Fiscal fundamentalists

Economics focus

Fiscal fundamentalists

Austerity or stimulus? Some economists have much more extreme views than that

BY MOST people’s standards, George Osborne, Britain’s 39-year-old chancellor of the exchequer, is a fiscal hawk. In his first budget, announced in June, he promised to raise taxes and cut spending without flinching. As a result, Britain’s net public debt should peak at about 70% of GDP in March 2014. According to the Institute for Fiscal Studies, a think-tank, his spending proposals are even more mortifying than the hair shirt imposed on Britain in 1976 by the IMF.

But Mr Osborne’s efforts look dainty compared with the rigours some economists think necessary. For example, Christian Hagist and his colleagues at Freiburg University believe Britain’s fiscal condition is far worse than the official figures suggest. In 2005, a time of prosperity and tranquillity, the country’s “fiscal gap” already amounted to 505% of GDP, they calculate, almost 14 times its official net debt for that year. Mr Hagist is an exponent of “generational accounting”, a method pioneered by Larry Kotlikoff of Boston University, among others. Through this lens, the rich world’s public finances look dire indeed. Writing in the Financial Times last month, Mr Kotlikoff declared that America was in worse fiscal shape than Greece.

Conventional measures of public debt show the legacy of past borrowing. Generational accountants look far into the future as well. They tally how much the government can expect to collect from present and future generations, through taxes and the like, and how much it can expect to spend on them. The fiscal gap is the difference between the two, expressed as the amount the government would have to set aside today to fill the hole. For many countries, the gap is enormous—multiples of GDP—largely because their citizens are living longer and having fewer babies, all of which will put a burden on the exchequer.

Introduced in the early 1990s, Mr Kotlikoff’s unpleasant arithmetic is attracting renewed official interest. British statisticians have asked the National Institute of Economic and Social Research, another think-tank, to do the sums for Britain. In September the Federal Accounting Standards Advisory Board recommended that America’s government include similar calculations in its yearly financial report by 2013. The board gave its blessing despite the pointed objections of another group of economists, of whom James Galbraith is the most prominent. Mr Galbraith, of the University of Texas, Austin, thinks generational accounting is “not only wrongheaded, but also dangerous”. He and his fellow critics fear the board has been “led astray by intergenerational warriors”.

If Mr Kotlikoff is the most hawkish of fiscal hawks, Mr Galbraith perches at the opposite corner of the menagerie. He thinks America is in a far better position than Greece because it has not given up its monetary sovereignty. It can always meet its bills because it can print the money to pay them. “There are surely limits of wisdom and prudence on federal spending,” Mr Galbraith and his co-authors have written, “but there is no operational limit. The federal government can, and does, spend what it wants.”

What, then, are the limits of wisdom and prudence? A big-spending government might crowd out the private sector, commandeering resources that would be used better elsewhere. But given the amount of slack in America’s economy, that danger seems distant. As the economy recovers, government overspending may result in inflation, Mr Galbraith concedes. But that raises another objection in his mind. The scary fiscal projections beloved by worrywarts tend to show rising ratios of debt to GDP, driven by growing health-care costs and rising interest rates. But these projections simultaneously assume that inflation remains low. Mr Galbraith believes these “doomsday scenarios” are “internally inconsistent”. If inflation remains subdued, why would the Federal Reserve allow interest rates to rise so high? And if inflation were to rise, then nominal GDP would surely expand alongside debt, keeping the ratio between them steady.

Besides, the curse of rising health-care costs afflicts private as well as public care, Mr Galbraith points out. Controlling costs is therefore a job for health policy, not budget policy, he says. To tackle these costs by cutting government programmes like Medicare and Medicaid is to pick on the aged and the poor.

Mr Galbraith also believes the government’s balance-sheet cannot be judged in isolation. Its heavy borrowing in recent years reflects everyone else’s eagerness to save. The public debt is a liability for the government but it is an asset for the private sector. America’s domestic creditors have a claim on the government; the government, through its powers over taxation and the printing press, has a claim on them. It is as if the private and public sectors are locked in a marriage, wherein the division of the family’s resources is always negotiable.

The odd couple

But that image comes from one of Mr Kotlikoff’s papers, not from Mr Galbraith. Indeed, in some ways, these unconventional thinkers resemble each other more than the less striking birds in-between. Neither thinks that official debt figures mean all that much. Neither thinks the government’s balance-sheet can be understood on its own, without reference to what the other spouse is up to.

Messrs Galbraith and Kotlikoff both worry above all about the distributional effects of taxing and spending. Mr Kotlikoff fears that fiscal entitlements allow the elderly to make outsize claims on the young. He denounces “gerontocracy” and “fiscal child abuse”. Mr Galbraith fears that in the name of fiscal restraint, taxpayers will shirk their responsibility to the country’s most vulnerable citizens, who rely on public pensions and health care. For both, then, the chief fiscal danger is inequity not insolvency, as normally understood. The question is not whether the government can pay its bills, but who pays what, when.