The cost of US fiscal imbalance

It is obvious that the US government is currently spend more than normal. It is also obvious that the current level of deficits is not sustainable. But just how bad would it be if the current fiscal imbalance would be maintained? We have models that can calculate welfare costs of such policies, but because the current policy is not sustainable, it is impossible to solve them and get a number. The only solution we can have is to look at what it would cost to delay going back to a sustainable path.

Bertrand Gruss and José Torres do with a heterogeneous agent DSGE model. According to their results, postponing the return to a sustainable path (defined by a pre-crisis debt/GDP ratio) by two decades leads to a permanent loss of output of 17% and a consumption equivalence loss of 7%. That is gigantic. The losses come mostly from the long run, thus it is all about whether the short-term gain is worth the long-term cost. To understand this result, it is thus important to understand the model.

This is a model of occupational choice (entrepreneur/worker), with idiosyncratic employment risk, no borrowing at the individual level, distortionary taxation and lump sum government transfers. There is another public good, wasteful government spending. A major role of the government is thus to insure agents against shocks, which they can also self-insure with accumulating Treasury bonds. Everybody knows exactly the path of policy. There is no aggregate shock except for fiscal policy. To summarize, the only beneficial thing the government does is insure people against shocks, to some extend. Otherwise, the government is harmful: it takes away goods to destroy them and distorts household choices in adverse ways to finance this. It is then no surprise that almost any government spending is harmful, no matter what the circumstances. In particular, the fact that there could be, for example, a temporarily very high unemployment rate that justifies larger public expenses is ignored here.

In other words, the model ignores the potential benefits of current deficits. Not very useful.

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