10° 40' N, 61° 30' W

Monday, July 21, 2003

Intergenerational Transfers

The Independent's economics columnist, Hamish McRae, is de digeur reading, especially his Sunday column. This week's installment is about fiscal policy, and our children paying for our present consumption:

With a growing economy and, equally important, a growing population, some net borrowing seems quite acceptable. But with the prospect of slower growth and a stable or falling population, the burden becomes huge.

A typical maturity for government borrowing is 20 years and some debt issues will not be repaid for 30 years. It is reasonable to make a distinction between current and investment spending, for money invested should bring some future flow of income to pay back the debt. However, much of what governments call investment is actually disguised consumption - it just sounds better. And any government that borrows to consume is saying to voters that the extra resources they get now, be they in the form of tax cuts or higher spending, will be paid for by their children.

There is a moral dimension to this. In a democracy, people have the right to vote for higher public spending and higher taxation. Different electorates make different choices. But do current voters have the right to impose higher taxation on children too young to vote, or on the unborn? If we have a duty to future generations to follow ethical environmental standards, as many of us believe we do, surely we also have a duty to follow ethical fiscal standards too?

In the past, large increases in government borrowing have taken place in time of war. You can make a solid argument that the cost of financing the Second World War should be carried by the entire post-war generation, not just people who were voters between 1939 and 1945. But when the spending is on, say, a subsidy for European farmers, is it reasonable to expect our children to foot the bill? I would argue not.

This comes a couple of days after the Economist published an article on Europe's demographic situation and its implications. I don't have much to add to what Edward Hugh and Brad DeLong have written good about this. Journalists love to read each other, and today there is a leader about implicit liabilities in the Financial Times. It talks up transparency as a first step:

Ideally governments should display long-term discipline, while retaining the ability to respond flexibly to the economic cycle. It would be difficult to design such a policy. But the next step should be for finance ministries to publish annual estimates of their governments' implicit liabilities, to lay out their assumptions clearly and to subject themselves to cross-examination.

This would no doubt provide finance ministers with a few sticky moments. But such public discussion would help them make the case for the needed reform of pensions and healthcare. This, then, is the second reason transparency should be encouraged. The third is that, even if governments still do not take the required action, the public debate should help individuals to see the need to make their own provision.

In the absence of such a regular and open discussion of implicit liabilities, where do we stand? The US fiscal system has the desirable level of short-term flexibility but lacks long-term discipline. The euro area countries are in an even more unfortunate situation: they lack the necessary long-term discipline over their implicit liabilities but suffer from short-term rigidities. This is the exact opposite of the ideal model.

Governments are paying for the commitments of the present in part by adding them to the promises of the future; policymakers are thus making huge demands of long run economic performance, and demographic trends are not helping. Sustained long-run economic growth, as Robert Lucas points out, is the next frontier in macroeconomic policy, and the stab at solutions that the Economist mentions--immigration, pension reform, childbearing incentives--don't actually do anything about this; throwing more people at the problem, with the set of economic policies as it presently stands, is bound to run into diminishing returns sooner or later.

The FT's suggestion on implicit liabilities is a useful start; it could lead, if done well, to a shift in popular expecatations. In a speech last November departing Undersecretary of the Treasury for Domestic Finance Peter Fisher said that "Federal budget decision-making needs to follow good business practice and move on from cash accounting to accrual accounting. If we can do this, maybe the federal government can learn how to better align the promises that we make with those that we can keep." Fisher's advice is difficult politically and methodologically, and I can't say where it could lead. The public could either feel the need to rely on themselves more for their own "welfare" provision, or could demand that the government do more somehow to stave off a bleak future. At present, though, these questions remain a bit academic; proper accounting would allow a proper public debate a chance.

UPDATE: Jane Galt has more on implicit liabilites, saying that "long term deficit spending is deeply immoral: those alive get all the fun, while those unborn get all the bills." Very true.