Saturday, September 5, 2009

Two views on budget deficits

The Wall Street Journal this morning covers the efforts of David Walker, former Comptroller General and current president of the Peter G. Peterson foundation, to rein in both short and long-term deficits.

On the other hand, Conor Clarke writes at that it's not a big deal to hand over big debts to our kids and grandkids since they'll be better off than present generations in any case.

To come to any kind of conclusion on this type of question you need two things: first, some idea on how big the effects of low saving and high debt will be on future Americans; and second, your own judgments on how to value your kids' and grandkids' well-being relative to your own.

Regarding the first question, the steady state level of economic output per worker (which we'll call here y) depends on the saving rate (s), the rate at which existing capital depreciates (δ, or delta), the rate of population growth (n) and the capital share of output (α, or alpha) which is usually around 1/3rd, with the rest flowing to labor.



Let's start by assuming a saving rate of 15 percent of output, with a depreciation rate of 4 percent, population growth of 1 percent and a capital share of 1/3rd, or 0.33. That gives us a value of 1.7, which by itself isn't all that meaningful. But now let's lower the saving rate to 5 percent. That reduces output per capita to only 1, which is about a 35 percent reduction. Even if saving drops by 5 percentage points output per worker declines by around 17 percent. Clearly, the saving rate can have a pretty big effect on the future standard of living.

Now, Conor's point is that in addition to the effects of saving we have the effects of technological growth, which can grow the economy even if saving is low. Roughly speaking, saving equals more tools while technology equals better tools; think of lots of pick axes versus one steam shovel. If technology improves at a rate of 1 percent per year, then people fifty years from now will have incomes two-thirds higher than today.

Conor assumes that the saving rate is unrelated to the rate of technological growth, which is true in a traditional Solow economic growth model though not necessarily so in the so-called "new growth theory." While this is far from settled ground, there's a plausible story to link saving and technological innovation: investment can fund physical capital or it can fund research and development; presumably, if lower saving reduces investment then it will have an effect on both ends. So I wouldn't be a sanguine as Conor about where we'll end up in a low saving economy a couple decades hence.

My own value judgment is that we should treat future generations more or less the same way that past generations treated us. Prior generations passed on to us a large stock of capital that's helped generate high incomes for today's Americans. It seems a bit churlish to say we're simply going to spend that down for our own benefit rather than keep the cycle going. But again, that's a value judgment.

1 comment:

JG said...

Hey, Paul Krugman's given us two completely different opinions all by himself.

"I'm terrified!". No, wait, he's "sanguine".

Krugman versus Krugman on the debt.