Stimulate This-Thoughts on Intergenerational Fairness

Since this is the season for giving thanks in the US, we might give some consideration to the unsung heroes who have been underwriting a big chunk of our economic recovery of late. Actually, we literally owe our future to them - in more ways than one.

We recently asked a bright young economics student from a prominent European university about the right role of government in an economy. And the answer, somewhat predictable: "well, to stimulate it!" When we then asked how the government pays for that stimulus, and what impact it will have on the economy at that point, there was silence.

Just as we would have stayed silent when we were in his shoes decades ago. This has been the dogma of mainstream economic thinking for many years: in its omnipotence, the government should always step in to correct deficiencies in aggregate demand, so as to smooth out the business cycle. Stated differently, the government is much better at spending your money than you, especially when you don't want to spend it. And voilà, less unemployed people – and more happy voters.

These expenditures need to be funded via taxes, which depresses current demand (in a way, representing your own stimulus foregone because the government decided to spend it for you); more debt, which will also depress demand but only when it needs to be repaid at some point in the future; or any combination of the two.

Modern Keynesians (central planners by another name) argue that in the post-2008 financial crisis world debt should be the primary funding vehicle of enhanced government intervention, whenever possible with the assistance of central banks to avoid any adverse impacts on the private sector. They mean it. It was reported a few days ago that Paul Krugman, arguably the most vocal proponent of this line of thinking, recently advised Japanese Prime Minister Shinzo Abe not to raise consumption taxes - after the failure of that country’s unprecedented central bank intervention to stimulate the economy became obvious for all to see.

So to get out of the current economic funk we must yank up government expenditures and finance the whole thing with debt created by our central banks. If the economy fails to respond, we should stimulate more... and more… until finally things get back to normal. We can then deal with the consequences once growth is normalized, irrespective of the debt levels at that stage.

But since there are no free lunches in economics (that we all must agree on), somebody has to pay for this. And it should be obvious by now who that will be: our children and grandchildren (and at this rate, probably their children and grandchildren too).

Consider what's happening in the US. Here’s a chart of Federal debt owned by the public as percentage of GDP, past and projected:

US Federal Debt Held by the Public (% GDP): 1999 – 2039E

Source: US Congressional Budget Office.

Federal debt jumped enormously after the 2008 crisis and is not expected to look back over the next 25 years. This was the main driver behind the US’ increase in total non-financial indebtedness from 108% in 2007 to 154% of GDP by the end of 2013 (Z1 report, Federal Reserve). This of course excludes the unfunded portions of Medicare, Social Security and other contingent liabilities, which will add a great deal more of percentage points as they come due.

We are told that there’s nothing to see here. The debt capacity of an economy with a well-developed financial system is much greater than people think. This “resilience” is demonstrated by the historically low bond yields today, despite record government debt levels. Japan, with its government debt now representing over 230% of GDP, is paraded as the proof. If we all turn Japanese, so what?

The more accurate description, in our opinion, is to say that this well-developed financial system is a highly efficient mechanism to shift current debt burdens into future generations. And the further out the better, as that way the detrimental effect on demand from having to pay the bills as they come due is postponed. As Keynes noted, “in the long-run we are all dead”; that is true indeed, but much less advertised is the fact that someone will be left behind to pick up the tab.

And that’s a crucial point which is often lacking in the whole stimulus debate. Our ability to get longer duration credit materially declines once we hit 60ish years old (the banker knows how to calculate our life expectancy). Not so with governments. Why? Because there are whole new generations of tax payers who will become liable for those debts. Therefore, such stimulative policies can only work because they are effectively being underwritten by – or better put, forced upon – our young ones.

Seen in this light, we can certainly state that our current credit-driven economic “recovery” comes at the expense of the prosperity of future generations. Laurence Kotlikoff, an economics professor at Boston University, has been sounding the alarm on the dire state of intergenerational finances for years. In a 2009 paper he warned:

“For our children, the hour is getting very late to make the radical reforms needed to restore our fiscal and financial systems. As we economists know, the developed world’s fiscal operations have been endangering our children for decades. But governments have spent decades carefully concealing this fact. Indeed, governments have spent decades teaching their financial sectors the fine art of non‐disclosure. In particular, governments have failed to systematically account for their treatment of future generations by spelling out what current policies imply for the future tax burdens of today’s and tomorrow’s children.”

More recently, Kotlikoff looked at the amount of tax revenues that would need to permanently increase or spending that would need to be permanently taken out of the current government budget in the US, so that future generations can enjoy the same benefits of Americans today on a tax-adjusted basis. We call this "intergenerational fairness".

His findings are presented in the graph below:

Permanent Change in Federal Budget Items Required to Achieve Intergenerational Fairness

This is telling us is that in order to preserve intergenerational fairness, the US government would need to either permanently cut its 2013 spending by a massive 35% across the board or increase taxes by a whopping 64% (“permanently” meaning that from now until such generations reach the front of the line to receive their benefits). This problem will only grow larger if left unchecked, as evidenced by the 2023 projection.

These numbers are enormous. Unsurprisingly, you will be hard pressed to find any references to this dire state of affairs in politicians' speeches. In fact, quite the opposite: everyone is clamoring for more “pork”. And the same goes for central bankers, who inadvertently have become the greatest enablers of this intergenerational transfer through successive rounds of quantitative easing (“QE”). Fed Chair Janet Yellen recently complained about income inequality, but said nothing about how unfairly future generations are being treated.

Americans are certainly not alone in counting on future generations to support their current lifestyles. Here are government debt levels in the Eurozone in recent years:

Eurozone Government Debt (% GDP): 1995 – 2013

Source: European Central Bank.

A substantial debt increase after 2008 can also be observed here; and Europeans also have to deal with ballooning contingent welfare liabilities. With all the discussion already raging across Europe about wealth transfers – within social classes, within country regions and even across countries themselves – one wonders when the young(ish) will enter the debate versus their elders in earnest. With youth unemployment remaining at stubbornly high levels in many Eurozone countries, it probably won’t be that far off.

And it's not just that debt loads are rising fast. In many Western nations there are now less kids around to pay for the whole thing. For instance, the number of newborns in Portugal just hit new decadal lows. There is little doubt that kids in these countries will struggle to continue to pay for their parents’ retirement, on top of all the debts we are already bequeathing them.

OK, but the argument is that if central banks and governments had not acted the way they did back in 2008, the world would have plunged into another great depression. That may be true, but who was responsible for getting us that close to the brink in the first place? Organizations in crisis tend to make the same mistakes as before, only faster and with greater intensity. The seeds of that crisis were sown many years before, just as now we might be sowing the seeds for an even bigger crisis in the future. Why should the kids have to pay for this?

Kotlikoff (and also Paul Samuelson before him) was warning much before 2008 that the burden of fiscal policy excesses is going to be unfairly paid by future generations. Nobody in the political and central banking circles seems to care; and frankly, neither do most of us in our societies. For one, we don’t recalling seeing any headlines like “More QE; Investors Cheer as Kids Are Screwed Once Again.”

In fact, given the way that we are treating the environment and our planet, going broke might be the least of their worries.

Therefore, let’s pat ourselves in the back because the Great Recession is behind us and US nominal GDP is up 16% since 2007 – even if the federal government debt is 140% higher over the same period (Z1 report, Federal Reserve). Let’s all hope the ECB, the Fed or whatever central bank of the day do yet another big round of QE; prosperity for all is just around the corner!

But above all let’s spare a thought for the children around us. They will need all the encouragement they can get.

So here’s to you kids, Happy Thanksgiving!

Image credit: Michael Ramirez