Monday, April 27, 2015

Self-censoring on superannuation

When applying for a job recently I was asked to write a 500 word opinion piece about using superannuation funds for home deposits. I didn’t get the job so there is no reason to waste 500 good words; I’ve published the piece at the bottom of this post.

But that’s not what this post is really about.

I am writing this post to reveal that I severely self-censored in that opinion piece. Those are not my genuine views about superannuation. Like many before me I twisted my words to fit within the Overton Window of acceptable public discourse. Maybe it was the wrong thing to do. But I did.

I want to say what I really think, even if some find it too far outside the range of acceptable conversation.

My view is this: Australia’s superannuation system will not survive another 30 years in its current form, or anything like it.

The reason for that view is that there was never an economic logic for a compulsory superannuation system in the first place.

The modern superannuation system was introduced in 1992 to relieve pressure on the age pension system by forcing all workers to save for retirement reduce wages and has since been reinterpreted as a retirement funding system. But forced saving does nothing to address the fundamental problem of a shrinking workforce - all the income streams drawn down from superannuation upon retirement rely on purchases of assets from those currently working. The net effect is exactly the same as if the working population simply gave retirees money through the tax system. Any problems with the age pension system due to demographic change also affect the superannuation system.

Furthermore, the problem of a shrinking workforce has been dramatically overblown. While the age-dependency ratio will increase when baby-boomers retire, this effect will be balanced out by relatively fewer births and a declining youth-dependency ratio. On balance, the share of the population out of the workforce under the worst-case population growth scenarios (yes, higher population growth makes the dependency ratio worse), will peak around 70% - exactly the same as the 1960s and 1970s.

To be clear about how the same demographic patterns affect the superannuation system just as they do a public pension system we must think in terms of goods and services produced in aggregate, and assets and their prices in aggregate.

In aggregate, the total goods and services produced depends on the size of the workforce and installed capital. Whether boomers retire in pensions or superannuation incomes, the rate of growth of this total production will be lower as the growth rate of the workforce decreases.

This lower rate of growth of goods and services must still be shared amongst all workers and retirees. Who gets what out of the economic pie depends on who has which rights - which claims on incomes streams in any form, either assets, public pensions, or wages. Under a public pension system workers give up some of their rights to wages by paying taxes which would go directly to the pensions of the retired. Under a private superannuation system, workers give up some of the rights to wages to buy assets, which would be sold by retirees who had previously accumulated them, in order to provide a retirement income. The net effect of both of these schemes, shown below, is identical.

Whereas with public pensions it is clear that more retirees in the population requires larger contributions by workers to support them, the superannuation system disguises this element. It does this through incremental changes to the minimum contribution requirement - from 4% of wages in 1992 to soon 12%, along with increases in the preservation age, from 55 as of this year, to 60 in 2024. This means that new contributors to the super system pay more and get less - exactly as would occur under a public pension system when increasing pension funds come from direct transfers from the workforce.

What’s more, the net effect of superannuation as a mere transfer between workers and retirees will become all too obvious when the ever-growing rate of new money pouring into the asset classes held in superannuation accounts begins to fall as the rate of superannuation drawdowns grows faster than the rate of new contributions. In the chart below the benefit payments in green will increase faster than the contributions (the red, blue and purple) as boomers begin to retire en masse.

When this occurs, the asset classes that dominate the super system, like Australian shares, will see fewer buyers and more sellers, depressing currently inflated prices and reducing the investment income of superannuation account holders. With lower account balances more funding will be needed from public pensions anyway. To be clear about this asset price effect, does anyone think the share market, or even the property market, would be at its current value without the massive inflow of funds from the compulsory super system?

Depressed incomes from super accounts will again see the need to increase contributions, or increase public pension funding, or otherwise rejig the rules to inflate asset prices at the expense of wages.

At the moment the music is still playing. But in the next 20 years there will be a generation who puts more than 12% of their wages into the super system for half their working life only to find the system requires a complete rethink. They will lose out due to their demographic destiny with the superannuation system, just as they would with a public pension system only. But the super system allows us to pretend that this is not happening by disguising transfers as investment.

This is the big issue with Australia’s superannuation system, and one that is till now outside the range of acceptable discourse. In any case, here’s my self-censored opinion piece.


Hockey’s housing ideas are anything but super

If you think home ownership is out of reach for the average family in Australia today, you ain’t seen nothing yet.

If Federal Treasurer Joe Hockey has his way, superannuation funds could be used by first-time buyers as a home deposit.

Taken at face value, Hockey’s idea reveals a deep misunderstanding about not only the role of superannuation in the welfare system but of the housing market itself.

Worse still, allowing access to super accounts will increase prices above even their current astronomical levels.

Compulsory superannuation was introduced in 1992 to anticipate and counteract the age pension tidal wave as baby boomers entered retirement.

Yet one big issue we are seeing as this demographic tidal wave approaches, is that many retirees have low superannuation savings, but very high home values, yet they are unable to tap into their home value to generate a retirement income.

The great majority of retirees prefer the stability of their own home within their local community, and are unwilling or unable to use their home as a source of income during retirement.

Directing more retirement savings into home ownership will only amplify this problem, rather than amplify retirement incomes as superannuation was designed to do.

While reforms could improve the ability for retirees to utilise their home values to generate retirement incomes, one thing that cannot change is the economics of the housing market.

Hockey’s proposal would produce a massive boost in buyer activity and turn superannuation funds into subsidised quasi-home deposit accounts, with associate tax savings advantaging the highest income earners.

Like many home buyer initiatives, such as the First Home Buyers Grant (FHBG), increasing buyer purchasing power has a clear and definite effect of increasing home prices, negating its supposed benefit and passing it directly to the home seller.

To see how this works, imagine you are at a home auction, and after great excitement and fanfare, the bidding has stopped at $500,000. The final two potential buyers are now on edge as they decide whether to tip their hats one more time.

In one scenario the second buyer stays quiet and the home is sold at that price.

But in another, the government steps in and allows the last two bidders to use their super accounts to help buy the home, or alternatively give them a FHBG. What do they do?

The extra funds allow the auction to continue as the losing bidder sees value in outbidding the previous winning price, and the previous winner is able to also outbid that new price.

This only stops when the extra buying power from the new regulations is completely absorbed into the price. If it was a $7,000 FHBG, the sale price would be $507,000.

It is clear then that Hockey’s proposal is at odds with the intention of using superannuation to provide retirement incomes, and by making the housing market more expensive, will completely contradict its intentions of facilitating home ownership and saving.

Saturday, April 4, 2015

Macroeconomics = Fallacy of Composition

I am teaching an introductory macroeconomics course for graduates this semester at the University of Queensland. Coming up is soon is the AD-AS model and I must say, I’m having a hard time generating useful tutorial questions for my students.

The illogical contrivances required to interpret any real economic events in terms of the model are almost laughable. I've asked a number of experienced macro teachers in the school to explain the model to me in an internally consistent way. It turns out that most economic professors don’t have a clear grasp of what aspects of the macroeconomy the model is meant to be capturing. None could explain what the concept of the price level in the aggregate even is, nor what mechanism was meant to be at play in generating the relationship between price level and output. If anything I learnt that I should use the curves to support some kind of Keynesian story-telling exercise.

What kind of serious intellectual could be happy with this situation? Is this the way we pass on our discipline’s knowledge to the next generation?

So far my tutorials are looking quite different from your typical introduction to the AD-AS model. More like an introduction to defending oneself against the claptrap sprouted by many economists.

Perhaps we may soon leave this nonsense out of economic teaching altogether. Here's my compromise for the time being.

Question 1

What is the fallacy of composition?

Create a list of phrases, sentences or paragraphs from the description of the AD-AS model in Chapter 10 of the textbook that commit the fallacy of composition.

Additional reading material is here, here, here, and here.


A common definition for the Fallacy of Composition is
the fallacy of inferring that a property of parts or members of a whole is also a property of the whole
In terms of the study of macroeconomics this is of particular interest, since we are trying to take lessons from the behaviours of individuals and determine the likely aggregate response in the economy as a whole.

Here are some examples from Chapter 10, though many others may be included.

1. The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households (p268). 

The AD curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded (p268)

The fallacy at play here is that there is an aggregate price level. As we saw in Chapter 8 on Inflation, price levels are not absolute but relative to some base year. In the economy as a whole there is no external price from which to determine a price level. Hence the idea of an economy-wide price level is in a given time period is a fallacy. 

Often the AD-AS model is interpreted as showing Real GDP related to the rate of inflation in a period (not the level, but the rate of change of price levels relative to a base year). This overcomes the fallacy of composition because it compares the price level with last year’s price level, but contradicts earlier discussions about anticipated vs unanticipated inflation. If inflation is anticipated at any reasonable level then there should be no economic effect, and hence no relationship (no curve, or a vertical line at best).

2. As income rises consumption will rise, and as income falls, consumption will fall (p269)

In aggregate the total consumption (or demand) in the economy is equal to the total incomes in the economy be definition, since someone’s consumption is somebody else’s income. This sentence, allowing from proper aggregation that avoids the fallacy of composition, merely says that aggregate incomes and consumption just rise and fall together since they are equal at any point in time by definition. 

3. When prices rise, households and firms need more funds to finance buying and selling. Therefore when the price level rises, household and firms try to increase the amount of funds they hold by withdrawing from banks, borrowing from banks or selling financial assets, such as bonds. These actions tend to drive up the interest rate charged on bank loans and the interest rate on bonds. (p269)

First, if all prices rise then households and firms also have more income, since wages and profits are also prices in the economy. 

Second, as we discussed in Chapter 4, Measuring GDP, transfers of financial assets are not included in gross value added because they are mere transfers between on individual and another. Hence, a household selling financial assets requires another household to buy those financial assets leading to no net change in the aggregate ability of households to spend on current consumption. 

Third, if these actions have no aggregate affect by their own definitions it seems implausible that there will be aggregate affects on interest-rates (another price) set in the economy.

The end of the paragraph goes on to admit that it just committed the fallacy of composition when it says

The impact of the price level on investment is known as the interest-rate effect, and is a second reason why the AD curve is downward sloping. However there is caveat to this explanation. Lenders to banks and other financial institutions - people with savings are lenders - will have their wealth increased as the interest rate rises, and will increase their consumption spending. 

Essentially this contradicts all that went before it. In addition, the wealth effect on savers is incorrect in general (higher interest rates decrease the value of financial assets, not increase it).

4. Table 10.1, government purchases and tax effect on AD curve (p272).

The second and third rows in Table 10.1 show; 1) the effect of an increase in government purchases on, 2) the effect of an increase in government taxation. If the economy is at equilibrium prior to and after either of these changes then by definition one effect must counteract the other - the shift of the AD curve from an increase in government purchases must be accompanied by an equal and opposite shift from an increase in taxation. 

5. Because changes in the price level do not affect the number of workers, the capital stock or technology, in the long run changes in the price level do not affect the level of real GDP (p275).

This contradicts all that went before it, and relies on an undefined notion of the short and long run. How can there simultaneously be both an effect and no effect?

6. The main reason firms are willing to supply more goods and services as the price level rises is that, as prices of final goods and services rise, prices of inputs - such as wages of workers to the price of natural resources - rise more slowly. Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs (p276).

Here we see the fallacy of composition result in many confusing comments. First, the inputs of one firm are the outputs of another firm, hence in aggregate input and output prices cannot differ systematically.

Friday, March 27, 2015

Uncertainty and morality in a dynamic economics

Ignorance of the distinction between risk and uncertainty lies at the heart of many economic conundrums, particularly dynamic behaviours through time. Yet the critical importance of this distinction in predicting economic behaviour was clear to prominent economists of the 1930s, including Shackle and Knight. Knight wrote that
... that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
Economists have now forgotten that a world of uncertainty generates a strong incentive to delay choices. We do not make immediate choices informed by some probabilistic expectation of future outcomes. We usually can’t even know the potential scope of future outcomes. That means we delay choices to keep options alive, miss good opportunities, and sometimes commit to poor investments. Because time is irreversible, unlike in economic models. When we commit to decisions matters as well as the decisions themselves.

But the ignorance of uncertainty is evident in other social sciences as well. Approaching problems in philosophy and ethics without acknowledging uncertainty has lead to many seemingly intractable puzzles that are easily resolved in a world of uncertainty.

I hope that observing the crucial role uncertainty plays in these contexts encourages economists to take the concept more seriously and see the economy as a dynamic environment, rather than a static one.

In ethics, the Trolley Problem has occupied the minds of philosophers for decades. In its simplest form, the puzzle is as follows.

In Scenario A a trolley is barreling down the tracks towards five people who will be killed unless the trolley is stopped. Luckily, there is a fork in the tracks, and by simply pulling a lever, the trolley can be diverted onto a second set of tracks. Unfortunately, there is a single person in the path of the tolled on this track who will be killed if you pull the lever.

The dilemma is whether you should pull the lever and save five people by sacrificing one? In surveys, most people say they would.

In Scenario B you find yourself on a bridge next to a fat man with the same dilemma of a trolley hurtling down the tracks towards five people. The question here is whether it is permissible to push the person next to you onto the tracks if you knew it would stop the trolley and save the five people.

Most people in this scenario would not push the man off the bridge, even though the same welfare gains in terms of lives saved would be the same as Scenario A (so you know, 68.2% of philosophers would push the man to save the five). Some philosophers and psychologists put this down to a ‘dual-process’ theory and for some reason that two different setups invoke "the operations of at least two distinct psychological/neural systems".

Fundamentally the incompatibility of these two outcomes arises because we are presented with a dilemma in terms of risk, or knowable probabilities. In fact, we have point distributions at perfect certainty for each outcome. You push the fat man off the bridge (assuming away the logical problem that a man fat enough to stop a runaway trolley is somehow easily able to be pushed off a bridge) you have a probability of 1 that the man will die and the trolley will be stopped. If you don’t, you have 100% certainty that the five people on the tracks will be killed.

When you add risk by looking at possible probability distributions of choice outcomes you can generate a balance of risks that predicts survey responses. This is a step in the right direction. But it still overlooks the dynamic nature of true uncertainty.

Let us now look at the question in terms of uncertainty. For a start, how do we know the trolley is out of control? Is it possible to delay the decision to get more information?

A very simple resolution arises when we add a time dimension to the problem, which is what is required under uncertainty. We can think in terms of an option-tree expanding over time, with choices unable to be fully anticipated in advance.

We can see in the diagram below that in Scenario A, switching the tracks leads to a new situation that opens up the set of possible choices in the grey shaded area while eliminating others. Switching the trolley onto the side track buys time and keeps options open without killing anyone.

In Scenario B, most people choose not to push the fat man. Here, what they are doing is buying time before anyone gets killed. Even after the decision is made not to push the man, there will be time available for many other as-yet-unknowable situations to arise.

People are making choices in a way that allows them to navigate through a choice space over the irreversible dimension of time. I’ve highlighted in red a possible path for each scenario that could be envisaged by someone making choices in a world of uncertainty.  In both cases, there is an unknowable chance that a resolution to the dilemma will involve no death if the dynamic choices that arise are navigated appropriately. But choosing to push the fat man in Scenario B eliminates the option of resolving the situation without any deaths.

The whole rationale of making decisions in a world of uncertainty revolves around keeping options for desirable outcomes open, and often this involves buying time by not making a decision at all.

We know that buying time to keep an option open is a strong impulse. In experiments where participants are given the choice of which of two identical drowning swimmers to save, knowing they can only save one, many are unable to make the decision in a timely enough manner and instead spend their time searching for better information in the hope of maintaining the option of saving both. But in doing so, they let them both drown. Because the choice to commit to saving one swimmer is associated with a commitment to allow the other to drown, the logical choice is to delay to maintain the option of saving both.

In military training, overcoming this instinct to delay choices to keep options open forms an integral part of the psychological training. Soldiers are known to delay making any choice in high-stakes combat dilemmas (what amounts to ‘freezing') or in many cases they shoot to deter rather than to kill, to keep open the option of finishing a battle with fewer deaths in general.

In criminal behaviour, Becker’s expected utility framework has been called into question due to the radical difference between human behaviour in a world of uncertainty versus a world of risk. Increasing the chance of being caught and increasing punishment if caught are substitute methods for changing probability distributions of expected outcomes in a world of risk. But in a world of uncertainty, they have quite different effects on criminal decisions.

The same logic of uncertainty can be applied in social psychology to understand the bystander effect. The bystander effect is the label given to the occasionally observed inverse relationship between the number of people witnessing a victim in need, and the number of people offering help. Various reasons for this empirical phenomena have emerged, with the idea of a diffusion of responsibility dominating explanations.

But when we dig a little deeper we can see the logic of uncertainty at play. Repeated experiments on the bystander effect show that the degree of ambiguity is a crucial determinant of the willingness to assist, with reaction times being much slower in the presence of more ambiguous situations. The logic of how ambiguity, or uncertainty, results in the bystander effect is as follows:
…most emergencies are, or at least begin as, ambiguous events. As the bystanders are deciding whether an event is an emergency, each bystander looks to the others for guidance before acting. 
… Seeing others remain passive causes the bystander to interpret the ambiguous situation as non-serious.
So it is not that people do not want to help. But as each person individually chooses to delay their actions to gain new information, they also observe others doing the same thing. By observing others they gain the new information that the situation is non-serious, and hence as a group they ultimately choose a path through the choice space over time that resolves to a belief that the situation is a non-emergency.

What happens as people delay choices here is a cascade of new information that changes the decisions of each individual and the group as a whole. In sociology, there are many simulation models of these type of choice cascades, from standing ovations to riots, and other herding behaviour including musical tastes, and crucially for economists, asset market speculation.

Uncertainty is primarily a concept about choices in a dynamic environment. Here I have shown that human behaviour is adapted to our dynamic irreversible environment, and as such, uncertainty is required to understand behavioural logic, morality, and sociability. Moral puzzles resolve easily in an environment of uncertainty, and many psychological phenomena, from soldiers freezing in battle, to the bystander effect, to our taste in music, can be seen to arise from a result of human tendencies to delay decisions in order to cope with uncertainty.

It is not just economists who have acknowledged that uncertainty is tremendously important, but then later ignored the concept in their analysis. Given the high stakes arising from political choices based on economic analysis, putting uncertainty front and centre in a new dynamic economics is critical.

Wednesday, March 25, 2015

Economics: Blah blah blah

Economic comedian Yoram Bauman translates Mankiw's 10 Principles of Economics in this video. The three macro concepts were immediately translated to blah, blah, blah.

Here I want to improve of his efforts and translate some of the many concepts that seem to mystify all who encounter them. Some readers might not agree. Others might have better suggestions. Let me know in the comments. 

Economic Term
Actual Meaning
Accounting unit
Medium of exchange
Medium of exchange
Accounting unit
Accounting unit
Credits and debits (‘promise unit’)
Production function 
Just kidding, economists don't care about time 
Magic attractive force
Current state of the world
Unexplained residual
New recipe
Free Markets
Very specific set of government institutions 
Stylised fact
Deadweight loss
Difference between a real pudding, and the magic pudding
Structural reform
Non-specific legal change to give rich people more power in the name of efficiency
Why aren’t we in equilibrium?
Low wages
Bigger numbers devoid of meaning
Degenerative scientific research programme
Why don’t people agree with me?
Laden with hidden value judgments
State of the world
Opportunity cost
What you could be doing instead
Some other prices
Rent seeking
Buying political favours
Market failure
Real life
Outside the club. Go home.
Pipe dream
Mystical element allowing decisions to be made
Monetary incentives
Short run
Arbitrary time period that makes the model work
Long run
The end of time itself
Perfectly known distribution of possible outcomes
Comparative advantage
Started producing it first
Comparative advantage
Was on/under the land when we conquered
How rich your parents are
Representative agent
One person
Uniform distribution of agents
One person
Property rights
Unspecified institutional setting
Covertly transferring money to people you know
Someone else covertly transferring money to someone they know
Vitally important, but I can’t explain it
AggregationFallacy of composition

Tuesday, March 3, 2015

Coaches’ Calls: Should debt be on the scoreboard?

Guest post by Michael Harris, first published at Medium.
TL;DR version, because it’s long!
  1. There is no reason to think we are nationally living beyond our means at the moment.
  2. There is no “debt and deficit disaster.”
  3. Debt does not mean we (the current generation) are ripping off “our children and grandchildren” (future generations).
  4. It’s the real things that finally matter.
Also: why government budgets are not like household budgets (fallacy of composition; infinity; and printing presses).
1. The scoreboard

On a recent episode of the ABC’s panel show Q&A, radio announcer and former rugby coach Alan Jones declared that “there is a golden rule in sport. You look at the scoreboard. The Labor Party haven’t produced a surplus since 1989,” which certainly sounds like a damning indictment.

But why would that be the thing on the scoreboard? Imagine a football coach looking at the results and details of a match his or her team had convincingly won on the weekend. “OK, so we dominated in terms of share of possession. If we look at ground gained each time we gained possession, we dominated. And, of course, we ended up with twice as many points as the opposition. But look at how many times we dropped the ball! We dropped it twice as many times as the opposition did! This is terrible! You’re all losers!”

This would obviously, and rightly, be seen as the weirdest way possible to judge who won and who lost in that sporting contest. Obviously, the team with the most points wins, regardless of how messy the victory was. A good coach would focus on improving aspects of play that need improvement, but they wouldn’t confuse what’s on the scoreboard with other aspects of performance that contribute to — but aren’t the same thing as — the final score. The team may have dominated the game but still played with fumble-fingers, which would make ball-handling something to work on in training. But it’s not the criterion by which the outcome of the game is finally judged.

Neither is the budget, whether a deficit or surplus is achieved. Unlike a football game, there is no one single final score on which to adjudicate performance, but for a macroeconomy, the trifecta of economic growth, unemployment, and inflation are key indicators that should be up on any “economic performance” scoreboard. The average trend rate of unemployment during the Rudd and Gillard years was 5.1% (a period including the Global Financial Crisis); the average during the period since the Abbott government took office is just above 6%. Inflation is low, with the most recent annualised rate of CPI growth being under 2%, the bottom of the Reserve Bank’s target rate. Too-low inflation, like high unemployment, is symptomatic of a weak economy, a fact reflected in the most recent RBA decision to lower interest rates to a record low. Any sensible score -boarding of the macroeconomy would show that things have definitely not been improving since the 2013 election.

No reasonable analyst would contend that this is entirely the fault of the Abbott government. International conditions are challenging, with Chinese growth slowing, and Europe remaining subdued. The Reserve Bank sets interest rates without government influence, meaning options to manage the economy are few. Any government in power now would find circumstances difficult.

But this is exactly the problem; to manage an economy in difficult conditions requires an accurate understanding of the issues you face, and a willingness to seek — and an ability to listen to — expert advice from professionals on the government payroll whose job it is to provide such advice.

The first — and in current conditions, the worst — mistake to make is to confuse what should be prominently displayed on the scoreboard. As mentioned above, changes in GDP, unemployment and inflation are key magnitudes to monitor. Underpinning those are trends in employment and productivity growth, and international conditions as reflected in our terms of trade. What doesn’t belong in bright lights as a headline indicator is the budget “bottom line”. As a number, the budget outcome is best regarded as an outcome of events in the economy; as a process, the budget is a tool to assist with managing economic performance given all the circumstances it faces. The bottom-line number in any year cannot be finely controlled, and it’s foolish to claim that it can be.

Yet in Australia we repeatedly hear about budget emergencies and debt and deficit disasters. We’re told that we’re living beyond our means, and engaging in intergenerational theft by loading our children up with our debt. So why has political discourse turned so heavily towards treating the annual budget figure as a, if not the, key indicator of economic management? Why has “austerity economics” — with its inevitable focus on short-run budgetary outcomes over everything else — dominated the discussion when budget outcomes are not nearly the most important issues in people’s actual lives?

2. Bad reasons

A worst-case conspiratorial view would have it that “austerity economics” is really code for reducing public expenditure in order to shrink the size — and role — of the state. In this “starve the beast” view, the state is ever-growing as a share of the economy, and this growth must be arrested. Cuts in both tax rates and government expenditure are the intention, but this rather extreme philosophy puts the tax cuts first, in the belief that cutting taxes will reduce revenue and (hence) lead to spending cuts based on the realisation that there is simply less money available for government to spend. Since this contravenes the argument of supply side economics that cutting taxes will increase revenue, it is sometimes posited that starve-the-beast is the post-facto argument to use when it turns out that taxes cut based on supply side arguments have not in fact resulted in the expected revenue increases.

Slightly less conspiratorially, there have been seemingly respectable arguments for austerity economics coming from the economics profession, such as the claim by two leading economists that their evidence showed economic growth was hampered by a country’s high external debt levels, with particular problems emerging when debt levels reached 90% of GDP. Obviously, the principle that correlation does not equal causation applies given that causality could run either way (an economy slowing for other reasons would expect to see its debt-to-GDP ratio rise), and the authors carefully talked of correlations. However, this did not stop their work influencing conservative politicians in both the US and the UK in favour of austerity policies.

(This was not the only academic work used to support austerity economics. “Expansionary austerity” arguments, involving claims that fiscal consolidation improves business and consumer confidence sufficiently to bolster growth, have been proposed by serious academics. But this argument, too, has come under fire.)

Whether legitimate or dodgy, the academic work seems to serve more as a rationalisation than a pure justification for austerity economics narratives. Once you decide to engage in austerity policies, reference to scholarly work that seems to support your approach is convenient to refer to, but not essential to motivating your choice or action in the first place. What makes austerity so compelling in the first place, so that it can be sold to the media and the public as representing plausible and serious policy?

A focus on budget outcomes obviously engages with our intuition about managing our own budget and living within our means. It seems so intuitively simple that it’s obvious; a balanced budget means we are living exactly within our means, and an unbalanced budget means that we are not. In particular, a deficit budget is putting us into debt (successive deficit budgets driving us deeper into debt each year), while a surplus budget is required if there’s existing debt to be paid down (requiring lower spending/higher taxes in future). And if there’s a debt that’s being maintained, clearly it is something that our descendants will be left with to pay back, so we must be impoverishing them, right? Right?

It seems so obvious as to be self-evident. How are we to be convinced that, in fact, this intuition is almost entirely incorrect?

There are at least three reasons that a government budget is not like a household or business budget; so much unlike a household budget that it’s seriously misleading to compare them. They are, in turn, (i) the fallacy of composition problem aka “owing the debt to ourselves”, (ii) the effects of infinity, and (iii) the printing press. Working through these will not only make clear how much a government budget is not like a household budget, but that being in debt does not automatically represent “intergenerational theft” — far from it. But running deficits and accruing debt does have immediate distributional consequences that are worth paying attention to.

3. Government budgets are not like household budgets. Seriously. (Part 1. Fallacy of composition)

Let’s look at the first argument, sometimes referred to as “owing the debt to ourselves”. It’s a basic fallacy-of-composition argument; incorrectly asserting that what’s true of a part is therefore true of the whole. We think of a family/household budget as something run within a household, based on money coming in and going out of that household, just as though it was a single person’s budget, balancing incomings and outgoings. Instead, let’s look at a household budget as if all the debt occurred within the household, with multiple members borrowing from each other.

Think of it this way. There’s a head of the household who manages the “household budget” on a day to day basis. All members of the household earn their own individual incomes, and the head of the household collects a small amount from each of them to help fund collective household expenditures. Other than that, each individual family member manages their own personal budget personally. From time to time, the head of household borrows extra money for urgent household items or investments from other members of the household, writing IOUs that the lending household member can keep in their desk drawers for later repayment. The household head ensures agreed interest payments are made, and is responsible for eventual repayment of the debt. If a surplus fund is not available when any of the debt falls due, the household head simply borrows from another member to repay the one whose repayment is due.

Is the household as a whole impoverished as a result of what are in fact a series of internal transfers? Are future members of the household collectively on the hook for borrowing decisions being made today? The household head may need to increase the amount collected from household members, simply to repay what is owed to some of them, but this is obviously a redistribution of household resources rather than a net loss of household income. Intergenerationally, it is hard to see how all the future children of household members are being impoverished by all the current members.

Two things are worth considering in terms of impacts over time and whether “intergenerational theft” is occurring; first, who is owed repayment (compared to who will be contributing to the household fund in order to build up the surplus needed to make the repayments), and second, what the borrowed funds are used for and whether they have enriching impacts on the household over time. If borrowed funds are used to purchase furniture for common areas in the house, or upgrade the house physically or technologically, those actions will yield benefits to future occupants of the house, in which case it’s hard to see them as having been collectively “stolen from” as the result of the earlier reliance on IOUs.

(It is not for us to wonder why IOUs were used instead of the head of household simply “taxing” the household members more at the time. A deeper analysis could focus on this choice. For now, all we need to look at is the impact on one generation from the choice of a previous generation. It’s clear that the generational impact depends on spending choices made earlier — improving the house in long-lasting ways versus holding more parties, in effect. The pattern of cost-sharing can change based on the use of IOUs versus pure taxation, and that may affect consumption and savings choices of individual household members that flow on to their individual offspring. But the total impact across generations of using debt does not in any way imply future impoverishment.)

Convinced yet? We could look at this a different way, by going back to the Q&A episode we began with. Imagine the 5 guests + host are the entire population of a (tiny) country, with Tony Jones as the head of the country, responsible for its overall finances. Then imagine that Alan Jones and Heather Ridout represent the “rich” members of this society, while Chris Bowen, Jamie Briggs and Corinne Grant are the “less rich” members. Tony Jones runs a balanced budget, until one day he decides to do the following: (1) maintain expenditure as it stands, (2) reduce taxes on the rich folk (Alan and Heather) by cutting the top marginal rate, and (3) issue bonds (IOUs) to cover the difference — the deficit — which Alan and Heather buy up with their extra cash.

The most obvious thing about this is that there is an immediate distributional impact, as opposed to an intergenerational one: Alan and Heather have their tax liability reduced, and end up holding some financial assets they otherwise would not have had. A different tax change — say, an increase in the tax-free threshold — would have different distributional consequences, but these impacts would be felt far more between “rich” and “less rich” than they would between “older generation” and “younger generation.”

Governments do of course borrow “outside the family”, in other words from foreigners. Hence not all of our debt at any time is “owed to ourselves”. But to discuss this at length would require making the point that our domestic savings pool is insufficient for our desired investment, requiring imports of foreign capital, some of which would come in as public borrowing.

4. Government budgets are not like household budgets. Seriously. (Part 2. Infinity)

The above discussion is about the fallacy of composition that is involved in mistakenly treating the government budget as if it were like an individual managing their own finances. The next main difference involves the effects of infinity.

If a household were like a government, then that household would have to effectively live forever. A household led by someone with eternal life and effectively a guaranteed stream of income would be a very safe household to lend money to, and in effect, it would never have to be out of debt because rolling over its existing debt when it came due would be straightforward. The need to be out of debt at some point is a product of finite lifespans. (This is not an argument for always being in debt; just a statement of the fact that always being indebted is feasible.)

Infinity has other weird properties that come into play in working out what different patterns of consumption and investment have over time for a society — in particular, whether we are impoverishing our children by running deficits. With a society of finitely-lived people (I.e. society lasts forever, but individual humans have finite lives as usual), with each generation owning an “endowment” of goods at birth, if we could have each generation give an equally-sized gift of some of their endowment to the older generation, then the oldest generation is better off, and each later generation is no worse off.

This is an example of the weirdness of infinity, where now we are considering an infinite number of generations rather than a single immortal human. Of course, to engineer such a transfer from younger to older requires something akin to a debt transaction; but a more realistic evaluation of the impacts of transfers across generations of this kind involves thinking about (long-lasting) capital goods, population growth and more. UCLA economist Roger Farmer helpfully lists key contributions to the academic literature in this area. Two unsurprising conclusions emerge: first, the analysis is necessarily technical and very difficult for beginners to follow; and second, the answer to the question of whether current debts will cause economic hardship to future generations is ambiguous and depends on the interplay of a number of variables.

Infinity has weird properties. And since nobody knows when a government is going to bring down the shutters and have to clear all its debts — and nobody knows when society will eventually collapse, in which case debts denominated in official currencies are likely to be moot — lenders to the government (buyers/holders of its bonds) simply want to know that their debts owed by the government will be honoured in their lifetimes. A stable government can pay any individual creditor back on a due date by rolling over that debt; effectively, other creditors step in to repay the first.

The fact that people willingly purchase “consols” (bonds without redemption dates, promising an eternal stream of payments) indicates quite clearly that people regard the likely duration of sovereign states as being longer than their own lifetimes.

5. Government budgets are not like household budgets. Seriously. (Part 3. Printing press)

A third reason government budgets cannot be compared directly to household budgets is that government’s can print their own currency. This is an astonishing power that households don’t have.

Printing one’s own currency — and have it be legal tender, and have it be required for payment of taxes owed to the government — is an enormous advantage, which admittedly doesn’t come without consequences, although there are debates about what those consequences actually are and at what stage things become tricky.

Moreover, governments within federated systems (like Australian state governments) and government belonging to monetary unions (like governments of EU states) do not control their own currencies, and have greater restriction on their actions than do governments of independent nations. (Their budgets still should not be regarded as comparable to household budgets, for the previous two reasons.)

6. Conclusions

Where does this leave us?
  1. There is no reason to think we are nationally living beyond our means at the moment. “Living within our means” is a far harder concept to pin down for a government — and for the society it governs — than it would be for a single household. It is not meaningfully understood (let alone measured) by the outcome of a single annual budget. It is also not meaningfully understood by the simple existence of public debt. There are surely better ways to spend the money we’re spending, and different and better ways to raise (more) revenue than we’re currently raising, but it’s hard to have that kind of sensible conversation in a state of alarm.
  2. There is no “debt and deficit disaster.” Debt is one aspect of public finance (and I’ve glossed over much detail around the balance between taxation, borrowing, and money printing, because this post is too long and detailed already), and it’s a thing to be managed sensibly, not a thing to panic about. If we could have that conversation, it would be a significant improvement.
  3. Debt does not mean we (the current generation) are ripping off “our children and grandchildren” (future generations). The choice to finance some activities via debt rather than taxation has distributional consequences, but it’s not obvious that these can or should be cast simply as inter-generational effects, with later generations losing out as a result of our profligacy. Money and assets and liabilities are moving around the place, but the real resource implications (from e.g. infrastructure investments, sectoral adjustments, regional distributions, demographic transitions, productivity implications) are contingent upon subsequent policy choices made.
  4. It’s the real things that finally matter. Whether we’re living beyond our means, and whether the standard of living of future generations will rise or fall, depends on what we deplete and what we improve as we move through time. Our productive capacity, as well as our resource base and environmental quality. If we’re avoiding making productive investments out of a fear of debt—let alone we’re avoiding dealing appropriately with climate change—that’s the clear and present danger for the well-being of people in the future.