DRAFT For “Rethinking Macroeconomics” Conference Fiscal Policy Panel
Comments, critiques, and suggestions very welcome…
I take my assignment to discuss “fiscal policy in the medium term” to mean that I should assume a régime in which the economy is not at the zero lower bound on safe nominal interest rates. Thus I can assume that monetary policy can adequately handle all of the demand-stabilization role.
With demand stabilization taken off the table, it seems to me that there are three big remaining questions, even if I just confine myself to the North Atlantic:
- The proper size of the 21st-century public sector.
- The proper level of the 21st-century public debt for growth.
- The adjustment to the proper level of 21st-century public debt advisable because of systemic risk considerations.
The answers to the first two questions seem to me to be very clear and straightforward: the optimal size of the 21st-century public sector will be significantly larger than the optimal size of the 20th-century public sector, and the proper level of the 21st century public debt should be significantly higher than typical debt levels we have seen in the 20th century. The answer to the third question seems to me to be less certain: it hinges on the risk of a large sudden upward shift absent fundamental news in the willingness to hold government debt, and on the ability of governments to deal with such a risk that threatens to push economies far enough up the Laffer curve to turn a sustainable into an unsustainable debt. Since I believe the risk in such a panicked flight from an otherwise sustainable debt is small, and hold along with Rinehard and Rogoff that the government’s legal tools to finance its debt via financial repression are very powerful, I think this consideration has little weight.
Let me expand:
The Proper Size of the Twenty-First Century North-Atlantic Public Sector
When commodities produced and distributed are properly rival and excludible—access cheaply controlled, scarce, and produced under constant-returns-to-scale conditions—and if information about what is being bought and sold is equally present on both sides of the marketplace—no adverse selection or moral hazard—then the Smithian market has its standard powerful advantages as long as the distribution of wealth is such as to accord with utility and desert. The role of the public sector should then be confined to (1) antitrust policy to reduce market power and microeconomic price stickinesses, (2) demand-stabilization policy to offset the macroeconomic damage caused by price stickinesses, (3) financial regulation to try to neutralize the effect on asset prices of the correlation of current wealth with biases toward optimism or pessimism, along with (5) largely fruitless attempts to deal with other behavioral-economics psychological market failures—envy, spite, myopia, salience, etc.
The problem is that as we move into the twenty-first century, the commodities we will be producing are becoming less rival, less excludible, more subject to adverse selection and moral hazard, and more subject to myopia and other behavioral-psychological market failures.
The twenty-first century sees more knowledge to be learned and thus a greater role for education—and if there is a single sector in which behavioral-economics and adverse-selection have major roles to play, it is education. Deciding to fund education via very long-term loan-finance and thus to leave the cost-benefit investment calculations to be undertaken by adolescents has been a disaster.
The twenty-first century will see longer life expectancy, and thus a greater role for pensions. Yet here in the United States the privatization of pensions via 401k(s) has been an equally great disaster.
The twenty-first century will see health-care spending as a share of total income cross 25% if not 33%. Enough said. Sooner or later some insurance plan is going to start saying that we do indeed cover cancer treatment as part of our essential health benefits—but we believe that the proper and state-of-the-art treatment for cancer is via aromatherapy.
The twenty-first century will see information goods a much larger part of the total pie than the twentieth. And if we know one thing, it is that it is not efficient to try to provide information goods via a competitive market for they are neither rival nor excludible. It makes no microeconomic sense at all for services like those provided by Google to be funded and incentivized by how much money can be raised not off of the value of the services but off of the fumes rising from Google’s ability to sell the eyeballs of the users to advertisers as an intermediate good.
Infrastructure and R&D. Enough said.
The only major category that should not and to an important degree cannot be provided by a competitive price-taking market that might be a smaller share of total income in the twenty-first century than it was in the twentieth might be defense.
Now all of these raise enormous problems: We know that as bad as market failures can be, government failures are often little if any less immense. We will badly need to develop new effective institutional forms for the twenty-first century. But it is clear that the increasing salience of these market failures means that the private market sphere in the twenty-first century needs to shrink relative to its proper size in the twentieth century.
The Proper Size of the Twenty-First Century Public Debt
When we examine the public finance history of major North Atlantic industrial powers, we find that the last time that the average over a decade of
the 10-year government bond rate UPDATE: ARITHMETIC ERROR: government debt service as a percentage of outstanding principal was higher than the average growth rate of its economy was… the Great Depression, and before then… 1890. Since then, over any extended time period for major North Atlantic reserve currency-issuing economies, r < g without fail. That is now 125 years. Only those who see a very large and I believe exaggerated chance of global thermonuclear war or environmental collapse see the North Atlantic economies as dynamically efficient from the standpoint of our past investments in private physical, knowledge, and organizational capital. But the fact that r < g for a century and a quarter with respect to the investments we have made in our governments raises deep and troubling questions. Since 1890, a North Atlantic government that borrows more at the margin benefits its current citizens, increases economic growth, and increases the well-being of its bondholders (for they do buy the paper voluntarily): it is win-win-win.
That fact strongly suggests that North Atlantic economies throughout the entire 20th Century suffered from a form of dynamic inefficiency, in that there was excessive accumulation of societal wealth in the form of net government capital—in other words, government debt was too low. Given the debt secured by government-held social wealth ought to be a close substitute in investors portfolios with debt secured by private capital formation, it is very difficult to understand how economies can be dynamically efficient with respect to private capital and dynamically inefficient with respect to government-held societal wealth in the absence of truly mammoth financial market failures.
These considerations militate strongly for higher public debts in the 21st-century then we saw in the 20th-century. Investors want to hold more government debt: the extraordinary prices at which it has sold since 1890 tell us that. Market economies are supposed to be in the business of producing things that households want whenever that can be done cheaply. Government debt fits the bill, especially now. And looking out the yield curve Government debt looks to fit the bill for the next half-century at least.
The only live question is whether levels of government debt issue large enough to drive r > g for government bonds will create significant systemic risks. Yes, the prices of the government debt of major North Atlantic industrial economies are very high now, but what if there is a sudden downward shock to the willingness of investors to hold this debt? What if the next generation born and coming to the market is much more impatient? Governments might then have to roll over their debt on terms that require high debt-amortization taxes, and if the debt is high enough those taxes could push economies far enough up the Laffer curve to render the debt unsustainable in the aftermath of such a preference shift.
Two considerations make me think that this is a relatively small danger. First, when I look back in history I cannot see any such strong fundamental news-free negative preference shock to the willingness to hold the government debt of the North Atlantic’s major industrial powers since the advent of parliamentary government. The fiscal crises we see—of the Weimar Republic, Louis XIV Bourbon, Charles II Stuart, Felipe IV Habsburg, and so forth—are all driven by fundamental news. Second, as Rinehart and Rogoff have pointed out at great length, 20th and 19th Century North Atlantic governments have proven able to tax their financial sectors via financial repression with great ease. The amount of real wealth for debt amortization raised by financial repression scales roughly with the value of outstanding government debt. Only when even semi-major industrial countries have allowed large-scale borrowing in potentially harder currencies than their own–and thus cough written unhedged puts cough on their currencies–is there any likelihood of difficulty.
I conclude that, looking forward:
- North Atlantic public sectors should be larger than they have been in the past century.
- North Atlantic public debt levels should be higher than they have been in the past century.
- With prudent regulation—i.e., the effective limitation of the banking sector’s ability to write unhedged puts on the currency—the power to tax the financial sector via financial repression provides sufficient insurance against an adverse preference shock to the desire for government debt.
Thus, if the argument against a larger public sector and more public debt is going to be made, it seems to me that it needs to be made on a political-economy government-failure basis. The argument needs to be not that larger government spending and a higher government debt issued by a functional government would diminish utility, but rather that government will be highly dysfunctional.