Thursday, March 24, 2011

Correspondence

A reader requested via email that FLG check out this Matt Yglesias post in which he is arguing that the analogy that national fiscal policy is like a household is fallacious.

At the outset, FLG must say he agrees that the household analogy is somewhat problematic. Ideally, government should run a balanced budget over the business cycle, which would result in the government running surpluses in good times and deficits in bad ones. The household analogy usually runs contrary to this when it comes to the running deficits part in bad times. The household story, in bad times, is all about belt tightening and tough choices.

Matt's analysis is almost correct enough to sound convincing. He writes:
A household typically measures its wealth in terms of money. So many assets and so many liabilities. And it doesn’t just do this as an accounting convention. An influx of extra dollars into your bank account is a real increase in your wealth.

[...]

The United States of America also uses dollars as a unit of account for tallying up assets and liabilities, but the wealth of the United States is properly measured not by how many dollars there are but by what real production we’re engaged in and what real stock of assets we possess. We have the I-95 and the aircraft carrier Ronald Reagan and the Hollywood movie studios and Yale University and the casinos of the Las Vegas strip and the Mayo Clinic and fertile farmland and many detached single-family homes. Unlike a household, if we as a country want more dollars, we can just print more dollars. But also unlike a household, if we as a country want more stuff we actually have to make more stuff not just obtain more currency. This means that to say we’re “broke” or “running out of money” is nonsense. The relevant issue is are we running out of productive capacity? If we try to boost demand faster than we can produce, we’ll end up with inflation. But if our level of demand is well below our potential for production, then we’ll get richer (have more stuff, more production) merely by increasing our demand to something closer to our potential.

Much of these statments is correct individually, but when put together starts to fall apart.

First, he's drawing a distinction between real and nominal. He says what matters for nations is their real productive capacity. That we measure GDP in dollars is merely an accounting issue. Okay. However, he also tries to says that, for a household, "[a]n influx of extra dollars into your bank account is a real increase in your wealth." Well, that's not strictly true. It's only a real increase if the influx of dollars is greater as a percentage of your existing nominal wealth than the inflation rate. If you had $100, put in $1 and inflation is 2%, then you are actually worse off in real terms. To the extent that Matt is arguing that most people think in nominal rather than real value, he's probably correct. But FLG'd argue that's because inflation has been more or less under control as of late. If inflation became an issue, people would pay more attention to real rather than nominal value. Nevertheless, one really ought to deal only in real or only in nominal.

Matt's second point is that household wealth is more a question of net worth rather than income, whereas the wealth of nations is about output -- GDP. Fine. No problem there.

So, where exactly is the issue with Matt's analysis? Well, the post is really about debt and there are types of problems with debt -- liquidity and solvency. Liquidity problems happen when the borrower is good for the loan, .i.e they would be able to pay back the rest of the loan, but there's an issue right now with getting the money together for a payment. Solvency problems arise when the borrower is no longer good for the loan.

Matt argues that since governments can print money, it's not possible for them to have a liquidity problem. So, no need to worry about all this debt nonsense. No liquidity crisis, then no solvency crisis.

Trouble is that creditors are greedy fuckers who like to get paid back in real returns, not nominal ones. Printing money to pay back creditors may work for a little bit, but once debtors realize that you're paying them back with inflation, well, they tend to object.

Moreover, Matt's statement that "[t]he relevant issue is are we running out of productive capacity?" is true. And he's not entirely incorrect with the subsequent analysis. But he completely ignores a couple of things. First, there is a government debt. And we ought to assume that over the long run it has to be repaid with real interest. Moreover, there is a national productive capacity, but in reality we cannot tax all of it. So, asking merely about the real productive capacity is great, but the way in which he is approaching it is sophistic.

Basically, Matt's trying to argue not to worry about the man behind the debt curtain with a plausible, but ultimately incorrect argument. It's important to think in real terms and vis-a-vis GDP when it comes to nations. However, let's not think that because a country with its own currency cannot have a liquidity crisis that it cannot have a solvency crisis.

What does all this mean? All things being equal, a government should be able to run a deficit equal to its GDP's real growth rate forever. That's a sustainable deficit. Anything more than that is unsustainable.

3 comments:

Tim Kowal said...

I think my problem is that I don't quite understand why, at least at a very abstract level, a national economy is fundamentally unlike a household economy, other than the different tools they have at their disposal to cook the books. For example, take your conclusion:

"All things being equal, a government should be able to run a deficit equal to its GDP's real growth rate forever. That's a sustainable deficit. Anything more than that is unsustainable."

I agree. But couldn't this also be applied to a household economy? My salary might be X, but I expect to be paid X+10 next year, and I also expect my wife to start making Y after she goes back to work, etc. The major difference is, I don't get to evaluate my own growth rate and print money to try to accurately reflect it. I'd instead have to convince a bank or a family member to lend me money so that my actual income meets my productive output.

Tim Kowal said...

Maybe this is a better way to say it: A household's value is determined by how the market values the members' productive output. Those values will change based on organic, decentralized market factors, and the end result is a nominal household income that, as well as anyone can measure, also reflects the real value of its output. A nation's economy, is also determined by an estimate of its total productive output. However, that estimate is not produced by the same, decentralized market factors as value the household's output. Instead, it is determined in significant part by centralized forces who control the money supply to try to make sure the amount of currency keeps private market transactions working smoothly.

However, we can get into trouble if those centralized forces misjudge the actual productive output and thus make more nominal value available than the actual productive output warrants. It is when we start making this mistake that people like Yglesias urge us to stop worrying about debt because, see, we have all this productive output, and let's not worry that the powers that be are accurately assessing all of it and making the appropriate amount of nominal value available, and let's also not worry that they're making more of that nominal value available than is warranted.

I hate economics.

Andrew Stevens said...

Major difference is that the federal government can't save money after it pays all its debts the way that a household can. In order to save money, the government must either A) remove huge amounts of money from the money supply, which is obviously undesirable, or B) it must invest in equities, which is also undesirable (though not as obviously so).

So the choices for the federal government are either A) having debt or B) not having debt. It can't be in a surplus position. (States can, since they don't control the money supply, but the federal government is different.) This limits its options.

 
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