Structural vs individual poverty theories: A comment

Matt Bruenig has stirred up Noah Smith by laying out why life-coaching is a foolish way to address poverty, since most people churn into and out of poverty during their lives, meaning that most people already achieve what the life coaches are intended to achieve.

He characterises the debate about poverty as falling into two theoretical camps, individual or structural, and presents some data to make the case that poverty is a structural problem, concluding that 

Since the problem is structural, the solution must be structural as well 

Bruenig outlines the two theories as follows.

Theory One: Poverty Is Individual
The right-wing view is that poverty is an individual phenomenon. On this view, people are in poverty because they are lazy, uneducated, ignorant, or otherwise inferior in some manner. If this theory were true, it would follow that impoverished people are basically the same people every year. And if that were true, we could whip poverty by helping that particular 15% of the population to figure things out and climb out of poverty. Thus, a program of heavy paternalistic life contracts to help this discrete underclass get things together might conceivably end or dramatically reduce poverty. 

Theory Two: Poverty Is Structural
The left-wing view is that poverty is a structural phenomenon. On this view, people are in poverty because they find themselves in holes in the economic system that deliver them inadequate income. Because individual lives are dynamic, people don't sit in those holes forever. One year they are in a low-income hole, but the next year they've found a job or gotten a promotion, and aren't anymore. But that hole that they were in last year doesn't go away. Others inevitably find themselves in that hole because it is a persistent defect in the economic structure. It follows from this that impoverished people are not the same people every year. It follows further that the only way to reduce poverty is to alter the economic structure so as to reduce the number of low-income holes in it.

Smith doesn’t like this for some reason. He responds with a bunch of reasons why it bugs him, which I summarise as

1. The theories are not mutually exclusive and the dividing line is a bit arbitrary (his points 1, 2 and 5) 
2. We might not care about structural poverty because people can borrow to smooth consumption during periods they are in poverty 
3. There are measurement issues 

Bruening then responds.

My contribution to this discussion is to offer an analogy that might be useful in both explaining the problem to a broader audience, and narrowing down where the line between the two competing theories lies.

Imagine a highway full of potholes (structural holes on the road of life). At one end of the highway, people start their lives with certain endowments of vehicles (wealth), certain starting points, either near lots of potholes, or near smooth parts of the road (social capital), and certain levels of driver training (education). This is the structure, or the setup, of the situation in which individuals then make decisions about how to navigate the highway without falling into a pothole of poverty.

Even if it is technically possible that everybody could get along the highway without falling into potholes (which it may not be), it may require a great deal of effort not only for those with disadvantageous starting points and clunky vehicles, but a great deal of effort for those zooming along the fast lane in their Porsches, who may need to make space, give way, or lend a hand to make it happen for everyone.

Getting people out of potholes is not as simple, as many like to think, as telling the drivers of clunky old VW Beetles to stop hitting potholes. Some are really stuck; many get themselves out only to fall in the next one. No one wants to be in a pothole. 

So the trade-off is this. Either we

1. just keep yelling at people to drive around potholes, 
2. rely on passers-by to devote resources to getting everyone along the road by digging them out, giving way, towing if needed, 
3. or we systematically change the structure of the highway by filling in the potholes. 

Taking the last choice allows each individual more freedom to do as they please along the road of life without fear of landing in a pothole.

We might even start the race with more evenly matched vehicles, say, through inheritance taxes on those who start life with a Ferrari.

If we change the structure of the road, individual behaviour doesn’t matter in terms of potholes and poverty anymore. That's the approach we take to running actual highways. We don't pretend that having a road network full of potholes is fine, because people can make choices to steer around them. But when it comes to poverty such reasoning is all too common.

To borrow from the handbook of Bruenig reasoning we can think of the possible poverty solutions in terms of individual or structural changes as follows.

• Changed individual behaviour, no structural change - maybe 
• No changed individual behaviour, no structural change - no 
• Changed individual behaviour, structural change - yes 
• No changed individual behaviour, structural change - Yes 

Looks like the common factor that solves the poverty problem is structural change. Sure, we could technically say that it is a little bit of both, but that doesn’t help guide any policy solutions. Once you start along the road of blaming the individual, you can justify just about any economic and institutional structure. Why not make it even harder for people to get out of poverty? It is still their choice, and there is still technically a set of individual choices they could make to get out of poverty. But that's not at all helpful in solving the problem.

Most important chart in human history - debunked

Exponential growth is one of those things that confuses many people. Here's probably the best example getting traction in social media at the moment.

Thank you industrial revolution(s). Most important chart in human history right here. pic.twitter.com/xMbWpALiW4
— Michael Dearing (@mcgd) July 21, 2014

Notice that at this scale we know nothing apart from the general exponential shape of the curve, which is all that is communicated by representing the data in this way.

Similar exponential graphs have been used to support many ideas and predictions. Mostly these have to do with some kind of impending doom, or sometimes it is to do with an observation about the how unusual the period of recent history has been.

But the existence of an exponential trend tells us nothing about whether an imminent limit is about to be reached, or how a trend may progress into the future. It certainly doesn't tell us that recent rates of growth of a particular measure are unusual, because an exponential curve has the same rate of growth at all points.

To make my point I have a series of charts to show. Below I have plotted the exponential function 2^x/25 over different ranges of 1000 on the x-axis . Think of x as years AD to match this with the image in the tweet.

What do you notice?

Looking at the same function at different points in time produces the same shape. In fact the ‘hockey-stick’ effect, that suggests the recent period is unusual, is just as prominent 1000 years ago as it is today. Here we merely have a doubling of the indicator every 25 years, and that's what it looks like.

The lesson here is that at any point in history this same graph could be produced because the rate of growth is constant. It tells us nothing special about the current period.

But what about the likelihood of reaching a limit? Doesn't the exponential growth approach any limit more rapidly each period?

Sure, but we don't know whether this pattern is actually a logistic function rather than an exponential one. Notice in the graphs below that a logistic function can look very much like the exponential growth charts in the tweet. But rather than hit some catastrophic limit, the rate of growth slows as the limit gets closer. This type of function is commonly used to describe population dynamics, and with recently falling global population growth, it seems that such a pattern for human population growth is also likely.

Remember this next time you see an exponential graph that is argued to support an argument that there is something unusual about recent history, or that a sudden rapid collapse is imminent. 

Review: Bubble Economics (Soos and Egan)

Paul Egan and Philip Soos [1] have a new book out. It available for free here (pdf), and it’s called Bubble Economics: Australian Land Speculation 1830-2013.

Some reviews and reactions have started to flow in - locally, internationally, and even some critical reactions. This post gives my take on this very detailed and topical book.

A short review would go something like this: Read this book if you want a very rich long term view of Australia’s economic history, particularly regarding land use and land cycles, mining booms, taxation, banking and finance. Think of it as a reference book that brings together historical data, institutional context, and economic analysis in manageable sections that can be easily referred back to.

As an example of the scope of topics covered, Soos and Egan conclude with 57 (yes, 57) recommendations about tax reform, financial regulation, public policy, and economic practice which are derived from the analysis in earlier chapters. As expected, the no-brainer reforms are all in there - transition to land and resource taxation, improve macro-prudential regulations, consciously plan for counter-cyclical government spending, and adopt more secure rental tenancy controls. But they also take hints from a broad range of perspectives, suggesting, for example, the possibility of a job-guarantee style scheme popularised by modern monetary theorists.

The book consists of three sections - Australia’s Three Depressions, Understanding How Asset Bubbles Form, and Modern Australian Economic and Financial Settings.

Part 1 introduces the reader to a long term perspective of Australia’s economy and the asset cycles that dominate the long run trends. As its heading suggests, this section details the economic situation prior to, and during the depressions of the 1840s, 1890s, and 1930s. This is important historical context that we often ignore in modern debates about the business cycle.

I was particularly impressed with their research on the 19th century Australian economy. Since land was such a major component of economic activity in that era, the role of land prices and impacts of land speculation were even more pronounced.

One element dominating that process, which is not a feature of the modern cycle, was the privatisation of public lands by State governors, which, prior to the 1830s, involved discretionary gifts of land to private individuals. Later, lands were sold at auction into private possession. Although there was an effectively endless supply of land to the private sector by government through this auction process, there was still a massive land boom and bust cycle during that period. The chart below, taken from p14, shows the land bust of that era quite clearly.

You notice many similarities across Australia’s three depressions - an asset price boom, followed inexplicably by a bust where asset prices fall at the same time as turnover plummets. In the latter two depressions we can see a clear pattern of deflating prices across the whole economy (chart below), with retail prices falling around 35% in the 1890s, and around 20% in the 1930s. It makes you appreciate the automatic stabilisers that come with a larger government sector and the willingness to conduct counter-cyclical policy (including guaranteeing bank deposits). 

Part 2 of the book provides a number of perspectives on asset bubble formation. Soos and Egan detail a decent range of ideas from different schools of economic thought - from Minsky’s description of an economy with increasingly speculative uses of debt during stable periods which later stifle investment, to the many micro-economic behavioural explanations that result in speculative herding in the aggregate.

In this part I was impressed by the effort to clarify the role of economic rent, both as part of the economic cycle, but also as a permanent feature of political machinations. If one is to believe that the use of debt for speculation is an inherent driver of booms and busts, then one must consider the political situation that allows, or sometimes encourages, this to occur. Obviously speculative asset price booms are in the interests of the rentiers who gain immense value from the risks taken by new speculative entrants in their respective asset markets. I don’t think we can really understand why certain countries seem able to stabilise their economies so well, while others do not, unless we understand this political element.

For example, in the section about debt dynamics and asset price cycles Soos and Egan test the simple correlation between housing debt acceleration and changes in housing asset prices. For most countries where it is well known that housing bubbles formed during the 2000s boom, the correlation is very significant (see table below). But then we have a number of outliers - Italy, Austria, Germany and Portugal. This analysis, to me, generated more questions than it answered. For example, where can we look for explanations of the apparent asset price stability of these outliers. 

We know that Portugal suffered a housing boom and bust while Germany has seen prices a flat as a pancake. Could it be foreign euro buyers herding into Portugal’s housing market, which disguise the domestic relationship between housing debt and pries?

And what of Germany? Which part of the political or institutional structure can we emulate if we want stable prices? Does it matter that German housing is 60% rental, and there is a major institutional sector operating in the rental market? Is it their tax incentives that promote long term investment over speculation? Or all of the above?

At the end of the second part of the book Soos and Egan settle on their preferred model of asset price cycles that they call a synthesis of ‘post-Keynesianism, Georgism and behavioural finance’, which they present as a summary to this section. I find this synthesis compelling. Indeed, it seems quite obvious when you think about it (though I don’t know why Minsky was not acknowledged in the title).

But their treatment of this synthesis is a little vague for my liking; then again, I enjoy the nerdy technical details maybe a little too much. The reason I still like their attempt at reconciliation of theories is that it seems obvious to me that people are irrational in the pure sense used in economics, hence the behavioural element, and that if we are not in a static equilibrium, then we are in the dynamic world of the Post-Keynesians, and if debt can be used for speculation instead of productive new capital, a la Minsky, then we are in a Georgist world with economic rents as well as competitive markets in capital goods.

Lastly, Part 3 begins with 40 pages of detailed historical Australian housing metrics, some of which have been published in various articles around the web by the authors. This is followed by a similarly detailed treatment of Australian banks, where I took the main message to be that banks have become much more housing focussed in their lending operations than ever before.

In this part of the book Soos and Egan delve into trends in modern lending standards and cases of fraud. We get a brief introduction to the US situation of subprime lending and securitisation, then move back to Australia, with very balanced overview of the alleged widespread fraud of loan application forms by banks and brokers, which contributed to the rise of no-doc lending.

Soos and Egan’s refute the ‘urban containment hypothesis’ at the end of this part of the book, which does not come as a surprise. After all, once you have read a detailed account of the three Australian depressions that occurred prior to any town planning, one of which occurred in an era of essentially unlimited supply of land from government to the private sector through the land auction process, then it would seem strange to turn around and invoke planning as a key factor in the current cycle. Indeed, after reading this book you can’t help but see the current land cycle as one of the least volatile in our history. Soos and Egan make their point here very clearly, and bring very compelling evidence and logic to support their position.

While Bubble Economics deals mostly with events that occurred over a century ago, it is nevertheless a timely contribution to the public debate around land, banking and the business cycle in Australia. The book is very detailed and you may find the style a little dry, but as I said, best thought of as a reference book. Again, Bubble Economics is free and available here.

fn. [1] Readers may recognise Philip from his work assembling long term data on the Australian housing market. I’ll also disclose that I provided feedback on some draft sections from Part 3 of the book.

Krugman vs Bank of England (or QE bails out the rich)

I like Krugman. He takes a common sense approach to economics and writes clearly for a broad audience.

But, like others, I have to take issue with his insistence that quantitative easing (QE) and low interest rates punish the wealthy and fulfil some progressive distributional objective. In fact they achieve the opposite result.

Here is the crux of his argument.

But I now think that class interests also operate through a cruder, more direct channel. Quite simply, easy-money policies, while they may help the economy as a whole, are directly detrimental to people who get a lot of their income from bonds and other interest-paying assets — and this mainly means the very wealthy, in particular the top 0.01 percent.

He supports his case with this graph in a previous post showing the loss of interest income for the top 10% of households.

But if you are going to talk about distributional effects, you have to compare the whole distribution, not just the change over time of one cohort. Because this graph can show the exact opposite point if households in the lower income deciles have had their incomes decrease by more than this amount. In this case all it takes is for low income households to have a 5% lower real income in 2011 than 2007 and we end up with a net transfer towards the top 10%.

The simple problem here is that Krugman fails to observe the change in the value of assets and instead focuses merely on the cash-flow. It is a simple fact that any asset that is a promise of future cash flows will increase in price in a low interest rate environment compared to a high interest rate environment (holding all else constant). Even the RBA shows how this effect has been a major contributor to last decade’s Australian house price boom.

More over, low interest rates are even more of a transfer to those who are highly leveraged into asset markets - property, equities and so forth. Since they receive a double effect of lower borrowing costs and supported asset prices.

To be clear, the table below shows a basic example of an asset representing a right to a cash-flow of 5 each year (call is $5, call it $5million, it doesn’t matter for this purpose).

If the asset is purchased in the first time period, assuming for the sake of the argument that risks are perfectly captured in the yield, that there is no net positive return. You buy an asset yielding 5%, it costs you, in risk adjusted terms, 5% to buy it, so there is no economic rent to speak of here. 

Then in a later period the interest rate falls, and this asset is traded at a price reflecting a lower yield. That means the price has increased. Over the period when interests rates fall from 5% to 3% in this example, there has been a massive 67% gain in price of this asset, which can all be considered an economic rent.

We can also consider the case where the cash-flow is declines, which probably more accurately reflects the post-crisis situation. Here the cash flows, due to a downturn in real economic activity, are falling, but so are that traded yields (the interest rate), and hence the price is supported and owners of these assets gain from capital appreciation.

This is the exact scenario I see Krugman presenting. The cash-flows from owning particular assets have fallen, so interest incomes will be down for asset owners, but the prices have risen due to the interest rate adjustment. We see evidence of this all around with equities trading at record highs.

To be clear, this is not some absurd reasoning I just made up (although it does overlook the expectation of capital growth in prices to make a simpler point). The Bank of England has conveniently published a document outlining their view on the distributional impacts of low rates and their QE program.

Here’s how the Bank of England summarises the effects on wealth from quantitative easing

By pushing up a range of asset prices, asset purchases have boosted the value of households’ financial wealth held outside pension funds, but holdings are heavily skewed with the top 5% of households holding 40% of these assets.

Which is the exact opposite of Krugman’s point, since he overlooks the prices of assets altogether. And now the BoE’s take on how QE and low interest rates have affected bond holders

By pushing down gilt yields, QE has reduced the annuity rate. But the flipside of that fall in yields has been a rise in the price of both bonds and equities held in those pension pots. Another way of explaining this is that the income flows from a pension pot (dividends in the case of equities and coupons in the case of bonds) will not be reduced by QE. Indeed, if the pension pot contains equities, then the flows could even be higher as a result of increased dividend payments from the boost to the wider economy from QE.

There you have it. Low interest rates and asset purchases bail out the rich. I hope Krugman reads this and thinks more carefully, because he has a very wide influence in the public debate about these issues.

Are the LDP’s principles useful for policy-making? (No)

The big news in Australian politics has been the new rabble of Senators. David Leyonhjelm of the Liberal Democratic Party (LDP) is one surprise newcomer.

Leyonhjelm is desperately trying to differentiate himself and his party as one based on a set of principles that promote freedom in both economic and personal realms.

But every time I read or hear anything he says alarm bells ring.

I want to show in this post that the LDP principles he so feverishly promotes offer no guidance on making real political decisions that involve trading-off rights and responsibilities between different segments of society.

As a basic example, if I believed in the principle that football players should be free to make individual choices about their kicks, passes, and various strategies, within the rules of football, how does that guide me in the creation of the rules themselves? It merely assumes the existence of appropriate rules, yet the government, in this case football’s governing body, has the task of creating the rules.

Take another example. I believe in the freedom of drivers to choose their routes on the road. Okay fine. But that’s not going to help in deciding the rules of the road that allow people to cooperate to the degree necessary to ensure their freedom to choose. Should we have traffic lights? Stop signs? How will rights of way be decided or enforced? At every stage of these many decisions involved in rule-making there are trade-offs between groups to consider.

Even if you believe there should be no rule governing a particular behaviour on the road, that is itself still a choice that needs to be assessed against alternatives.

Let us now take a quick look at the principles of the LDP.

Economic Principles
• Free markets and freedom of choice
• Low tax, limited public spending and minimal regulation
• Widespread ownership of private property 

Social Principles
• Civil society and volunteerism
• Civil liberties and individual freedom
• Individual liberty and personal responsibility under the rule of law 

Government Principles
• Constitutional liberal democracy
• Ethical and impartial government under the rule of law
• Devolution of power including decentralised government and competitive federalism 

International Principles
• Free trade in goods, services and capital
• Free trade in ideas and culture
• Freedom and human rights

Their first economic principle is “free markets and freedom of choice”. Let’s pick it apart a little. The existence of any market, ‘free’ or otherwise, implies many things, such as private property, extensive contract and tort law, regulations against fraud, theft, bankruptcy, and many regulations governing externalities and so forth.

The government’s role is to decide which trade-offs are acceptable in the legal structures and institutions that allow any market to function. Having a principle that assumes the existence of a market of some sort doesn’t provide any guidance on what sort of legal structure will provide a more, or less, free market.

Minimal regulation is also a principle that doesn’t provide much guidance on how to write regulations. We know from many political exercises (for example in Queensland recently when the Newman government was elected), that legislation page-counts are no guide to the actual tangible impact on productive activity and organisation from a piece of regulation.

So how can this principle offer guidance on which legislation is minimal or not? What metric could be used to assess whether a regulation is minimal or not?

Then there is a principle of ‘widespread ownership of private property’. Really?

Think about it.

All private property is owned by definition. If you mean that just about every individual should own some portfolio of private property, then you have a problem, because that conflicts with the free market principles, which generally concentrate ownership of private property rights. It’s beginning to sounds a lot like ‘we want free markets only if they provide the outcomes we want’.

And if your free markets don’t provide this outcome, then what?

At every turn the LDP want to privatise public assets and abolish government service provision; in health, education, public utilities and transport, and just about everything else. It’s almost like market failures don’t exist, and that somehow granting various monopoly rights to vast parts of what was the public realm, would provide immediate and perfect equality of opportunity and harmony amongst citizens.

It’s the dream of rich old men; a utopia that no one with a sane mind would consider.

Okay, let’s move on to social policies; perhaps this is easier territory.

Again we see freedom professed as a guiding principle, only this time it’s personal. But aren’t all individual freedoms really two-sided? Ronald Coase explained this principle in much detail - that private rights are inherently arbitrary and two-sided.

Does the LDP believe in my freedom to walk the streets naked? Or does it believe in my freedom to walk the streets free of naked people?

Here’s one a little closer to home. The LDP policy on religion states they “Support the freedom of private individuals and organisations to apply religious tests for membership or employment”. But what about our freedom from such treatment?

The LDP have a firearm policy that is straight from the playbook of the NRA. ‘Good’ people should all have guns, so that ‘bad’ people cannot do ‘bad’ things. As if we all know exactly who is who at all times, and what is good and bad. And like all their personal freedoms, they neglect the freedom to live in an unarmed society.

Another principle-free principle to finishes off their social section - personal responsibility under the rule law. But again, by definition, the rule of law is what politics defines, and the law then defines personal responsibility. So how does stating that you want people to obey the law guide you in making laws?

Next, to the LDP’s government principles. Again, not much of substance here. Be ethical and impartial. Whose ethics? The LDP’s or the Labor Party’s?

The last point states something of a goal for the LDP. So I’ll let their competitive federalism stand.

The LDP’s international principles are some of the strangest. Their principle of free trade in ideas and culture, freedom and human rights, seems rather in conflict with Leyonhjelm’s comments about immigration - “some cultures are incompatible with our way of life”.

In the LDP policy on immigration they seem to want to crack down on ‘unauthorised’ arrivals, but promote ‘authorised’ ones. As if there is no debate about the laws that determine who is authorised and who is not.

So where’s the freedom and human rights? Where’s the free trade in ideas and culture. Or aren’t these really guiding principles at all?

My prediction is that Leyonhjelm will reveal in the coming years that his, and the LDP’s, beliefs in freedom are just as arbitrary as any other. They will pick and choose the freedoms they like based on their personal biases and appeals to their support base. This is nothing new in politics. It is the nature of the game. Just don’t fall for the idea that this party is principled.

A tribal ceremony: Reconciling the economics of debt

The sociology of economics is intriguing. While many observers note the tribalism of the discipline, with the mainstream tribe being the largest and most dominant, within that tribe itself there is surprising confusion about its unifying ideas.

In fact, if I was to be cynical, I would say many economists who attach themselves to the mainstream, in whatever specialist area that may be, are not interested in any consistency of ideas.

Also, many were taught economics in a way that never delved deep enough into the underlying assumptions that core models embody. Perhaps the effort to understand the mathematical representation of a model took away from effort to understand the conceptual ideas within it.

Unfortunately this set of circumstances is hindering efforts at reconciliation and consistency between economic tribes. I consider this post a ceremonial attempt at reconciling theories of debt across economic tribes.

In fact there are many concepts that are easily reconcilable (capital, uncertainty, emergent properties, savings, etc) but there are unfortunate incentives against unifying the discipline.

Debt

Currently there is much concern worldwide about debt. It is widely claimed that the mainstream economic community could not see a crisis coming because it fundamentally ‘looked through’ money and debt to the real economy. And since debt, or in fact the dynamics of debt, seemed an important factors in the crisis, this was a failure of the theory.

It is easy to agree with this critique. But to really understand it we have to disentangle all parts of it, and as we will see, there is an obvious way to reconcile the mainstream with the critique.

Household example

To begin, a theory of resource allocation is right to treat debt as an internal allocation mechanism of real resources in the economy.

In a my household, for example, I can lend my wife money to treat herself a new dress today. If we were accurately keeping internal household accounts that would be a transfer from myself to her. In real terms, my consumption of resources decreases and hers increases.

Next week the debt is ‘repaid’ according to our internal accounts when my wife lends me money to take the kids to the football.

When we look at our household as an aggregate entity, our total resource consumption is unchanged by the debt, which merely represents an internal reallocation.

There were no future resources brought forward for my wife to consume. The debt did not leave a cost to our children. Even if it was never repaid, I already paid for my household’s debt with the resources I didn’t consume when I transferred purchasing power to my wife.

It surprises me that on this crucial point the core mainstream concepts are consistent with the functional finance or modern monetary theory perspective, yet there remains animosity between these groups. I have come to believe that this is mostly a result of inadequate understanding of their own conceptual apparatus by the mainstream (here’s an example of how the noisiest mainstream commentators remain confused about their own theories).

Much of the mainstream has equated 'looking through' debt to the real resources of the economic with  ignoring the money creation aspect of debt altogether. This has lead to further confusion in the analysis of banking and economics generally, with the Bank of England recently having to explain the process to the economics community.

These core economic concepts are easily confused when one fails to properly understand the complete accounting of the system at all points in time. Specifically the use of overlapping generations (OLG) models can confuse more than inform, and many students come away from learning these models believing in the possibility of inter-temporal reallocations of resources.

OLG example

To labour the point, the errors made in understanding the concepts at play in debt are evident in the overlapping generations models (OLG) which is commonly applied in economics in order to understand various internal shifts in resource burdens. It can be easily misunderstood to show that debt enables resources to travel through time.

Abba Lerner made the argument I am about to make back in 1961, when he was President of the American Economic Association. He was pulling into line economists Thomas Bowen, James Buchanan, and others, on their acceptance of the political propaganda that debt can distribute burdens across time. You’ve all heard a politician claim that debts are ‘leaving a burden for our children’.

The mistake of Bowen and Buchanan arises because of their incoherent conceptual application of the OLG model. In the model they merely redefine the current generation to mean those who lend the money, and the future generation as the one who pays the money (principle and interest) back.

Let me try and represent the model as simply as possible.

There are two generations (which are simplified into two people) alive in each time period, the ‘old’ and ‘young’. Each lives for two time periods, being young in their first time period, and old in their second. In the table below, which I will use to explain this, the coloured (and white) shaded cells are the same people, or cohort.

Starting from a no debt baseline at period zero, the first period has the old borrow $100 from the young. It doesn’t real matter whether this a new money (how we think of bank debts), direct peer-to-peer transfers, or taxes and welfare spending, the net effect is that those who borrow are able to capture a share of resources in that period.

In resource terms the young transfer $100 of resources to the old. In period two the previous old generation has died, and the previous young generation is now the old generation (yellow table cells), and there is a newly born young generation (white table cells).

The new young cohort then repays the debts, giving up $100 of resources to do so, which are transferred to the now old generation who lent the money in the previous period.

As Lerner explains, if you label the newly born young generation in period two as the ‘future generation’, which lives from period two to three (shaded white) and the cohort who originally borrowed the money in period one, who lived from period zero to one (also shaded white), the ‘present generation’, you can see how a transfer through time seems to occur.

The ‘present generation’ sees a lifetime consumption from debt of +$100, while the ‘future generation’ sees a total lifetime consumption of -$100 from this debt repayment.

Labelled in this way it seems perfectly obvious that debt burdens are being passed along. But only if we artificially conflate the creditor and debtors with 'generations', which can't be done in general.

But of course, the reality is that the resource transfers occur at each point in time, not between times. As the final row shows, in each period there is an accounting balance in resource terms between borrows and lenders. It is only because of the artificial way lenders and borrows are identified by generations, and the necessity to eliminate the debt balance in the next period that provides the result.

Let’s have a look at an alternative, where the same debt is incurred, but repaid (if at all) only after all generations alive upon its creation have died (and the real interest rate is zero for simplicity).

As you can see, this time it is clear that the generation born in the zero period is simply using debt to reallocate from the generation born in period one to themselves. Given the institutional power, they could of course have taxed that generation instead in order to redistribute resources. It is the same net effect.

The generational structure of the repayment of debt at some future point, however, is indeterminant. I have made this clear by labelling the period four repayment of debt with question marks, since who pays who in resource terms in that period for debt repayment is by its nature a result of all institutional resource allocations, including most importantly tax and transfer system. This is the general case.

A final illustration shows that when we consider continual debt-financed redistribution, that the redistribution problem goes away entirely, since all people receive the same redistributions at the same stages of their life. The table below show a continually debt funded reallocation from young to old, with ever increasing debt levels, but no identifiable winning or losing generation.

If you are concerned about general welfare of all people living at any point in time, then you must consider debts as internal transfers at a point in time.

Before I conclude this section, I need to again be clear that identifying winners and losers from these internal debt transfers is not at as easy as bundling all debtors and creditors together and labelling them. The complex interactions of the complete system of internal transfers means we simply cannot isolate these two groups. In fact, it may be very possible if an individual to be a borrower and lender at any point in time.

If I have just borrowed money to buy a house I am a borrower of purchasing power, which is paid for by the community at large via inflation and taxation. But of course I too am part of the community and give up resources via inflation and taxation. Understanding the balance even at an individual level is nigh impossible.

For a policy maker the whole system of transfers in a given period is all that matters, whether this occurs via taxation, transfers, debts or inflation. This is exactly what the core of macro economics says - debts are transfers in resource terms, and therefore balance out in aggregate. But somehow this is easily forgotten when it comes time to talk about policy.

Levels vs rates of change

The level of debt within an aggregate is not systematically important in terms of investment and macro economics. It is, however, important in terms of internal distribution, of which it forms a small component.

But the way in which debt levels change over time is vitally important to understanding the investment and business cycle. The reason being that debts in the private sector are typically incurred in order to finance new capital equipment and construction. By the nature of our banking and financial system, the rate of change in lending is a very good indicator of the aggregate investment occurring in the economy.

Steve Keen has repeatedly made the point is that rate of change in private debt, and its derivative (which he call acceleration of debt, being the second derivative of the debt level with respect to time), are far better indicators of the direction of the macro economics.

So while debt is an internal allocation, because our banking system generally produces debt in order to finance real new capital investment, the rate of change in the debt level can be used to understand the level of economic activity in aggregate.

This point is very subtle, but important. There is no conflict between the view that ones can look through debt in terms of its role in static allocations of resources, while at the same time understand debt dynamics as important mechanisms for financing new investment and therefore determining aggregate demand and growth.

Sadly, some economics tribal leaders have failed to acknowledge these subtleties and merely prefer to fight each other over confusing interpretations of what can be consistent ideas about debt.

Foreign debt

Finally, the mainstream economics tribe usually has divergent opinions about different forms of debt. Foreign debt gets relabelled as foreign investment and miraculously becomes a great thing. But of course this is the only type of debt where a country in aggregate is borrowing externally.

It is the type of debt most loved by economists in general, but the only one in which countries like Australia are generating future obligations to an external party.

The same rationale as before applies to foreign debts - the distribute role of levels versus the investment role of debt dynamics. Foreign debts are a resource transfer at a point in time. We can only accumulate foreign debts by running a deficit in the current account, typically by importing more goods than we export. Hence, in resource terms, we get the transfer from our imported resources.

The investment role here is far more subtle, because unlike domestic lending, there is not necessarily a close relationship between the creation of debts and new capital investment. But I won’t unpick this point any further in this post.

The point I want to make is that unlike internal debts, international debt balances are much more politically interesting. The two (in fact many) parties have different objectives, institutional constraints, and a complex web of non-monetary relationships such as military alliances, and resource interdependencies, such as reliance on either food or minerals imports.

Any questions about external debt are therefore inherently political.

One could construct a hypothetical baseline with which to compare and make judgements about external debts. This baseline would have a hypothetical market generate a relative currency value at a level that maintains a current account (and therefore capital account) balance. We only trade goods for goods in this scenario. In fact, it is a ‘no foreign debt’ scenario.

What we then need to determine is what benefits a country gains by deviating from this baseline over an extended period. We know that depressing a currency increases foreign demand for tradable goods, and therefore enables more rapid large scale investments in these sectors if there is sufficient internal organisation.

This has been a recipe for development in East Asia for the past many decades, and the subject of much political discussion and intervention (eg. the Plaza and Louvre Accords).

On the other side of the baseline we have countries like Australia that have run trade deficits and current account deficits in general for half a century. The benefits to such countries are short term gifts of relatively cheap tradable goods, at the cost of long term investment in those sectors.

Over time foreign debts have the surprising effects of generating greater reliance on each party for continued stability. In Europe we can see that ignorance of this fact is bringing down the area as a whole.

It should be obvious to any economist who understands their theoretical apparatus that the very existence of foreign debt is a sign of a political will on both sides to sustain an imbalance for their own national objectives. There is no need to continue looking at residual measures of productivity or technology or other magical explanations to understand what is ultimately a political construct.

Conclusions

Debt is a fundamental accounting feature of the monetary system. Economists used to know that they ‘looked through’ these accounts at real resources, and hence were able to see debts as merely the consequence of an internal reallocation. This lead most to believe that debt balances and their dynamics were of no interest at all.

Unfortunately, the discipline has seen a decline in the understanding of core concepts and theories, which I put down to a greater emphasis on a narrow set of mathematical techniques instead of their economic application and interpretation.

Yet there is a clear consistency between looking through debt levels as merely an account of past distributive choices, and paying very close attention to the dynamics of debt in relation to investment decisions, aggregate demand, asset prices and economic growth. Because private debts (and a portion of public debts) are, by the nature of lending processes, used for investment, their dynamics are both a signal of demand, and a driver of demand via feedbacks in the economy.

The inability to see this obvious consistency I believe is brought about by the perverse incentives in the discipline and its sociology that rewards loyalty to a tribe, and punishes attempts at reconciliation between tribes.