Tuesday, December 12, 2006

Five Macroeconomic Myths

Intersting piece in the Wall Street Journal yesterday by Nobel Prize winning economist Ed Prescott. It's excerpted here. Prescott tackles 5 popular macroeconomic myths, one of which is the notion that our debt creates a burden on our grandchildren. First, the myths:

  • Monetary policy causes booms and busts;
  • GDP growth was extraordinary in the 1990s;
  • Americans don't save;
  • The U.S. government debt is big; and,
  • Government debt is a burden on our grandchildren.

The last two points are the most interesting to me, so I will excerpt the explanations:

Myth No. 4: The U.S. government debt is big. The key measure here is privately held interest-bearing federal government debt, which includes debt held by foreign central banks, and does not include debt held by the Fed or government debt held by the government. So let's turn to the historical data once again.

Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. This debt level was not alarming then, and it is not alarming now. From a historical perspective, the current U.S. government debt is not large.

Myth No. 5: Government debt is a burden on our grandchildren. There's no better way to get people worked up about something than to call on their sympathies for their beloved grandkids. The last thing that I want to do is to burden my own grandchildren with the sins of profligacy. But we should stop feeling guilty -- at least about government debt -- because we are in better shape than conventional wisdom suggests.

Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. This assumes 1% population growth, 2% productivity growth, 4% real after-tax return on investments, and that people work to age 63 and live to age 85. Currently, privately held public debt is about 0.3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt.

What's going on here? There are not enough productive assets -- tangible and intangible assets alike -- to meet the investment needs of our forthcoming retirees. The problem is that the rate of return on investment -- creating more productive assets -- decreases as the stock of these assets increases. An excessive stock of these productive assets leads to inefficiencies.

Total savings by everyone is equal to the sum of productive assets and government debt, and if there is an imbalance in this equation it does not mean we have too little or too many productive assets. The fix comes from getting the proper amount of government debt. When people did not enjoy long retirements and population growth was rapid, the optimal amount of government debt was zero. However, the world has changed, and we in fact require some government debt if we care about our grandchildren and their grandchildren.

If we should worry about our grandchildren, we shouldn't about the amount of debt we are leaving them. We may even have to increase that debt a bit to ensure that we are adequately prepared for our own retirements.

I think that there are political arguments for budget balancing, and there are prudential arguments - primarily that government budgets ought to operate like family budgets. But there are many economists who agree with Prescott's central point: that the debt (at least at current levels) does not constitute a burden on future generations.

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