conversation like this:

Cohort A: I have this IOU I'll sell you for 110 apples

Cohort B: Ok, I'll give you 100 apples for it.

How and why would any rational member of Cohort B move up from that price? At that point regardless of Cohort A's time preference is the interest rate is now zero.

[Nick Rowe]

Michael: We should instead ask this question: what rate of interest will the government need to promise to pay on its bonds in order to persuade A to buy them? The easiest way to think about is in terms of one period (or rather, one generation) bonds, that the government has to rollover every generation. So the government first figures out the rate of interest it needs to promise cohort A to buy the bonds. Then it figures out the rate of interest it needs to promise cohort B to buy bonds so it can redeem the bonds it sold to A. And so on.

Then you could use the same rate(s) of interest to figure out what the government would need to promise on 3 (or more) generation bonds.

[Michael Carroll]

"The easiest way to think about is in terms of one period (or rather, one generation) bonds"

Yeah, that helps.

[wh10]

Nick, this is why you can't think in terms of real goods of production like apples and loanable funds and instead need to recognize the power of credit in a fiat economy with a central bank creating reserves out of thin air. If the Fed and by extension banks create credit out of thin air at some price the Fed determines (and you admitted this in your post about growing debt, and I thought we saw eye to eye on this at the time), it is that *that price* which will determine the interest rate to be paid on govt debt given competition.

Seriously, why am I wrong about that??? Again, please don't ignore this:

: "First, there are these things called primary dealers, who can borrow at the repo rate and fix their costs for any maturity in forwards and buy any Tsy issue that goes above the borrowing costs. And the repo rate--created out of thin air with just a previously issued security as collateral--always arbitrages with the overnight target rate.

Second, there are these things called hedge funds--like 100s of Warren Moslers--who can (and in the case of Mosler, have and will continue to) borrow at LIBOR and fix this rate at any maturity in swaps or forwards. And LIBOR arbitrages at the overnight target rate, while eurodollars are created out of thin air like any bank loan."

[wh10]

BTW, this is me coming back after the New Year, when I was away from the computer, to explain why this is important and you can't just go "back to apples" to understand interest rates on govt debt and when taxes are necessary. Like I acknowledged above, I agree that *if* there is a tax, that is a burden. But I am addressing a different issue here since you've ventured into the interest rate argument.

[Michael Carroll]

Ok,

I took a minute to scan the comments to see if anyone raised the issue of inheritance here or in the other post but didn't see any.

You know, Gov't taxes C to pay B, B dies apples go back to C.

I am feeling like if this all depends on generational overlap AND limited inheritance AND unproductive debt then #1 is just short hand for #4 (Samuelson). But I am not an economist so what do I know...

[Nick Rowe]

wh10:

Do you remember my very old post:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/reverse-engineering-the-mmt-model.html

Suppose that third diagram in that post (where desired saving and investment are independent of the rate of interest so the IS curve is vertical) were true. Then there is no natural real rate of interest. The central bank can set whatever real rate of interest it likes, even in the long run.

I think that's where you are coming from.

(Almost) everyone else in this debate has in mind a model where desired saving and/or investment depends on the rate of interest, and the IS curve slopes down (like in the first and second diagrams) and there is a well-defined real natural rate of interest, and the central bank cannot permanently set an interest rate either above or below that natural rate without destroying the economy by creating hyper-deflation or hyperinflation.

That's where the rest of us are coming from.

I don't want to get into that debate here (because I've got too much on my plate as it is), but that might help clarify the issue for you.

[Nick Rowe]

Michael: when I talked about "Ricardian Equivalence" that *is* talking about inheritance. Ricardian Equivalence says that we will increase our bequests to our kids to offset any increased debt burden on our kids. My simple model explicitly assumed Ricardian Equivalence was false.

[wh10]

Nick, I think you are right that's where the debate is, and we don't have to do that now, but by retreating to ISLM you are continuing to ignore the above quotes / how the Fed and credit market actually work. When you talk about desired saving and/or investment, you are envisioning having to convince someone to give up their apples. In the real world with credit markets, no one has to give anything up. Instead, the credit market creates an opportunity for a costless profit - essentially arbitrage that anyone would take advantage of.

[wh10]

Or alternatively, you're thinking about it as if the borrower has to borrow out of the money of another person, but again, we settled that misconception on your 'growing debt over time' post.

[Nick Rowe]

wh10: "When you talk about desired saving and/or investment, you are envisioning having to convince someone to give up their apples. In the real world with credit markets, no one has to give anything up."

When aggregate demand is at the right level (when we are scared that any additional increase in AD would trigger accelerating inflation) you *do* have to convince someone to give up eating their apples, if you want to eat them instead. The government/central bank cannot allow the total demand for apples to increase any further.

[wh10]

Nick, for the purposes of understanding what is operationally possible, you need to, for the moment, separate the ability to sell govt debt from what happens to the prices of goods and services. After, we will integrate and make sure things jive.

The Fed, directly or indirectly, supplies all the credit that is needed at a certain price to get the debt to sell, at a price which is necessarily tied to the price of credit the Fed controls, assuming the ability for actors to fix costs in forward mkts. For this reason, the Fed does not have to vary the interest rate to get the debt to sell, at any level. At this stage, the Govt *does not have to* convince any one to give up their apples or savings to get the debt to sell at a certain interest rate. Instead, the interest rate on the debt arbitrages with the price of credit that the Fed controls. (Repetitive, but I want to be clear.)

If too much deficit spending occurs, and there is too much demand, then prices on apples will rise. But if the govt engages in bad policy from a price stability standpoint and wants to continue selling more debt, in order to deficit spend again, it is back to square 1. No one needs to be convinced to buy the next batch of debt- the price is still ultimately determined by the Fed.

Now policy could be so bad that we eventually find the economy hyperinflating, but there is a middle ground between inflation and destruction of the currency.

The point is, the level of inflation is always the issue, but it doesn't impact the interest rate which is needed to sell the debt. And even if you would think the Fed would be wise to change interest rates, that is not going to impact whether or not the debt gets sold at whatever price the Fed wants. The same amount of net financial assets will still be injected into the economy through that deficit spending and transmit to prices. Changing interest rates might change the amount of NFA being added to the economy through interest payments on debt or change appetites to borrow credit etc, but it doesn't matter for the purposes of selling the debt.

[wh10]

We may or may not be partially agreeing. It's like you keep moving the goal posts, refusing to think about the process by which govt debt is sold, and skipping to what will happen to the price of goods and apples. And once you see that the price of apples starts to rise, you declare game over. But I am not saying the price of apples won't rise - that's not the game I am playing. I am talking about govt debt and the interest rate at which it can be sold. Instead of thinking about apples, think about what is involved when the govt sells debt, and you necessarily need to understand the system to properly do this; you can't think about it like me having to borrow from you.

[Nick Rowe]

wh10: some background:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/08/taylor-wicksell-fisher.html

[wh10]

Whether or not I believe it, nothing there suggests, to me, that the interest rate on debt is not operationally at the control of the Fed, and the point still stands that the debt can always be sold at whatever interest rate up until the currency is destroyed. I say that happens if the govt deficit spends way too much. If you subscribe to the idea that changing the interest rate to the right level will solve part of the inflation problem, then the Fed still has full ability to do that. But none of this means debt can't be sold at the Fed's price in fiat free floating system. It just means inflation is a problem.

One day I am going to study econ more formally (grad degree?), understand this stuff better, and be more convincing to myself and others on how this stuff works.

[Nick Rowe]

wh10: "It just means inflation is a problem."

Imagine that you believed that if inflation were a problem, and you didn't raise interest rates to control it, inflation would become an ever-worsening problem, like a slippery slope that would get worse and worse and eventually destroy the monetary system.

That's what I and most economists believe.

It's a bit like saying "It just means our falling off a cliff is a problem".

When you get to grad school you will know more (I mean really know more than the others). Because you will have tried to think through this stuff, not just copied out the math models. The two are (or should be, if the world was as it should be) complementary. And you will rack your brains trying to fit it all together. Good luck!

[vimothy]

wh10,

The issue is that even if it controls a nominal short term rate, the Fed doesn't control the real rate of interest that consumers are will to lend at. That's determined by things like their intertemporal preferences, etc.

BTW, a couple of years ago, I read too many econ blogs and weird hetero papers (;-D), had the same idea as you, swapped from English Lit, and enrolled in "grad school" (as you guys call it) to study econ. Now my life is basically one long neverending bloody optimization problem. (Is the function defined on a compact set? What about its Hessian matrix of second order partials? Is the value function also continuous? Nnnnnnn). So my advice is to be careful what you wish for!

[Nick Rowe]

You are brave, vimothy, going from EngLit into that deep end. Unfortunately, vimothy's experience may be all too representative. Oh God, why can't we find some sort of happy medium? I used to know what a Hessian matrix is, but I've forgotten now.

[wh10]

Nick, I am not saying it isn't a problem. I agree that would be a logical conclusion if I believed in the natural rate. I could also not believe in the natural rate and instead believe self-fulfilling inflation or hyperinflation could occur if the govt is adding too much NFA to the economy and causing prices to rise due to AD, independent of interest rates. But in either case, it still doesn't show why bonds will not be sold as per the Fed's policy... until the economy ceases to exist. The govt may throw the economy into hyperinflation, but they do it at their own interest rate on the debt! In any case, MMT/Lerner wouldn't advocate stimulus past full employment and would adjust taxes or the interest rate to address the situation, although they might view the interest rate as more important via the interest income NFA channel. Seems in this regard we're not far apart..

"The issue is that even if it controls a nominal short term rate, the Fed doesn't control the real rate of interest that consumers are will to lend at. That's determined by things like their intertemporal preferences, etc."

Vimothy, consumers don't have to lend their apples or savings as in the loanable funds model. Again, credit is made out of thin air and defended at a certain price by the Fed. This I think is our disconnect.

Per your decision- are you still enjoying it? Is all that math stuff useful in understanding or exploring these kinds of problems? Nick, your thoughts?