Further evidence undermining the mainstream case against fiscal deficits

Yesterday, I discussed the results of recent research that demonstrated the ‘trickle down’ hypothesis, which has been used to justify the sequence of tax cuts for high income recipients, was without any empirical foundation. While mainstream economists have been enchanted with that hypothesis, heterodox (including Modern Monetary Theory (MMT) economists have never considered it had any validity – neither theoretical nor empirical. But it is good that mainstream researchers are now ratifying that long-held view. Today, I am discussing another case of the mainstream catching up. When I say catching up, the implications of these new empirical studies are devastating for key propositions that the mainstream macroeconomists maintain. The ECB Working Paper series published an interesting paper (No. 2509) yesterday (December 21, 2020) by an Italian economist from the Bank of Italy – Losers amongst the losers: the welfare effects of the Great Recession across cohorts. In brief, the research found that younger people bear disproportionate burdens during recession in the short-run, but also, face diminished prospects over the longer-term. The paper bears on some of the major fictions that have been propagated to disabuse governments of using fiscal deficits to smooth out the economic cycle – namely, the alleged burden that is created by the current generation’s excesses (the deficit) for their children and grandchildren (who according to the narrative have to pay back the debt incurred by the excesses). This is another case of evidence being produced that ratify the analysis that MMT economists have been advancing for the last 25 years.

Background reading

I have written about these issues – the grandkids myth – several times over the last few decades.

1. Democracy, accountability and more intergenerational nonsense (May 22, 2009).

2. The rising future burden on our kids (August 2, 2009).

3. Another intergenerational report – another waste of time (February 2, 2010).

4. Our children never hand real output back in time (December 13, 2010).

5. 66,592 children relieved of debt burdens by their parents (April 11, 2011).

6. When 50 per cent youth unemployment is (apparently) protecting the grand kids (June 18, 2012).

7. Lower deficits now, undermine our grandchildren’s future (May 7, 2013).

8. Australia – the Fourth Intergenerational Myth Report (March 5, 2015).

So a consistent record of conceptual and empirical analysis based on MMT rejecting the arguments that are designed to convince the public that they should lower standards of public services and higher unemployment because it is good for their grandchildren.

Latest evidence

The author of the ECB Working Paper, Alessandro Ferrari, who works for the Bank of Italy (its central bank), set about examining how recessions impat on different age cohorts.

The reason why we might expect different impacts is because of the different life-cycle behaviour in saving, debt profiles, wealth accumulation, age-earnings profiles across the age cohorts.

So young people engage in schooling enter the workforce to earn labour income and expect to keep earning for the duration of their working lives as they start to accumulate assets.

Retired people no longer rely on labour income (typically) and rely on a combination of financial wealth and government transfers.

In terms of these age profiles, recession damages the older cohorts because it reduces the value of their financial wealth, whereas persistent unemployment damages workers who are reliant on labour income.

The author of the ECB Working Paper sought to estimate how these two impacts affect “households at different ages and quantify the welfare costs of deep recessionary episodes for different cohorts.”

Mainstream economists have previously claimed that younger people benefit from recessions because they can buy up risky financial and real estate assets that lose value during a recession.

The problem with the extant studies is that they typically ignore the impacts of unemployment.

Mainstream theory is generally in denial about involuntary unemployment and so it is no surprise that they ignore it in these type of studies.

The ECB Working Paper explicitly includes the intergenerational impacts of income loss arising from unemployment.

The Working Paper focuses on the impacts arising from the GFC. It uses three US datasets – the Consumer Expenditure Survey (CE), and the Panel Survey of Income Dynamics (PSID) which is a household panel survey going back to 1968, and the Survey of Consumer Finances (SCF).

The use of the PSID allows the researcher “to follow an household across the recession” and well beyond.

I won’t go into the technical aspects of the research design, which explots an overlapping-generations model approach. You can read up on that if you have that bent.

The main result of the paper is that:

… younger households, who become active during an economic downturn, are the most severely hit by the recession. Their welfare losses are more than double in magnitude than any other cohort and that this result is mainly driven by the permanent losses of unemployment.

The mechanisms or “channels” that cause this result are:

1. An enduring recession prevents young people from accumulating relevant ‘human capital’ (experience, skills etc), which impact over the duration of their working lives.

2. The loss of income arising from recession is the most important reason for the author’s main result.

We read that:

… as a consequence of the Great Recession households’ in their 20s experienced a loss in human wealth 25% higher than those of any other cohort in the model …

… the cohorts that entered the labour market during the Great Recession suffered a huge welfare loss from the uninsurable shock of being born during a major downturn.

3. Individuals impacted by recession adopt risk-averse attitudes to accumulating financial assets and real estate. They also cannot gain loans to enter the real estate market.

As a result, they fall behind the usual wealth profiles for those already accumulating wealth.

4. “welfare losses arising from employment fall dominate those arising from assets’ markets collapse.”

This result means that policies that bail out the financial markets are less beneficial than those who aim to restore employment as quickly as possible.

Why?

The author concludes that:

… it reduces the welfare loss of those cohorts that are most damaged and it reduces the welfare loss of all cohorts minimizing the loss on potential growth that affects welfare also to those cohorts that are already out of the labour market.

In turn, this means that policy should always prioritise large-scale job creation when private employment falls due to a non-government spending disturbance.

It also means that having a Job Guarantee in place as a safety-net employment capacity will deliver massive long-term gains, especially to young people who find themselves being the first to join the unemployment queue in a downturn under LIFO type hiring strategies.

And if you reflect on the results further, you will also conclude that employment creation strategies including a Job Guarantee buffer is far superior than an basic income guarantee (UBI) approach to income loss.

A UBI can never address the life-cycle earning profiles that result from on-going employment. A young person who gets trapped in a UBI (that may or may not be indexed) will never enjoy the income growth that their employed peers benefit from over their lifetimes.

The paper makes the important point that the income losses arising from recession are not temporary:

… a worker that suffers layoff and/or unemployment has, ceteris paribus, lower labour income even after decades …

In other words, there are first-round (immediate) losses, which then are made worse by the second-round losses that arise from the way individuals respond to the income losses and the constraints that are put on them as a result (such as ability to access credit to purchase homes).

I have also previously discussed the impacts on children who grow up in jobless households. The evidence is very clear that they inherit the disadvantages of their parents and endure negative effects all their lives – increased propensity for job loss, higher rates of job instability, lower life-time incomes, lower capacity to accumulate wealth (particularly housing), and other negative impacts relating to personal health, family stability and more.

With private spending lagging at present, higher deficits are required to stimulate saving and wealth creation at the lower end of the distribution. Higher deficits now will lead to a better life for our grandchildren later.

Poor framing subtracts from the paper’s credibility

Just as the research I discussed yesterday fell into mainstream framing about taxing the rich to repair fiscal positions, which reduces the impact of the substantive results presents, the ECB Working Paper also cannot break out of the mainstream framing.

In the first paragraph it talks about “the elevated public debt burden has reduced the fiscal policy space in many western countries”, which says that governments (so constrained) have to ration “available resources” to ensure they help the most impacted by recession.

The “available resources” are in the view of the author – government spending capacity – rather than actual real productive resources.

While the public debt issue presents restrictions on the 19 Eurozone Member States because they forfeited their own currency creation capacity, the other western nations (the majority) face no such constraint.

The paper concludes in the same way talking about increasing taxes on the next generation to pay back the debt.

The MMT position

The only reasonable conclusion when you understand how the monetary system functions is that burdens can only be considered in terms of real resources.

In that context, the level of public debt that is carried through time has no bearing on what each generation is able to consume (or produce). The next generation will be able to consume the outputs of their labour in the same way that the current generation is potentially able.

Clearly, governments bent on fiscal austerity deliberately deny successive generations the ability to consume and produce but that is not an intrinsic function of the level of public debt outstanding.

It is rather a wrongful policy direction driven by an irrational fear (and ignorance) of what the public debt means.

The mainstream belief is based on the erroneous conflation of a household and government budget.

So when a household/firm borrows now to increase current consumption (or build productive capacity) there is a clear understanding that future income will have to be sacrificed to repay the loan with interest.

This result follows because spending by the non-government body (household and/or firm) is financially constrained.

A household must finance its spending either by earning income, running down saving, borrowing and/or selling previously accumulated assets. There is no other way.

Borrowing has to be repaid via access to the other sources of spending capacity but by implication such repayments reduce the future capacity to spend.

This is translated (erroneously) into the public sphere with the claim that governments have to pay the debt back in the future by increasing taxes.

The consumption benefits of the higher spending now are enjoyed by us and our children pay for our joy by facing higher tax burdens. That is the nub of the mainstream argument.

But do our children forego real consumption in this way?

Answer: no!

If our children produce $x billion in real GDP in 2020 all of that flow of real goods and services (and income) will be available for consumption should they choose to do that.

They probably will save some of it (especially if the government runs a deficit of sufficient magnitude to fill the spending gap left by the desire to save by the non-government sector).

But the important point is that real GDP is not a reverse-time traveller. There is no government agency collecting real output to “pay back past debts”.

Moreover, running fiscal deficits which support aggregate demand at levels where everybody who wants a job can get one maximises employment and output each year and provides each demographic with the best opportunities to expand their real consumption possibilities.

Fiscal austerity – in the misguided hope that the public debt ratio will fall – undermines growth over time and the resulting unemployment erodes the capacity of our children to consume in the future.

Potential output (expanded by investment) and productivity growth are cyclical in the sense that if an economy is in recession or stagnating investment falters and future growth potential is reduced.

Similarly, productivity growth lags when aggregate levels of activity falter.

So the best way to increase the opportunity set for our children is to keep (environmentally-sustainable) economic growth strong and fiscal austerity will typically work against that reality.

The public debt ratio has no bearing on any of this. The only possible burden on our children relates to my term “environmentally-sustainable” which includes consuming through time within the limits of real resource availability.

If the current generation cruels the world’s environment and exhausts finite resources then unless technology changes dramatically (for example, to use different energy sources for transport, etc) then our children will not enjoy the same lifestyle that we enjoy (using enjoy liberally!).

But that conclusion relates to competing uses of real resources.

The public debt ratio has nothing to do with that possibility.

Public policy should be aiming to promote material prosperity across time that allows the available real resources to be shared across generations and prorated according to a sense of public purpose. Using the “price system” only prorates according to “dollar votes” and intertemporal considerations are subjugated.

Once you understand that there are no real consumption burdens to be borne by our children as a result of the public debt ratios, you then can trace the origin of this myth to the false government/household analogy.

Conclusion

It is interesting to see these ‘mainstream’ research papers seeping into the public arena.

They don’t tell me anything that wasn’t already clear decades ago.

And they don’t seem to question the underlying theoretical approaches that they effectively undermine.

But they do open the debate up further – more people see that the sort of conclusions that MMT economists were providing over the last 25 years have empirical support and that is a good thing.

The next step is to take these empirical results out of the mainstream framing at which time the full import of the findings will be realised.

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.