Must-Read: Douglas Elmendorf and Louise Sheiner: Federal Budget Policy with an Aging Population and Persistently Low Interest Rates

Must-Read: There is a big problem with Elmendorf and Sheiner…

What we as economists want to do and have been trained to do is to:

• take quantities and prices,
• interpret the prices as costate variables that the market and the current régime are using to currently solve their own peculiar and suboptimal dubious social welfare maximization problem,
• switch over from the market and the current régime’s to the real, sensible social welfare maximization problem,
• solve that problem under perfect foresight to figure out what good policies would be,
• and then adjust for uncertainty and risk.

The problem is that this requires that prices be coherent–that they actually be the costate values for the peculiar and suboptimal dubious social welfare maximization that the market and the current régime are solving. But if we know one thing now, it is that current asset prices are not coherent: the equity risk premium; the level of safe interest rates in a world with productive capital; etc…

Thus we fact a huge problem in interpreting Elmendorf and Sheiner.

And then there are the other problems with the paper as well:

• the metaphysical status of CBO estimates that it uses as a springboard:
  • The R&E tax credit…
  • The Medicare provider cuts…
  • The Cadillac Tax…
  • The Special Assistant to the Secretary of HHS for Exercising the Powers of the IPAB…
• r < g
• what is the price of a consol?
• how is this possible?
• financial repression
• risk premium–equity vs. bonds…
• how to adjust perfect-foresight results for uncertainty?

I do not want to criticize the paper as bad–it is very good. But I do want to say that it is grossly inadequate, and we desperately need–somehow–to do better.

Douglas Elmendorf and Louise Sheiner: Federal Budget Policy with an Aging Population and Persistently Low Interest Rates: “Debt is rising in part because of a major demographic shift as the baby boom generation retires…

…It is projected to occur even though interest rates on Treasury borrowing likely will be persistently lower than historic norms…. We argue that restraining the debt is necessary to give the government room to maneuver if a crisis of any sort occurs. In addition, we observe that the aging of the U.S. population, which lowers the fraction of the population that is working, means that the country should save more now than otherwise, which can be achieved by reducing federal debt.

How much and how quickly should the federal government tighten its belt? We note that, while debt should eventually decrease relative to GDP, the fact that U.S. government borrowing rates are at historical lows and likely to stay low for some time implies spending cuts and tax increases should be delayed and smaller in size than widely believed. Low long-term interest rates mean that the U.S. should borrow to make additional public investments. They also reduce the payoff from near-term debt reduction.

After considering other factors—including the role that fiscal policy can play during economic downturns when short-term interest rates are already so low that the Federal Reserve has little room to cut them—we argue for measured, gradual debt reduction with a higher debt-to-GDP ratio than has historically been the case.