February 18, 2015

Nobody understands debt — including the shrinks

Comment on Lars Syll on 'Debt myths debunked'


The burden-of-debt problem has never been solved but only kicked around in a circle because both orthodox and heterodox economists are ignorant of an elementary methodological principle.

“There can be no doubt whatsoever that a problem which has not yet been solved in all its aspects under its simplest conditions will be still more difficult to tackle if other, ‘more realistic’ assumptions are being made.” (Morgenstern, 1941, p. 373)

What, then, are the simplest conditions? In the following the intro and mainly Nick Rowe's posts are used as references; see the links below.

In order to simplify and to secure common premises ...
• ... take the world economy for a start. This rules out foreign debt.

• Take Samuelson's awkward infinity out. The process consists of three phases: (i) taking up credit, (ii) holding the debt, and (iii) repayment. For a start, each phase consists of one period only. This keeps generations and bequests out for a while.

• For the beginning, the pure consumption economy has to be considered as a limiting case. There is no investment, no real capital stock, no disinvestment.

• The economy starts with full employment and zero profit. There is only wage income. Productivity and output remain constant. At first, there is no growth.

• Money, credit, and bonds have to be consistently integrated. Stocks and flows have to be kept properly apart. The banking system is represented by the central bank.

• In order to exclude distributional effects all agents get the same wage income, save/dissave the same amount, and pay the same income tax.

• In the initial period the household sector's budget is balanced, that is, consumption expenditures are equal to wage income; and the product market is cleared, that is, the quantity bought is equal to the quantity produced at the market clearing price.

• The government needs part of the current output in period t. The need is legitimate and undisputed.

Benchmark scenario: The government taxes the wage income in period t. Households reduce consumption expenditures in step. Gov fully spends income tax, that is, total consumption expenditures remain unchanged and the market clearing price remains constant. Both, private and public households fully consume their respective shares of output. There is no real transfer of goods between periods.

First scenario: No income tax. Households reduce consumption expenditures. Through saving the household sector's current deposits at the central bank increase. Gov takes up overdrafts at the central bank. Both sides of the central bank's balance sheet are equal. Gov spends overdrafts. Total consumption expenditures and market clearing price remain unchanged.

In period t+1 the private households buy government bonds with their current deposits. The central bank's balance sheet shrinks again to zero. Each household gets the same interest income and pays the same income tax, that is, net income remains unchanged and is fully spent. The consumption good output remains constant, the market is cleared. The households in effect pay interest to themselves. The public budget is balanced, no matter how high or low the interest rate is.

In period t+2 the households spend their unchanged wage income and pay the income tax through dissaving. Gov fully repays the debt.

In real terms there is absolutely no difference between the two scenarios. The private households get the same quantity of consumption good output in each period.

The individual household is subjectively wealthier in period t+1 and keeps its wealth in the form of interest bearing bonds. Taken private and public households together, ‘our’ total wealth, though, does not increase. Psychologically, however, private households become the ‘prudent’ savers/lenders, public households become the ‘reckless’ borrowers. The problem of creditworthiness emerges. Both, lenders and borrowers become sleepless.

What happens in the most elementary case is a deferred payment of income tax. This should make the households happy, but it does not. The deferment is forgotten and future payment becomes a burden. Finally — the ultimate horror — the households' wealth is taxed away.

In real terms there is perfect equivalence between immediate and deferred taxation. Psychologically, both modes are worlds apart. It's all in the heads.

Now it is possible to consider variants. First of all, of course, the distributional effects from the heterogeneity of agents. Second, public investment instead of consumption. Third, permanent revolving or full monetization of debt and zero interest. Tax evasion, corruption, etcetera.

For the second scenario with no income tax and no reduction of the private households' consumption expenditures, which is psychologically even more challenging, see (2015, Sec. 8.4).

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: Aggregate Demand. SSRN Working Paper Series, 2564590: 1–23. URL
Morgenstern, O. (1941). Professor Hicks on Value and Capital. Journal of Political Economy, 49(3): 361–393. URL

Links hereherehere, and here.