Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.

Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:

One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“

There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.

Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.

Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.

But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.

Fareed Zakaria asks Ferguson:

“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”

Ferguson’s reply:

The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.

Finally Fareed asks the question everyone wants to know:”What the hell do we do?”

Ferguson:

One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.

Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.

The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.

Discussion Questions:

1. Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
2. How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
3. Do you think investors will ever totally lose faith in US government bonds? Why or why not?
4. In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?

To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:

Related posts:

1. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
2. “The Ascent of Money” – Economic historian Niall Ferguson on the Colbert Report
3. Loanable Funds vs. Money Market: what’s the difference?

For many years now, Chinese authorities have artificially intervened in the foreign currency market by buying up U.S. dollars spent on Chinese products and, in turn, investing those same U.S. dollars in U.S. treasury securities. For those that are students of the foreign currency market, Chinese authorities buy U.S. Dollars and supply Chinese Yuan to the foreign currency markets for the sole purpose of depreciating (weakening) the Yuan relative to the U.S. Dollar, thereby helping Chinese exporters to become more price competitive.

So while it is true that this action taken by Chinese authorities depreciates the Yuan and appreciates the Dollar, thus, unfairly harming U.S. exporters; it is also hitting the “sweet spot” by sending those same U.S. dollars back to the U.S. federal government to fund the record federal deficit spending. This action by Chinese authorities helps keep U.S. interest rates lower than possible during this important U.S. economic recovery time and provides a great source of lending for U.S. government’s $800 Billion stimulus bill and the expensive Federal budget.

In summary, it seems to me that in the short term the United States should consider not complaining, as Treasury Secretary Tim Gheitner has done on several public occasions. Perhaps Gheitner should keep quiet for now and should start complaining again to the Chinese in about three or four years, after the proposed Obama budget no longer calls for such large deficits.

What do you think?

Related posts:

1. Exchange rates, currency manipulations, and the balance of trade
2. China’s Vice Premier talks basic economics
3. Excuse me, China… could you lend us another billion?

On the micro level, the only way to consume beyond ones income is to borrow from someone else to pay for the additional consumption. In other words, savings must be negative for one to consume beyond his or her income. The US is a nation of borrowers, but from whom do we borrow? China, for one…

China is a nation of “savers”, where national savings averages 50% of income. What exactly does this mean? Well, just the opposite what negative savings means; rather than consuming more than it produces, the Chinese consume only about half of what it produces. Here’s how James Fallows, a Shanghai-based journalist, explains the China/US dilemma:

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

What happens to the rest of China’s output? Naturally, it’s shipped overseas for Americans and others in the West to consume. The irony is that the consumption of China’s products has been kept affordable and cheap thanks to the actions the Chinese government has taken to suppress the value of the RMB, thus keeping its products cheap and attractive to American consumers.

When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.

When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).

Clearly, a strong dollar is good for America in many ways. The dollar’s strength in the last decade can be credited partially to the Chinese, who have been buying dollar denominated assets in record numbers over the last seven years.

By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion… Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world.

China’s purchase of American assets keeps demand for dollars on foreign exchange markets strong, thus the value of the dollar high relative to other currencies, allowing American firms and consumers the benefits of a strong dollars described above.

As we learn in AP Economics, a nation’s balance of payments consists of the current account, which measures the difference between a country’s expenditures on imports and its income from exports (China last year had a $232 billion current account surplus with the US, meaning the US bought more Chinese goods than China bought of American goods), and the capital account, which measures the difference between the inflows of foreign money for the purchase of real and financial assets at home and the outflows of currency for the purchase of foreign assets abroad. In the capital account, China maintains a deficit (meaning China holds more American financial and real assets than America does of China’s), to off-set its current account surplus.

The two accounts together, by definition, balance out… usually. Any deficit in the China’s capital account that does not cover the surplus in its current account can be held as foreign exchange reserves by the People’s Bank of China. The PBOC, however, prefers not to hold excess dollars in reserve, as the dollar’s value is continually eroded by inflation and depreciation; therefore it invests the hundreds of billions of excess dollars it receives from Americans’ purchase of Chinese goods back into the American economy, buying up American assets, with the aim of earning interest on these assets that exceed the inflation rates.

The “assets” the Chinese are using their large influx of dollars to buy are primarily US government bonds. The government issues these bonds to finance its budget deficits (when government spending is greater than tax revenue; this figure was projected at around $400 billion this year alone!), and the Chinese are happy to buy these bonds for a couple of reasons: They are secure investments, meaning that unless the US government collapses, the interest on US bonds is guaranteed income for China. That’s one reason; but the primary reason is that the purchase of these bonds puts US dollars that were originally spent by American consumers on Chinese imports right back into the hands of American consumers (via government spending or tax rebates), so they can continue buying more Chinese imports.

The Chinese demand for dollar denominated financial assets, including government bonds, corporate stocks and bonds, and real assets like real estate, factories, buildings and so on, has resulted in a long period of a strong dollar. If the Chinese ever decided to stem the flow of dollars into American assets, the dollar’s value would plummet to record lows, leading to high inflation and eventually a balancing of America’s enormous current account deficit with China and the rest of the world.

However, a falling dollar is the last thing China wants to see happen, for two reasons: One, it would make Chinese imports more expensive thus less attractive to American households, thus harming Chinese manufacturers and slowing growth in China. Two, US dollars are an asset to China. Its $1.4 billion of US debt would evaporate if the dollar took a major plunge. To China, this would represent a loss of national wealth; in effect all that “savings” that makes China so unique would disappear as the dollar dived relative to the RMB. For these reasons, it seems likely that China will continue to be a willing buyer of America’s debt, thus the financier of Americans’ insanely high consumptive lifestyle.

Discussion Questions:

1. Many people in America are terrified that the Chinese might dump their dollar holdings. What would happen to the value of the US dollar if China decided to change its foreign reserves to another currency?
2. Why is it very unlikely that China will do this? In other words, how does the status quo benefit China as well as the US?
3. How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
4. Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?

Related posts:

1. Exchange rates and trade: a delicate balancing act, currently out of balance!
2. China’s “silver bullet” – a strong RMB could solve her biggest economic woes…
3. “What’s sinking the dollar?” – for IB students

Newsweek international edition editor Fareed Zakaria explains in clear terms the root causes of the United State’s economic hardships. Simply put, Americans have lived beyond their means for far too long.

When a household, a firm, or a national government spend more than it earns (in income or tax revenues), it must borrow to do so. The only problem with this type of deficit financed spending is that at some point “the only way people will keep lending you money is that you have to pay higher and higher interest rates…” This, according to Zakaria, is why the US economy has begun to slow down. Higher interest rates make borrowing and spending less and less attractive, while making savings more attractive.

Savings rates have started to rise in America as our debts have come due. Higher savings means less spending, less spending means weak Aggregate Demand, which means slower growth and rising unemployment. There you have it, the root cause of our economic meltdown. Americans have spent beyond their means for far too long; the question is, have we learned our lesson? Will our current hardships teach us to spend more responsibly in the future?

Related posts:

1. Those who foresaw the meltdown…
2. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
3. How big is the government spending multiplier in America? Well, it depends on which economist you ask…

Assuming you have read my previous post (“U.S. Financial Crisis! What Is Really Happening?”) on this topic posted last week on this blog site, a related and logical question might be who is most to blame for the unfortunate economic situation we find ourselves in?

As you can imagine, there is plenty of blame to go around! Republicans are blaming Democrats and Democrats are blaming Republicans. Many are blaming household decision makers, greedy executives, and bank regulators “asleep at the switch”. In short, everyone is blaming everyone except for themselves. I have yet to see one person blame themselves, their agency, or their companies!

I see the answers to the “who is to blame” question as a 6-point answer. Keep in mind that these 6 reasons are strictly my opinions and many would either disagree or add to the list:

1. Imprecise regulatory law allowed the financial institutions to carry too high a ratio of mortgage-backed securities to collateralized debt.
2. Banking regulators (Banking Committee, FED, Regulators, etc.) should have screamed louder earlier! Although there are many documented attempts from specific people that did warn of this problem it was more a whisper than a scream.
3. Private lenders (and their CEOs) got greedy either lowering or violating their own lending standards in hopes of making more interest income by loaning to people who were very risk bets.
4. New law had been passed several years ago, urging that Fannie Mae and Freddie Mac make more loans to lower income households that carried much more risk.
5. Households borrowed more than they could afford. Citizens that borrowed need to share the blame with lenders, although I place lenders at a higher standard than borrowers.
6. New accounting regulations under Sarbanes Oxley (regulation passed after Enron) are too conservative causing assets like mortgage-related securities to be valued less than their economic value (true worth), which caused the bank debtor run on the bank.

Yes, there is a lot of blame to go around on this one! If there is any good news it is the hope that new regulation and oversight will occur in our “mixed” economy to help prevent this from ever happening again. Of course, there will be many other “next problems” but, hopefully, we will learn from our mistakes!

Discussion questions:

1. Who do you believe is most to blame for the circumstances leading up to this bailout?
2. Have you remained unbiased in learning that this issue is neither solely a Republican nor a Democratic issue?
3. Which presidential candidate gave you the most comfort as to how he explained his views on the bailout?

Related posts:

1. Robert Reich – the financial bailout represents “the worst type of trickle-down economics”
2. The Costs of the Bailout, More Government Debt
3. McCain and the Republicans: fiscal conservatives? Think again…

How timely, just as my year 2 IB Economics class is studying the pitfalls of expansionary fiscal policy in times of economic slowdowns. Now, many critics would say that Clinton was the luckiest president of recent decades as he happened to ride a wave of technological innovation fueled by the internet that led to unprecedented grown in income and tax revenue during the 1990s. Sustained 5% growth combined with a period of relative peace on the foreign fronts in between the two Gulf Wars allowed Clinton to balance the budget and begin putting a dent in the country’s $3 trillion deficit during his final years in office.

Along come the “fiscally conservative” Republicans and their faithful leader GWB, just in time to evaporate our budget surplus and add $6 trillion to our national debt over the next eight years. Today, after a long period of “fiscal conservatism” the debt stands at $9.3 trillion, and last year’s budget deficit of $400+ billion broke a record for the largest gap between tax revenue and government spending in US history.

Yeah, you can blame it one the times: a War on Terror costing the US roughly a billion bucks a day, a slowdown in new technology creation, diminishing returns on internet investments, out-sourcing of American industry and jobs, yada yada… but the cartoon does hold some truth. The Democratic Party, long labeled as the “tax and spend liberals”, managed to do what few other administrations have done since the ’60s in balancing the budget, proving that the old stereotype is simply wrong.

Some now consider the Democrats the fiscally conservative party, based only on the simple observation that they tend to spend closer to what they collect in taxes. The Republicans, on the other hand, have had no qualms about spending what they DON’T collect in taxes, in other words, running up huge budget deficits through borrowing from the public and abroad. Are the Republicans the an even worse incarnation of the “tax and spend liberals”? Are they the “DON’T tax and STILL spend Conservatives”?

Discussion questions:

1. How did the Bush administration’s $160 billion “fiscal stimulus package” that sent $600 checks to every American worker demonstrate the Republican party’s willingness to deficit spend.
2. What effect will deficit spending by the government have on interest rates and private investment in the economy? What is this effect known as?
3. In times of weak aggregate demand, as in the US earlier this year, what sort of approach would a “supply-sider” recommend as an alternative to Bush’s deficit-financed expansionary fiscal policy?

Related posts:

1. The “teenager tax” – why expansionary fiscal policy just ain’t fair!
2. SAS student Alice Su critiques John McCain’s tax plan
3. Regressive or progressive taxes: Which road to follow towards fiscal discipline?

The shear magnitude of the U.S. national debt ($9.4T), coupled with alarmist comments by the U.S. Congress and the American press lead most Americans to conclude that our country is in a very precarious position and has perhaps grossly mismanaged its financial affairs. Moreover, more Americans are becoming aware that future Federal payouts for social security and Medicare alone, assuming current benefit levels, will rise at a much faster rate than the current tax revenues for those same social programs.

Well, guess what, I am here to tell you the concern is vastly overstated!

THE IMPORTANCE OF DEBT TO A COUNTRY (OR AN INDIVIDUAL)
Contrary to what many Americans believe to be conventional wisdom, debt is actually a beneficial and recommended pursuit, if used correctly, since it enables a nation or an individual to equalize income and expenditures over time, and improve standards of living earlier than what would otherwise be attainable. It is easier to accept this premise on the personal front as millions of Americans have been able to improve their standard of living currently by pulling their future incomes forward via borrowing to purchase homes, cars, and education. Of course, we all know that debt, like a car, can cause damage if it is not used and managed wisely, and that is where many alarmists focus, and even some go so far to say that all debt is bad and should be avoided. Many nations, with Russia being a prime example, have been criticized by noted economists for not utilizing enough national debt to improve their economy and their citizens’ standards of living. Thus, hopefully, with a conclusion that debt can actually be a ”good thing”, if used for productive purposes, one can then proceed to the next section as to what are acceptable levels of national debt.

$9.4T: AN ACCEPTABLE LEVEL OF NATIONAL DEBT?
The United States’ current level of national debt is both affordable and consistent with most all other nations. National accounting statistics show clearly that the U.S.’s 67% national debt/GDP percentage is roughly average compared with other modern economies, about right smack in the middle. Moreover, the level of U.S. national debt as a percentage of GDP (67%) is at the same ratio as it was back in 1997 and 1992, and is much less than it was in 1950! The ‘”trick” is that debt must be benchmarked to the size of a nation’s economy or income. I find it interesting that if I tell someone that Bill Gates owes someone $10M they quickly deduce that he’s probably fine, but if I tell the guy at Starbucks that the U.S. owes $9.4T they think the country is screwed up!

 One additional benchmark is to compare the annual interest paid on the U.S. national debt ($0.4T) relative to current U.S. federal tax revenue ($2.8T) to the percentage of household interest paid as a percentage of household disposable income. Both benchmarks are currently at a 14% ratio indicating that Uncle Sam’s (U.S.) debt load is actually very consistent with Uncle John’s (households).

Much has also been made of the fact that $2.4T of the U.S. national debt, or 26%, is owed to foreigners. Big deal! It sounds scary on the surface, but once you understand it is pretty harmless. Let me explain. Foreign debt is nothing more than saved U.S. dollars which will eventually be spent back into our economy. Foreigners have temporarily not purchased our products (foreigners have U.S. dollars because we bought their products!) and have temporarily lent their dollars to the U.S. Government to finance the U.S. Government’s deficit spending. Debt held by foreigners is “dollar savings” just like debt held by American citizens is “dollar savings”, so, in other words, it is really not that important whether the debt is held by foreigners or US citizens since eventually those dollars will be spent back into the U.S. economy since they can’t be spent in another economy! By the way, the U.S. national debt owed to China is only 5% of the total debt but the newspapers make it seem like 50%.  

SO IT MIGHT BE AN ACCEPTABLE LEVEL OF U.S. NATIONAL DEBT NOW, BUT WHAT ABOUT THE FUTURE?
Many have argued that the U.S. aging population coupled with the flood of “baby boomers” moving into their retirement years will cause social security and Medicare alone to “shoot through the roof” and cause the U.S. national debt to reach unacceptable and unmanageable levels, potentially, some say, even bankrupting the U.S. Government. Many use extrapolations of future social security and Medicare payments out into varying distant futures based on the number of retiring baby boomers and increasing life spans concluding that there are trillions of unfunded government obligations ($10T, $25T, $80T, etc.) which are insurmountable. The problem with most all of these analyses are that they fail to address how simple and relatively small adjustments make these problems disappear. For example, on social security, an increase in the social security tax rate from its current rate of 12.4% (6.2% for employees matched by employer) to 15.9% is deemed by one source to fully fund social security at today’s benefit structure out into perpetuity (i.e., forever). Similar analyses are out there for other actions such as updating social security retirement ages to be more consistent with longer life spans. Now granted, few would be happy with a 28% increase in their social security taxes paid or later retirement ages, but what will likely happen will be a combination of different types of changes including reduced benefits, higher taxes, later retirement ages, and reallocations of the overall federal budget.

CONCLUSION
Today’s current level of U.S. national debt is within our government’s means, is an “average” level of national debt compared to other modern economies, and has been an instrumental and, thus far, a necessary part of our country’s economic success. One should never be concerned with the increase in the nominal or absolute amount of the national debt, but rather it should be measured in relation to the corresponding growth in our nation’s economy, usually nominal GDP.

The U.S. economy has some sizable challenges ahead in terms of keeping our increasing national debt in line with increases in our economic growth. Most notably, our demographic trends of fewer births and increased retirees with longer life spans will put additional strains on our country’s debt/income relationship.

One needs to be aware of the increasing number of doomsayers and alarmists who quote projections that are too one-sided and do not paint a fair picture of our challenges ahead. Within the next several years, relatively small changes involving increasing tax rates, lowering government spending, redefining retirement & health benefits, and delaying eligibility of benefits to coincide better with increasing life spans will be necessary to position America into the future.

Related posts:

1. The “teenager tax” – why expansionary fiscal policy just ain’t fair!
2. Excuse me, China… could you lend us another billion?

Tim Harford, aka The Undercover Economist, loves to expose the overlooked effects of governments’ economic policies. For example, both the United States and the UK have recently announced tax cut and rebate plans aimed at putting hundreds of dollars back into the hands of taxpayers, with the hope that households will spend their “free money” from the government, giving the national economies a much needed boost in a time of economic slowdown.

Expansionary fiscal policy, as such a tax cut is known, is a popular tool in times of macroeconomic slowdowns. The hope, of course, is that taxpayers who experience sudden fiscal relief will rejoice upon their newfound disposable income, spending it on goods and services, creating new income for various sectors of the economy, which in turn will be spent on more goods and services. In economics, we call this the “multiplier effect”, the idea being that a certain tax cut (say $150 billion), will ultimately create some multiple of that amount in new spending and income throughout the economy as a whole.

In reality, however, house holds do not spend 100% of a tax rebate or tax cut like those recently passed in the US and the UK. When disposable income increases, household will spend a certain proportion and save or pay off past debts with the rest. The proportion of new income spent is determined by an individual’s marginal propensity to consume, and the proportion saved is based on his or her marginal propensity to save. The greater proportion of additional income that is spent, the larger the multiplier effect in the economy as a whole, and the greater impact expansionary fiscal policy will have towards achieving growth in the economy.

Policy makers, therefore, prefer households spend, rather than save, new income from a tax cut or rebate. According to the Undercover Economist, however, saving a tax rebate is precisely what smart households will do. Why? Because of the basic economic truth learned in the first week of most principles of economics courses: There’s no such thing as a free lunch! Tim Harford explains:

…since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

A tax rebate financed through government borrowing does not make American or British households any better off. Imagine a scenario where your buddy is experiencing some financial difficulties (maybe he’s lost his job, maybe he’s experienced an expensive injury and has no health insurance…), so you decide you’ll help him out by throwing some cash his way. The catch is, you’re already in debt and have spent more in the last couple of years than your actual income should have allowed. So, in order to help your buddy out, you actually need to borrow money from him. So you give him an IOU, he scrounges up the little cash he can find, gives it to you for the IOU, and you turn around and give it back to him to “help him out.” You can imagine, your buddy is not very thankful and certainly doesn’t feel any richer.

On the macro level, the cash mailed out to American households as part of the recent stimulus package came from new borrowing by the government from American households. All those IOUs issued to finance the stimulus must be paid back, and must be done so through future tax increases. The government has chosen to forgo future spending in order to stimulate current spending. Not everyone should dismay, however, as a certain lucky group will clearly benefit from today’s debt-financed fiscal stimulus packages:

…some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

A tax cut today almost certainly implies a tax increase tomorrow. Since teenagers enjoy almost none of the tax cuts today, but will bear the future increases required to pay back new debt, it is you, my students, who should be most opposed to the shortsighted policies being undertaken by US and UK policy-makers.

Related posts:

1. Fiscal policy and the “vicious” business cycle
2. Fiscal Stimulus package passes in Congress – here comes $170 billion, America!
3. McCain and the Republicans: fiscal conservatives? Think again…