Fiscal
sustainability and generational equity are two of the most pressing policy
issues of our times. Yet these two highly related concerns are difficult to
clearly define, let alone measure.
The standard metric of long-term fiscal imbalance is
official government debt (Reinhart and Rogoff 2009). But, as shown in Green and
Kotlikoff (2009), official debt, like time and distance in physics, is not a
well-defined economic concept.
In physics, the measurement of time and distance depends on one’s frame of reference, which can be viewed as one’s language. Measurement of debt is also language dependent.
Unfortunately, language is highly flexible. And there
is an infinite number of ways to label an economy’s fiscal policy in
neoclassical economies with rational agents, no matter how well or how poorly
such economies function. Each labelling convention results in a different
history and projected future time path of official debt. The same holds true of
taxes, transfer payments, disposable income, personal saving, private saving,
government saving, private wealth, and government wealth. Each of these
measures is devoid of economic content.
With the right labels, unsustainable fiscal policies
are compatible with huge and exponentially growing reported surpluses.
Likewise, sustainable policies are compatible with huge and exponentially
growing deficits.
The timing of policy is also up for grabs. There is no
use saying our fiscal problems lie in the future. They do with one set of words
(our short-run cash flows look great) and don’t with another (our short-run
cash flows look terrible). On the contrary, our fiscal problems lie in the
state-contingent policy path being followed, and its analysis defies truncation.
In Kotlikoff (2011), one of us illustrates the
‘economics labelling problem’ with the following completely painless way of
running massive surpluses forever. This example shows that even doing nothing
can be labelled in a way that completely alters reported deficits, taxes, and
transfer payments.
"Double income taxes and lend each taxpayer’s extra payments right back to the same person. Then, when each taxpayer makes interest and principal payments on the loan, hand back to that same person these monies as new transfer payments. This policy raises enough revenue to eliminate this year’s deficit, since this year’s taxes rise while this year’s spending doesn’t. Next year and each year in the future, repeat this policy, but with ever larger tax hikes. This will permit the government to run massive surpluses over time, while doing nothing real. Moreover, since money given is money returned, the government can save postage by simply recording the new policy in its books."
If the debt is hopeless as a measure of sustainability
and generational equity, what measures make sense? One answer is generational
accounting and infinite horizon (ie non-truncated) fiscal-gap accounting (see
Auerbach et al 1991; Gokhale and Smetters 2003; Gokhale and Raffelhüschen
1999). Both provide label-free measures of fiscal sustainability and
generational policy and present a picture of the fiscal positions of countries
that is wholly different from that based on official debt.
For example, US government liabilities (official debt
plus the present value of projected future non-interest spending) exceed
government assets (the present value of projected future taxes) by $211
trillion, roughly 14 times GDP. This fiscal gap is formed using Congressional
Budget Projections and appears, when scaled by GDP, to exceed those of all
other developed countries (Kotlikoff and Burns 2012).
Although fiscal-gap and generational accounting teach
us important lessons, they are constructs derived from a world of certainty,
not a world in constant, unpredictable flux. Measuring fiscal gaps and
generational accounts in our uncertain world requires properly discounting for
risk. But the difficulty of doing so has led to the standard, but
unsatisfactory, practice of discounting with a single fixed rate.
Alternative approach to evaluating unsustainable
policies
In Evans et al (2012), we take an alternative approach
to evaluating unsustainable policies, namely simulating them. Specifically, we
specify a stochastic general equilibrium model and determine via simulation how
long it takes for the economy to reach “game over” – the point where current
policy can no longer be maintained.
The policy is simple. The government takes (using
whatever language it wants) a fixed amount each period from the young and hands
it to the old, independent of the state of the economy, given by the size of
the capital stock and the level of multifactor productivity. When the hit on
the young exceeds their earnings, the game is over, with the government either
extracting all the income of the young and terminating the economy or switching
to a new policy regime, which leaves the young with something to eat.
Our simulations, based on an “overlapping generations”
model calibrated to the US economy, produce an average duration to game over of
roughly one century, with a 35% chance of reaching the fiscal limit in roughly
30 years.
The prospect of man-made economic collapse produces
realistic equity premiums. Our simulations also show that both the fiscal gap
(measured with constant as well as risk-adjusted discount rates) as well as the
equity premium rise as the economy gets closer to hitting its fiscal limit,
suggesting that the fiscal gap and the equity premium, even with fixed-rate
discounting, may be good indicators of unsustainable policy.
So far we have studied “game over” using a simple
two-period model. Our goal is to simulate more realistic models using the
sparse grid technique of Kreuger and Kubler (2006) and the Generalised
Stochastic Simulation Algorithm developed by Judd et al (2012). Yet, even at
this stage, it is clear that maintaining unsustainable generational policies of
the kind being conducted in the US and other developed countries is playing
with fire.
While our current and intended future simulations will
teach us about the timing of America’s end game, there is strong evidence that
Uncle Sam’s Ponzi scheme has already done tremendous economic damage to the
country.
In the lifecycle model, the young, because they have
longer remaining lifespans than the old, have much lower propensities to
consume out of their remaining lifetime resources. This prediction is strongly
confirmed for the US by Gokhale et al (1996).
Hence, in taking from young savers and giving to old
spenders, which Uncle Sam has spent six decades doing on a massive scale, the
lifecycle model predicts a major decline in US net national saving associated
with a major rise in the absolute and relative consumption of the elderly. This
is precisely what the data show.
In 1965, the US net national saving was 15.6% of net
national income. Last year, it was just 0.9%. And, according to Gokhale et al
(1996) and Lee and Mason (2012), the secular demise in US saving has coincided
with a spectacular rise in the consumption of older Americans relative to that
of younger Americans.
As Feldstein and Horioka (1980) document, US net
domestic saving tracks US net national saving. Hence, postwar intergenerational
redistribution has not only lowered net national saving; it has also reduced
net domestic investment, from 14.0% of national income in 1965 to just 3.6% in
2011. This decline in the rate of net domestic investment is, no doubt, playing
a major role in the slow growth in US wages. Indeed, the level of
private-sector average real earnings per hour, exclusive of fringe benefits, is
lower today than it was 40 years ago.
Conclusion
We call this America’s “fiscal child abuse”. If it continues, it will no doubt
shortly drive the national saving rate, which was negative 1.2% in 2009, into
permanent negative territory and further reduce net domestic investment and
prospects for real wage growth. This, plus the massive lifetime tax bills being
dumped on our children, will transform the American dream into something it has
never been – just a dream.
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