Wednesday, August 3, 2011

Is a decline in demand an unintended consequence of US debt ceiling debacle? Update

In an earlier post, it was suggested that zero interest rate policies create their own economic headwind because they provide an incentive for savers to restrict current consumption to make up for the loss in earnings on their savings.

In this post, I would like to add another policy that is likely to cause its own economic headwind.  That policy is reducing or eliminating the entitlements programs in the name of protecting the solvency of the US government.

Entitlement programs can be thought of as a source of "savings" for retirement.  If these savings are going to be reduced, then individuals who are saving for their retirement are going to have to save more today to offset this reduction.  The impact of this additional savings is to further reduce current demand.

How big an impact on demand could we see now that Washington is officially looking at reducing the entitlement programs?  While I do not have a PhD in Economics, common sense suggests that the impact on demand could be very large.

In China, the government does not offer entitlement programs like Social Security or Medicare.  The reported savings rate there is approximately 50%.

In the US, our reported savings rate last month was approximately 5.4%.  In 1975, it reached 14.6%.

Given that Washington would like to scale back the entitlement programs, is there any reason to believe that the US cannot return to a 1975 level of savings?

If the US did return to these higher levels of savings, demand would be reduced.  Consumers account for roughly 60% of GNP.  If they scale back their consumption to increase savings to 1975 type levels, this implies a drop of approximately 5% of GNP.


In a Bloomberg column, Laurence Kotlikoff reframes the discussion on deficits and social programs in a very useful way.  He puts forth the idea that the budget that should be balance is the generational budget.  At the end of the day, what each generation should pay for the social programs it receives.
Debt crises make great drama...The tough thing is sorting out what’s really going on. In the U.S. case, the answer is: not much...
Whatever you think of the House Republicans, they understand that our country is broke. But they have no idea how broke. They are pushing hard for a balanced-budget amendment. What we need is not budget balance, but generational balance. 
If we are going to amend the Constitution, let’s prohibit today’s adults from leaving tomorrow’s generations with higher lifetime net tax rates. 
Generational Balance Amendment would specify that, absent prolonged states of emergency, each generation would pay the same share of its lifetime labor earnings in taxes, net of benefits received. 
Stabilizing lifetime net tax rates isn’t just a matter of fairness. It’s critical to our country’s long-term economic survival. 
If we keep raising successive generations’ lifetime net tax rates, we will eventually be hitting up our progeny for every penny they earn, leaving them unable to consume or save. If they can’t save, they can’t invest, which means they won’t be able to maintain -- let alone increase -- the economy’s stock of capital needed to produce goods and services. 
The U.S., incidentally, has a national savings rate of zero and a domestic net investment rate of only 4 percent of national income. Both are postwar lows. 
Memo to House Republicans: Budget balance doesn’t imply generational balance. 
Consider Taxdonia, a country with zero debt. Taxdonia has never borrowed a dime and never will. Its constitution forbids borrowing. But Taxdonia deserves its name, actually, its new name. Its old name was Lovelandia. 
In Taxdonia, every young generation is hit with a higher and higher tax rate, historically called the Love Tax. The proceeds of the Love Tax are immediately handed to the contemporaneous old generation as transfer payments -- much as our Social Security taxes are transferred directly to current retirees. So taxes always equal spending, and the deficit is always zero....
Generational verbal warfare has broken out. Worse yet, the country’s single political party has split into two. One party, the Oldsters, wants to raise spending and taxes. The other, the Youngsters, wants to cut spending and taxes. Each side calls the other extremists and claims it is being cheated. 
Economists in Taxdonia think both are nuts. “What’s wrong? We’ve got budget balance. No debt, no deficit, relax. And stop calling our country Taxdonia. This is Lovelandia! And if you must disagree, disagree agreeably.” 
The Oldsters and Youngsters agree, disagreeably, on one thing: They both want to string up economists. They realize that their country, with the complicity of these fiscal experts, has incurred a huge, off-the-books liability to the oldsters -- a terrible debt, foisted on the young in a country where debt is verboten. 
The Youngsters have hired some young economists to use generational accounting to examine the lifetime net tax treatment of different cohorts. Their report isn’t pretty. It shows that past cohorts received, on a lifetime basis, far more than they put in and that the current young are being asked to participate in a Ponzi scheme
They also learn that measuring debt is a meaningless labeling game since the government can take from the young with the words “taxes,” rather than “borrowing,” and incur debts via promises of future repayment that are tied to the “taxes.” 
The latest news: Taxdonia’s central bank, Love Bank, has assured the current young that if their kids can’t pay them their desired old-age benefits, the central bank will keep them whole. It will print money, which will be used to pay their claims. 
The young are scratching their heads. “Won’t this lead to inflation and water down the real value of the money we already hold? Isn’t this just another way of taxing us?” 
Love Bank’s reply: “You’re young and financially inexperienced. Go back to work, pay your taxes, and all will be fine.”

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