Saturday, 20 December 2008

Borrowing from the future

"The crisis is caused by excessive debt"
"We have borrowed prosperity from our grandchildren - transferring consumption through time"

Economic illiteracy, all of it. We can only consume today what we can produce today. Was your iPod made in a factory built in 2016?

Monetary transfers (i.e. debt) cannot create new goods or services. You cannot transfer consumption from the future.

But it is a common fallacy to think you can. There are three kernels of truth in this viewpoint, and some of them give us a clue to the real answer:
  • Individuals can transfer consumption from the future to the present by borrowing money from other individuals. But there is an entry on the other side of this ledger - the lender is transferring their own consumption from present to future. The net effect on the whole system is nil.
  • Countries can do the same - if America (or American people) borrows money from China (or Chinese people), they can move today's consumption from China to the US in return for moving tomorrow's consumption from the US to China (assuming China can enforce this promise in the future). But the whole world cannot.
  • In the long run, debt (and especially writeoffs of debt) can change incentives, and this could affect the ultimate capacity of the economy. But this fact does not tell us what the optimal level of debt is, or how or by whom it should be held. Perhaps 300% of GDP is a better level of debt than 100%, and either is probably preferable to zero. Debt does give a way for different production and consumption choices to be made than would be available without debt, and this can enhance the efficiency of the economy (see the Megan McArdle link below).
The closest this viewpoint comes to reality is that it hints at recognising a fundamental truth: consumption today may be at the expense of investment today, which will reduce consumption tomorrow. Investment is the only real way of "transferring" consumption through time, and money is just a way to account for whose consumption happens when.

But debt does not intrinsically favour either investment or consumption. Debt is not the problem here. Productive (i.e. nonresidential) investment did not grow strongly between 2001-07 in Western economies, though it did exceed the rate of economic growth and was immense in China. I have not been able to find a worldwide figure so any contributions would be welcome.

However, even reduced investment does not immediately cause reduced consumption - it just shrinks the capital base on which future consumption depends. So this is not the proximate cause of the current recession.

A deep recession such as we appear to have now is caused by two related phenomena:
  • a coordination problem between the component parts of the economy
  • a confidence problem which results in self-feeding reduction in demand and utilisation of capacity
If we can solve these problems with debt, then debt is a good solution. The only long-term danger for the world economy is that our solutions reduce productive investment; but there is no reason to suppose that they will. The other danger is that some economies or governments become indebted and others do not; this could force a reduction in investment or consumption by the debtors, to the benefit of creditors. Which is all part of the argument for coordinated fiscal stimulus.

1 comment:

Beezer said...

I'll get back to you on this.
I haven't been able to figure out, as a non-economist, the real relationship between government investments in infrastructure improvements (made with debt)and future improvements in productivity (which will increase incomes and the ability to service debt).
I've seen figures re: employment increases expected from stimulus programs, but no calculations re: productivity improvements. Without this work, there's no actual number (goal) put to GDP to pay for deficit spending.

Also, I've seen no information regarding the price of inputs into an economy. It's nice to talk about debt, but what's debt buying?

If we spend $2 trillion today (in debt) for clean, sustainable energy, what's the economic impact if, three years from now, the cost of a barrel of oil is $250! And the $2 trillion spend today reduces our use of oil by 90%.

Debt doesn't do squat if it's pissed away, I guess I'm saying. But debt wisely spent has a multiplier effect on productivity.

If you deficit spend to reduce future expenditure on a variable that's going to go up 300%, then that's a great expenditure.

If you're China and you spend $3 trillion in your surplus to fund benefits for the poor and unemployed, and avoid having to spend $1 trillion shooting peasants, how does that effect your economic position.

These considerations are real world ones. If the economics can inform the right decision, that's great. Haven't seen it yet. But I'm an optimist.