Arnold Kling  

Kotlikoff on Social Security

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Steve Verdon points to a speech by Laurence Kotlikoff with a plan for saving Social Security and Medicare.


The Personal Security System

1. The accrual of additional Social Security retirement (OAI) benefits is eliminated.
2. Current retirees and current workers receive their accrued Social Security retirement benefits.
3. The OAI payroll tax is eliminated and replaced with equivalent compulsory PSS contributions.
4. A new federal retail sales tax is used to pay off OAI accrued liabilities.
5. Workers’ PSS contributions are shared 50-50 with their spouses.
6. The government contributes to PSS accounts on behalf of disabled and unemployed.
7. The government matches PSS contributions on a progressive basis.
8. All PSS balances are invested in a single, market-weighted global index fund.
9. The government guarantees the real principle contributed to PSS accounts.
10. At retirement, PSS balances are gradually sold to buy inflation-protected annuities.
11. Prior to retirement, workers’ PSS accounts are bequeathable.
...
The Medical Security System

1. The traditional fee-for-service Medicare system is discontinued.
2. Medicare participants receive vouchers to purchase health insurance coverage.
3. Voucher amounts are participant-specific and depend on the participant’s health status.
4. New vouchers are issued annually, and participants can change plans annually.
5. Insurers/HMOs cannot deny coverage, nor delay service.
6. Insurers/HMOs must provide basic coverage, including prescription drug benefits.
7. Insurers/HMOs are free to market additional coverage at additional premiums.
8. Government sets voucher amounts to limit per capita MSS growth to that of real wages.

These ideas are interesting. However, I believe that Social Security could be rebalanced by raising the retirement age for workers now aged 50 and younger. I think that would be simpler than the scheme that Kotlikoff concocted. The Medicare plan sounds a bit better, although I still feel that raising the age of eligibility would be helpful even if such a plan were adopted.

For Discussion. Would Kotlikoff's approach for providing health insurance to the elderly work just as well for those under 65?


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COMMENTS (57 to date)
Eric Krieg writes:

>>Would Kotlikoff's approach for providing health insurance to the elderly work just as well for those under 65?

Oh man! He ripped off Boonton's idea!

What about making the voucher for catastrophic insurance only? I still don't see why I should be paying for the routine medical care of the elderly, who, after all, are the richest demographic segment in the country.

Jim Glass writes:

"I believe that Social Security could be rebalanced by raising the retirement age for workers now aged 50 and younger."

What would be the benefit of giving today's young workers, including *poor* young workers, a loss on their SS contributions, so that SS on net impoverishes them -- as this would guarantee?

The savings accounts give them a positive return.

As Friedman has pointed out, the obligation to make SS's backward transfer is a national obligation that should be paid off by general revenue. Kotlikoff's proposal is just like Friedman's except he proposes using the sales tax instead of income tax. I'd still prefer to use income tax for reasons of simplicity and progressiveness.

But in any event, proposing to pay off the backward transfer entirely through regressive payroll taxes -- which is what increasing the retirment age does -- is, well, *regressive* both in real-time and inter-generationally.

It gives today's young, including the poor, a *negative* return from SS, impoverishing them, to assure undiminished transfers to seniors who both (1) receive large *positive* returns from SS, and (2) on net are much wealthier than those paying the payroll tax who will have their benefits cut through the increased retirement age.

I don't see any social virtue in that simple fix at all.

Steve writes:

I think that the idea that SS can be fixed and everybody comes out ahead has to be jettisoned.

It gives today's young, including the poor, a *negative* return from SS, impoverishing them, to assure undiminished transfers to seniors who both (1) receive large *positive* returns from SS, and (2) on net are much wealthier than those paying the payroll tax who will have their benefits cut through the increased retirement age.

And the income tax wont have similar problems?

Let me know if you find a magic bullet, but I'm pretty sure if Kotlikoff knew of such a magic bullet he'd be telling people about it.

Eric Krieg writes:

>>Let me know if you find a magic bullet, but I'm pretty sure if Kotlikoff knew of such a magic bullet he'd be telling people about it.

Magic bullet, no. But why must EVERY "solution" NOT include the people who caused the problem, and the people most able to afford change: today's seniors.

How about funding the transition to a fully funded system with an estate tax with teeth? The estates of today's seniors are artificially inflated because of all the transfer payments they have recieved over their lifetimes. Isn't it time that they paid something back?

Boonton writes:

"What about making the voucher for catastrophic insurance only? I still don't see why I should be paying for the routine medical care of the elderly, who, after all, are the richest demographic segment in the country."

Suppose you get more healthcare for your buck with an HMO? This is quite possible in some situations since HMO's can keep doctors in line while catastrophic plans lean more towards giving doctors a blank check once they hit the patient's deductable.

Tom Grey writes:

Why not look at Chile's 10% required retirement savings, remains personal property, is fully inheritable -- as the best practice? The SS is two taxes, one on employees and one on employers; that paid by employees should be theirs, paid by employers (yes, really a tax on workers) should go for the backward transfer.

Estate taxes are an excellent addition to pay the backward transfer.

Fat, smoking, drinkers should be able to retire early, if they want, on less -- since they expect to live less.

Eric Krieg writes:

Chile may have an excellent system, but the question is, how do you get there from here? How do you fund current retirees while freeing up money for the young to save for themselves?

I have no problem in principle cutting current retirees benefits, but that is politically dicey.

I wonder if taxing EVERY estate, for the purpose of funding SS, is a politically possible option. What would the tax rate need to be in order to generate the same revenue as the current payroll tax?

Jim Glass writes:

"How do you fund current retirees while freeing up money for the young to save for themselves?"

And ...

"And the income tax won't have similar problems?"
~~~

Look, gosh, SS's problem is very simple. (If this can't be grasped then regarding Medicare there is *no hope*, we are doomed).

There is a "backward transfer" in the current SS system that creates a funding gap that must be covered somehow in the future. It exists now as a sunk cost of the current system -- so it will exist unchanged in amount whether we continue with the status quo, or totally privatize SS, or close it down entirely, or whatever. And it must of necessity be closed.

Let us assume we won't close it by slashing benefits, that we will instead honor all benefits earned to date. Then we must close the gap by raising taxes, there is no other choice.

However, we *do* have a choice of what taxes to use.

1) Payroll taxes -- the status quo method. Payroll taxes on young workers are being used to fund both the backward transfer *and* their own future benefits. This is what drives their returns from SS into negative territory, impoverishing them. (And even so only closing the funding gap partially)

2) Other taxes -- Friedman prefers income taxed, Kotlikoff a sales tax.

Is either of these a "magic bullet"? Of course not, either is simply a conversion from $x collected in payroll taxes to $x collected in income or sales taxes.

The relevant question is, is either of these an *improvement*?

Let's look at income taxes. Say the entire payroll tax used to fund the backward transfer is replaced with an increase in income tax used to do the same. Improvements...

1) The payroll tax that destroys low-income jobs is eliminated. More jobs result.
2) Since the remaining payroll tax is used only to fund future benefits, it can be dropped and replaced with real savings. Better for the nation, better for the individual.
3) The cash flow cost of the savings to workers is less than that of the old payroll tax, so they have more money in their pocket -- an immediate increase in welfare.
4) Workers will receive a solid positive return on their SS savings rather than negative return on the old payroll taxes -- a long-term increase in welfare.

Win-win-win-win. So does this income tax have "similar problems" to the payroll tax -- negative returns on savings to low-income workers, etc.? No, it does not!

So is it something for nothing then? Of course not. The exact same amount of tax not collected from the payroll tax will be collected through the income tax. However...

5) Because the set of total income is much larger than the set of wages subject to payroll tax, the income tax increase in percentage points will be smaller than the payroll tax decrease, a healthy speading of cost over a much broader tax base, and

6)Because the income tax is highly progressive, the tax on net will be moved from the poor to the rich.

win-win (for most)

So, no, it's not a "magic bullet" -- now the rich get impoverished instead of the working classes and the poor. But they don't get *so* impoverished.

So you choose, it's just a choice.

It's very simple: there's a backward transfer that must be financed through taxes. Is it better to use regressive payroll taxes or progressive income taxes or a sales tax?

There's no "magic" involved -- it's no more difficult than making that choice.


"Let me know if you find a magic bullet, but I'm pretty sure if Kotlikoff knew of such a magic bullet he'd be telling people about it."

Eric Krieg writes:

Jim, funding current retirees via an income tax rather than a payroll tax is good because current retirees pay a portion of income taxes, where they don't pay payroll taxes. But it is a small portion.

What would income tax rates need to be in order to fund SS? Wouldn't they be confiscatory? Not that the payroll tax isn't confiscatory, or that a national sales tax wouldn't be either.

I'd just like someone elses income being confiscated, not mine. Preferably, I'd like the people who caused the problem with SS in the first place to be the ones penalized.

Once again, how about an estate tax? Eliminate the income requirements. Subject every estate to the tax. Use the money to fund current retirees. Eliminate the payroll tax, and create mandatory 401(k)/ IRAs in their place. Force workers to save and invest their portion of the current payroll tax. Give the employer paid portion of the payroll tax back to businesses, so that they can use the money to create new jobs.

Lawrance George Lux writes:

I see I must play the Judas here. The Social Security system was instituted to save the more disadvantaged from economic privation. It results in the richest segments of society receiving the greatest benefits from the system. How do We alter the system to make it both fair, and actually pay for the worst Government program ever designed?

We start by making one monthly benefit for Everyone, which We make subject to Income tax. We follow it with establishment of limited Medicare service program, with Medicare premiums raised to pay for Cost; though the Deductible will be eliminated to promote fairness. Then We turn to Taxes to pay for the System.

The System was originally designed to induce the Wealthier to pay for the indigent Elderly. This cannot be done by a Payroll tax. It cannot be done by an Income tax--which taxes Individual effort, something needed simply to pay necessary bills. The Tax must impact Those able to pay, if it is to be equitable; this is not achieved by a Retail Sales tax. Where do We go from here?

The only viable tax to pay for the System becomes Business tax, Corporate Income tax, and Capital Gains tax. Supply-Side theory would disclaim this announcement, but it is the only form of taxation where the cost will be borne equitably; as well as being the only way the Costs of the SS system will be held in check. lgl

Boonton writes:

There is no real 'funding gap' with SSI. Future benefits, whether they are coming from individual 401K type retirement accounts or SSI can only come from future production. Keynes is instructive here, in a very real sense it is impossible for society to 'save'. All current economic activity is either consumption or investment.

If SSI is fundamentally unworkable then so are retirement accounts. If the future will lack workers to fund SSI benefits then it will also be lacking workers to buy the stocks and bonds that the retired generations will be trying to cash out of their 401Ks.

Since that is a undeniable fact, SSI has an added attraction in a world that places more emphasis on individual retirement accounts rather than defined benefit pensions....diversification. We have seen that the stock market is highly erratic. SSI providing a stable benefit for life offsets the unpredictable balance of 401K's.

Eric Krieg writes:

>>If SSI is fundamentally unworkable then so are retirement accounts. If the future will lack workers to fund SSI benefits then it will also be lacking workers to buy the stocks and bonds that the retired generations will be trying to cash out of their 401Ks.

This is too static a view. 401(k) savings becomes investment now, increasing the productive capacity of the nation. In effect, it makes us richer in the future, so that we will be more able to afford a higher proportion of retirees to workers.

SS does no such thing. In fact, as we have discussed, SS was devised in order to decrease saving, and thus, investment. SS has made us poorer than we would otherwise be had it never been implemented.

It's all about productivity and growth. Can we become rich enough and productive enough so that we can afford to have so many retirees?

Eric Krieg writes:

NBER working paper 5413 "The Missing Piece of Policy Analysis: Social Security Reform"

Abstract:

This lecture discusses the economic losses that result from an unfunded social security retirement system and the potential gain from shifting to a funded system. The social security payroll tax distorts labor supply and the form in which compensation is paid. Although each individual's benefits are linked to that individual's previous payroll tax payments, the low equilibrium rate of return inherent in an unfunded system implies a `net' payroll tax that causes distortions. The resulting deadweight loss is 1% of each year's GDP in perpetuity, an amount equal to 20% of payroll tax revenue and a 50% increase in deadweight loss of the personal income tax. Also, there is the loss of investment income resulting from forcing employees to accept the low implicit return of an unfunded program rather than the much higher return paid on private saving or in a funded social security program. The present value of the annual losses from using an unfunded system exceeds the benefit to those who received windfall transfers when the program began and when it expanded. Shifting to a funded program cannot reverse the crowding out of capital that has already occurred. Recognizing the existing unfunded obligation only makes that piece of the national debt explicit, but shifting to a funded program limits crowding out of capital formation to the amount that already occurred. Future increases in annual saving that result from economic growth are able to earn the higher rate of return on real capital. The present value of these gains is equivalent to a perpetuity of more than 2% of GDP a year. The combi- nation of improved labor market incentives and higher real return on saving has a net present value gain of more than $15 trillion, an amount equivalent to three percent of each future year's GDP forever.

Lawrance George Lux writes:

Eric,
I agree with most of the Abstract, but it has shortcomings. It does not reflect the costs to the system of recessions. It does not reflect the costs of a fully-funded system, which is ignored. This consists of payment of current commission rates at times of purchase and sale, acting effectively as a Payroll tax; simply not going into Public revenues. The estimates in the Abstract must be cut to one-quarter of the stated benefit, due to the above, and due to the need to fund current obligations through withdrawals from the general Government revenues. lgl

Boonton writes:

"This is too static a view. 401(k) savings becomes investment now, increasing the productive capacity of the nation. In effect, it makes us richer in the future, so that we will be more able to afford a higher proportion of retirees to workers."

Not quite, whether SSI or 401K's are directed into investment or consumption is an open question. Since SSI taxes decrease the net borrowing of the US Gov't, money that would have went towards purchasing treasury bonds may very well be put into productive investments. On the flip side, simply purchasing existing shares of stock (in a 401K account) can very easily end up being a roundabout route to additional current consumption.

Investment in national income accounting has a special meaning. It means the production of capital (i.e. 'means of production')...durable assets such as machines, computers, and other assets that are meant to produce consumption goods *in the future*. In everyday language investment may mean putting your money in a savings account or buying shares of stock. This is only Investment in the above sense if it results in capital goods being produced. The bank can easily end up using your savings account deposits to fund credit card purchases (consumption)....likewise your stock purchases are very likely going towards funding someone's consumption (the person who owned the stock before you).

Eric Krieg writes:

>>The estimates in the Abstract must be cut to one-quarter of the stated benefit, due to the above, and due to the need to fund current obligations through withdrawals from the general Government revenues

Which is why I think that current obligations should be funded by the people whose wealth is being shielded by that money.

When current seniors move on the the great beyond, their wealth, which was NOT used to fund their retirement because of the existance of a social security system that they created, should be taxed at a rate sufficient to pay for their cohorts.

Is this a little punatice, spiteful, and vengeful on my part. Yes. But I don't see any way around it. The situation is that dire.

Boonton writes:

I wouldn't object to offsetting part of SSI's payroll taxes with an estate tax centered on larger estates and with provisions for illiquid assets (such as the family house or business).

Eric Krieg writes:

E-mail sent to Martin Feldstein:

Prof. Feldstein,

I'm having an argument with a friend about your paper on Social Security privatization. I'd like to know what you think.

Is it a valid counterargument to say that your numbers for economic growth are overstated because much of the investment that would go into private accounts would go into stocks, which might fuel current consumption rather than capital investment?

Did you take into account the cost of administering the private accounts? Things like stock trading fees, for example?

Eric Krieg writes:

>>I wouldn't object to offsetting part of SSI's payroll taxes with an estate tax centered on larger estates and with provisions for illiquid assets (such as the family house or business).

No, no, no. No minimum income, and no shielding assets like homes.

Look, in a perfect world seniors would use their own wealth to fund their retirements. They would do this with things like reverse mortgages and selling their businesses.

But, because they created a SS system that is insanely generous to them, many seniors are able to maintain their wealth throughout their retirement.

It just seems like economic justice that their estates be forced to pay back the largesse that seniors voted for themselves, at the expense of younger people.

And it wasn't rich seniors that created the system as it is now, it was the middle class that did. Thus, the middle class should bear the brunt of an estate tax to fund current retirees.

Eric Krieg writes:

I think an estate tax would be fair for another reason. We don't want to make seniors destitute in the here and now. So we don't want to cut their benefits now. But once they are dead, they are dead. They don't need the money. It's just going to go to their baby boomer scum kids anyway, who don't deserve it!

Boonton writes:

So are you advocating this because it is good policy or because you think that the current generation of seniors deserves punishment? It sounds a lot like the latter, except that you are putting the punishment off until after they die.

Eric Krieg writes:

>>So are you advocating this because it is good policy or because you think that the current generation of seniors deserves punishment?

I do think that the later is true. But that is not my main motivation.

I'm trying to find a solution to an almost intractible problem. How do you transition from an unfunded to a fully funded pension sysytem without increasing growth killing taxes like income or sales taxes, and without exploding the national debt? And how do you do it without causing pain to today's seniors? (which is a political requirement).

I think that I have found the answer: fund current retirees with a broad based estate tax.

Randall Parker writes:

There is another way to deal with the old age financing crisis. My own proposal: Accelerate Education To Increase Tax Revenue, Reduce Costs. Click on my name in this comment to see it.

Boonton writes:

"I'm trying to find a solution to an almost intractible problem. How do you transition from an unfunded to a fully funded pension sysytem without increasing growth killing taxes like income or sales taxes, and without exploding the national debt? And how do you do it without causing pain to today's seniors? (which is a political requirement)."

SSI is funded as long as there is a generation that is working. 401K's are in exactly the same boat. The 'intractable problem' that we are supposedly facing is that we cannot let retirement *grow* at the same pace it has in the past. This is like saying we are facing an intractable problem because in the past life expectancy went from 35 to 70 years but now we are unlikely to go from 70 years to 140 years in the same time period....so we'll have to settle at 110.

Eric Krieg writes:

B, you are still thinking statically. A fully funded pension sysytem increases growth AND productivity (as Feldstein says, INTO PERPETUITY).

The advantage of a fully funded system is that it makes us richer, and a rich person can afford to fund more freeloaders, I mean seniors, than a poor person can.

Boonton writes:

Exactly how does a 'fully funded' system increase growth and productivity (are the two different things?)?

As I pointed out, 'savings' done either through SSI taxes or through individual retirement accounts may or may not be channelled into true Investment.

Eric Krieg writes:

>>As I pointed out, 'savings' done either through SSI taxes or through individual retirement accounts may or may not be channelled into true Investment.

Perhaps not 100% of savings becomes capital investment. But a portion does.

The open question is to what extent does the increased investment lead to growth in excess of the decline in growth caused by increased taxation needed to pay for current retirees.

This is why I suggest a broad based estate tax. I think that it might allow the government a revenue stream that doesn't screw up incentives to work and save, as payroll, income, and sales taxes do.

Boonton writes:

Actually some of the savings in a 401K may become real investments, all of it may become real investments or none of it may become real investment. Buying a bond or share of stock does nothing to the amount of capital in an economy.

Imagine a group of neighbors. Every year they sell their houses to the person accross the street. Every mortgage is paid off & new ones are instantly created. No doubt the local newspaper will marvel at the real estate market is booming! In fact, the price of homes could skyrocket since the cost of every new purchase will be exactly offset by the revenue from each sale. But this is just trading paper deeds, no new homes are being built!

If the gov't runs a surplus (or smaller deficit) due to SSI taxes, then the number of gov't bonds available decreases which means lower long term interest rates. Lower interest rates increases the incentive for companies to borrow to fund real investment. Lenders seeking a place to park their money will also have an incentive to seek beyond gov't bonds for a higher return.

While the system may be 'unfunded' it really can generate additional capital production that means future generations will be more productive. In the end there is no such thing as a funded retirement for all of society. The medical care, cruises, golf outings, housing etc. for tomorrows retirees will be produced by tomorrows workers. If there are fewer workers tomorrow then the problem facing tomorrows retirees is exactly the same whether they live in a SSI-only world or a 401K-only world.

Eric Krieg writes:

Boonton, do you really think that "Rubinomics" is less controversial than your assertion that 401(k) savings doen't get translated into real investment?

I don't think that any link can be proven between federal debt and interest rates. No causal link anyway. Not even a correlation.

I wish Feldstein had answered my e-mail, because I would like his take on your argument. Too bad he isn't as vigilant with his e-mail as Prof. Vigador was. Different generations, I guess.

Boonton writes:

Rubinomics? It's more like there law that there is no free lunch. If there is no link between gov't debt and interest rates then what mechanism would prevent gov't from having zero taxes and running 100% of the budget on deficit? In fact, the gov't could then borrow the entire budget & also pay people with negative taxes!

As for my assertion regarding real investment, show me how $100 put into my 401K translates into real production of additional capital? Nearly all of the shares sold on the stock market are secondary, not public offerings by the company to raise investment capital but by old owners of the company seeking to cash out.

On the flip side, every billion dollars of gov't debt borrowed means there someone was seeking to invest some money and choose to loan it to the gov't. If the gov't didn't borrow that money then its likely that the person who lent it would not go on a consumption binge but seek another way to loan those resources at a profit. I'll agree there is no guarantee they will loan it for increased capital production. You could, for example, buy securities of credit card debt which would be effectively loaning that money out to finance consumption.

Eric Krieg writes:

Yes, Rubinomics. That's the name for what you are describing, where federal debt leads to increased interest rates (and vice versa).

Now, perhaps at extremes (no taxes, 100% debt example you cited) it does. But during the 1980s, the last time the federal debt increased significantly, interest rates went down. Ditto for 2001 to 2003. So it doesn't NECESSARILY apply.

The reason is probably because interest rates are largely set by inflation expectations, and the federal debt is largely a function of tax income to the government, which is a strong function of economic growth.

In a recession, the debt increases, but interest rates decrease. In an economic boom, the debt decreases, and interest rates increase. But neither is strongly correlated to one another.

Eric Krieg writes:

>>If the gov't didn't borrow that money then its likely that the person who lent it would not go on a consumption binge but seek another way to loan those resources at a profit.

Does that hold true when the treasuries are largely being bought by foreigners as a way to recycle their trade dollars without strengthening their currency, like the Japanese did in the 1980s and the Chinese are doing now?

Boonton writes:

If the Japanese or Chinese didn't have T-bonds as a means to recycle their dollars the what would they have done? Probably turn to other types of dollar related investments. This happened a bit in the 80's despite the expanding gov't debt as Japanese brought up American property.

The key here is the old catch-all 'all other things being equal'. Decreasing supply, for example, raises the market price. In the real world, though, you can find counter examples. That doesn't mean the rule is wrong, in the real world other variables will not stay still for your benefit...so the supply decrease may also coincide with a drastic demand reduction that results in the market price actually falling.

All things being equal increased gov't deficits (or decreased surpluses) does raise interest rates because it increases the supply of Treasury bonds. During normal times the effect on the final outcome is small so you won't find the relationship so easily but the effect is quite visible in extreme cases.

Just because you don't see this relationship doesn't mean it isn't real anymore than the fact that you can't normally see stars during daytime means they cease to exist at sunrise.

Eric Krieg writes:

>>Just because you don't see this relationship doesn't mean it isn't real anymore than the fact that you can't normally see stars during daytime means they cease to exist at sunrise.

Now you're getting existentialistic on me.

The Robert Rubins of the world make it out to be that the debt/ interest rate causation is so strong that it overwhelms every other economic actor. But it isn't true. Other factors are way more important.

And if the Chinese couldn't recycle their dollars, the yuan peg to the dollar would be toast. They would HAVE to float their currency. The yuan would become more valuable, and the dollar would become less so.

Boonton writes:

I'm not following what the ability of the Chinese to recycle their trade dollars has to do with capital creation in the US via personal savings or SSI savings?

I'm also not sure that Robert Ruban really does make the relationship out to be as blindingly bright as you are trying to depict. Perhaps you are picking up on the Bush administration's recent mocking of 'Rubanomics'...you should be careful about economic theories being thrown by people in glass houses....

Boonton writes:

I suggest doing a quick Google news search on 'Rubinomics' to see who is really the fool. The Mises site does a good job destroying the mockery of Rubin. I think they do an even better job of destroying th silly hatchet job done on the proposition that gov't borrowing raises interest rates.

http://www.mises.org/fullstory.asp?control=1146
***********
No matter how closely two factors may track each other historically it is nothing if not backed by a sound theory. Using statistics in this manner is inappropriate in attempting to understand the realm of human action. Hafer's writing is a perfect example of the fallacy of trying to refute logic with statistics. To Mises everlasting credit, he understood the limitations of statistics and refused to compromise on that truth.

What logic tells us

The relationship between deficits and interest rates has to be understood logically.

First we have to understand that there are two ways such a monster is fed. The government may borrow by financing its deficits through bonds bought and held by the public. This has the effect of redirecting savings from serving the wants of consumers to serving the wants of government officials.

As Murray Rothbard noted, "…logic tells us that if savings go into government bonds, there will necessarily be less savings available for productive investment than there would have been, and interest rates will be higher than they would have been without the deficits [italics added]." And there we find the answer and the key qualifier, which is highlighted in italics.

The simplicity and brevity of this argument stands in sharp contrast to the muddled empirical inferences wrought by many economists today. It is irrefutably true. Savings are finite and a siphoning of these funds by government can only mean less is available for private use. Whether the actual interest rate is higher or lower during times of deficits is irrelevant; what really matters is what might have been without the deficits.
**********

Boonton writes:

And what do you know! Even Bush Treasury Secretary John Snow admits that 'We are all Rubins now'!


http://afr.com/world/2003/02/06/FFXZUVE4SBD.html

Eric Krieg writes:

>>I'm also not sure that Robert Ruban really does make the relationship out to be as blindingly bright as you are trying to depict.

Come on, B. You were alive in, oh 1998. You know damn well that is exactly what Rubin was crowing about. He built his entire stewardship of Clinton economic policy on that very idea.

I don't doubt that there is a relationship between deficits and interest rates. But deficits are too small to have the influence that the Rubins say that they do. There are other things that are way more important (like marginal tax rates).

If you give too much credit to defecits, there is no way to explain the 1980s, when defecits and debt exploded, but interest rates fell sharply.

Boonton writes:

"I don't doubt that there is a relationship between deficits and interest rates. But deficits are too small to have the influence that the Rubins say that they do. There are other things that are way more important (like marginal tax rates)."

You mean like the 90's when marginal rates went up & the economy boomed? How strong is that relationship again?

"If you give too much credit to defecits, there is no way to explain the 1980s, when defecits and debt exploded, but interest rates fell sharply."

I would start by comparing not nominal interest rates but real ones. How did real rates fare? Nominal rates did fall sharply after the Fed pushed them up dramatically when they contracted money supply...but a large part of this had to have been caused by the fall in inflation.

Eric Krieg writes:

>>You mean like the 90's when marginal rates went up & the economy boomed? How strong is that relationship again?

Marginal rates went up in 1990 and 1993. When did the economy boom? 1997?

The recovery after the recession of 1990 was notable for its weakness. The increases in marginal tax rates were one reason the recovery was so weak.

Eric Krieg writes:

>>I would start by comparing not nominal interest rates but real ones.

Real rates were all over the place in the '80s. At the time that the defecit was increasing the fastest, real rates were dropping.

Boonton writes:

Regarding the boom, what exactly is the relationship being asserted here? That the tax increases slowed down the recovery? There wasn't any notable tax cut in 97, why did the boom happen then? Why was inflation falling dramatically when a supply shock (which is what the tax increases would be viewed as by supply side theory) would imply that inflation should increase during a recovery? Did the economy forget that taxes were higher in 97 than they were in 91?

Again I think you are focusing on too few variables. I strongly suggest you read the link http://www.mises.org/fullstory.asp?control=1146. Its silly to assert a causual relationship just the basis of a superficial observation.

Real interest rates were higher in the 80's than what they *otherwise* would have been due to the deficit. That is not a statistical statement but one of economic theory. The only way out of that bind is to assert that the economy was being under utilized during the 80's and therefore the deficits filled the consumption gap without crowding out investment. That's a highly Keynesian argument, even one that may have some merit to it. I think it would be a little too good to say, though, that the deficits of the 80's just happened to be exactly large enough to make the economy run perfectly. That seems a bit Panglossian to me....

Eric Krieg writes:

>>There wasn't any notable tax cut in 97, why did the boom happen then?

Capital gains tax cut, passed in 1996. That's what Kudlow would say, anyway.

I believe the 1990's boom was, in fact, a bubble. It was not caused by fiscal policy. It was caused by international factors (the Asian crisis, which, while hurting our export industries, resulted in the cheapest energy prices you and I will EVER see, thus putting a LOT of extra money in people's pockets, which we used to upgrade to Windows 98) and "bad" monetary policy.

I think Greenspan bought into the "New Economy" a little too much, and maybe should have increased rates a little bit more in reaction to the stock market bubble and historically low unemployment.

I realize that this isn't the Kudlow/ supply side explanation, but that's my explanation at this time. Fiscal policy can't explain EVERYTHING. I don't see how the bubble can be explained in any other way.

Eric Krieg writes:

>>Real interest rates were higher in the 80's than what they *otherwise* would have been due to the deficit.

Which, I think, is an uprovable statement. And I also think that if Rubinomics were strong, the 80's defecits would have driven real interest rates MUCH HIGHER. In fact, that did not happen.

Interest rates were being set by the market's expectation of inflation. As Volker and Greenspan were successful in their fight against inflation, both real AND nominal interest rates fell (not just in the '80s, but from 1980 to now, a time when defecits were all over the place).

Boonton writes:

>>Real interest rates were higher in the 80's than what they *otherwise* would have been due to the deficit.

"Which, I think, is an uprovable statement. And I also think that if Rubinomics were strong, the 80's defecits would have driven real interest rates MUCH HIGHER. In fact, that did not happen."

Welcome to economics, almost all of it is fundamentally unprovable. We can't replay the 1990's with the tax rates that Bush imposed in the 2000's. We can't replay the 80's with a balanced budget to see how things would have turned out.

This doesn't mean economics is just political spin with more mathematics. There are good theoretical reasons to think that budget deficits must crowd out private investment (and maybe consumption). More importantly, there are a limited of known reasons why this rule may not be applicable. Namely an economy operating below capacity can increase gov't spending without substracting from private consumption or investment.

If you want to reject the statement that 'the deficits of the 80's caused Investment to be less than what it otherwise would have been' then there are only a few paths that you can take and still make sense.

As for Ruban, I've argued elsewhere on this list that a good case has been made that the boom of the 90's was partially caused by special circumstances. At the start of Clinton's term, bank blanace sheets were very unstable being heavily invested in long term Treasury bonds. While demonstrating a desire to really control the deficit stimulated Investment with lower interest rates, it was the banks that made windfall profits as the value of their bonds soared. However since long term rates were falling banks had little incentive to reinvest their profits in more bonds so they started loaning again to the private sector.

This argument was put forth by Joesph Stigletz in the Atlantic Monthly, I'll find the URL again for anyone interested.

Eric Krieg writes:

The crowding out effect of deficits is insignificant at the sizes we are talking about (a "few" hundred billion dollars in a 8 trillion dollar economy, or whatever).

That is the criticism of Rubinomics. It makes deficits the be all and end all of fiscal policy, which is dangerous. Ask Herbert Hoover.

Seriously, Rubinomics could easily be called Hoovernomics. That's probably what Kudlow calls it.

Think about it. We have a pretty sizable deficit this year. What if our response were to raise the top marginal rate from the current 37% to 75% (what is was when Reagan was elected).

Maybe the deficit would be closed. But at what cost to the economy?

Look, I'm not a hard core supply sider. I don't say that deficits are irrelevant. Over the entire business cycle, I would like there to be no net deficit. But to be concerned with deficits during a recession is maddness. That's the mistake that Hoover made.

Boonton writes:

I think most of the educated concern (elitist if you will) has not been over the fact that the budget fell into deficit during this very mild recession but that the best projections show the budget went from eliminating the national debt to deficits as far as the eye can see.

We have long since departed from the hope that the deficit just represents the results of a mild recession, barring a long run super-economic bubble that's about to be inflated we are looking at locked in deficits forever. What effect will this have? I'm not really sure but I don't think it will be a good thing.

Eric Krieg writes:

>>We have long since departed from the hope that the deficit just represents the results of a mild recession

I don't agree with that sentiment at all. If we have gone from supluses as far as the eye can see to deficitis as far as the eye can see, it is simply the realization that the 1990's economy (and the capital gains taxes that it threw off) was an unsustainable bubble that won't be repeated anytime soon, if ever.

In any case, the deficit has started to decrease a little bit. It wasn't as large over the full year as expected, due to stronger economic growth.

Boonton writes:

Time shall tell but the reason for deficits as far as the eye can see is not just a collapse in tax revenue but also spending that is increasing not only faster than the economy is growing but increasing faster than the economy grew even during the height of the 90's 'bubble'. Even if your theory is correct that the 90's was unsustainable that doesn't excuse what appears to be a new long term visit by our old friend Mr. Deficit.

Eric Krieg writes:

>>Even if your theory is correct that the 90's was unsustainable that doesn't excuse what appears to be a new long term visit by our old friend Mr. Deficit

I can't argue with that. But remember that our national experience has been that deficits in and of themselves tend to restrain spending.

Boonton writes:

I don't see any evidence for that. Spending was more restrained in the 90's than today. The deficits of the late 60's and early 70's didn't seem to stop spending increases on either Vietnam or the Great Society.

I personally suspect that deficits probably encourage spending. It's like taking a bite out of the wedding cake....if you're going to take one you might as well enjoy a whole slice!

Eric Krieg writes:

http://www.nationalreview.com/nrof_canto/canto200310200839.asp

What we have been talking about!

Again, there is NO DATA to support Rubinomics.

Eric Krieg writes:

>>I don't see any evidence for that.

Remember Ross Perot? He got 19% of the vote in 1992, running against the deficit. The 1995 Republican Revolution was in part due to the deficit.

Boonton writes:

I noticed that the author of your National Review piece noted that there was no relationship between the 3 month Treasury Bill rate & the deficit. This is a rather stunning comparision because I thought the Fed used the 3 month T-bill as their peg for interest rates! In other words the 3 month rate is the one rate that is directly controlled by the gov't! How about a comparision between the 30 year *real* T-bond rate (which floats in the market) and projected deficits?

We come back to the Mises article (which I still recommend) and my simplier assertion: There is no free lunch. If the deficit is not connected to interest rates and real Investment in the economy then you have no mechanism that would limit a gov't's ability to spend any arbitrary amount over and above tax revenue.

In reality projected supply of T-bonds does move the bond market. In reality changes in the rates on T-bills and bonds does move other interest rates. Interest rates are a critical factor in determining whether or not to undertake an Investment.

The only way out of the free lunch trap is to recognize that the economy was underutilized in the 80's and therefore the deficit allowed consumption to increase without hurting Investment. While I'm willing to admit that an element of that may have been present I doubt the deficits of the 80's had no negative effect on Investment.

"Scheme"? Why, that's a type M word.....

rashx writes:

what's the relationships between consumption, icome and investment. can someone please explain. for me.

Hi, rashx.

Income is the easiest to understand: it's what people earn in a given period of time. In most economics discussions, we are talking about a year. We are also usually talking about the sum of everyone's income for a whole country. So, income refers to the sum for a whole country over the course of a year.

There are lots of ways to think about that sum. One way is to notice that the total of a country's income is the same as the total value of its output. After all, the income was earned by producing goods and services. The business owners sell those goods and services, and the resulting revenue is used to pay the workers, to pay for any capital items (machines, buildings, etc.), and to pay themselves. It all ends up as someone's income. Economists abbreviate that by saying that "income equals output."

Finally, output can be subdivided in various ways. One of the most common ways is to realize that most output can be classified as either a consumption good (meaning goods and services that are used up in the year in which they are bought), or an investment good (meaning new durable items--new capital--that will be used to help produce future goods and services). Economists summarize this by saying that "output equals consumption plus investment."

New machinery, reclaimed land, and education are all examples of investment. Food is an example of a consumption good. Some goods, like cars and houses, have features of both consumption and investment goods.

I've simplified a few things here by leaving out details like imports and exports, taxes and government spending, and borrowing and lending; but it turns out that those factors don't really change the basic ideas above. For more on investment, see Alan Auerbach's article in the Concise Encyclopedia of Economics at http://www.econlib.org/library/Enc/Investment.html

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