PHILADELPHIA REFLECTIONS
Musings of a Philadelphia Physician who has served the community for six decades

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Whither, Federal Reserve? (1) Before Our Crash
The Federal Reserve seems to be a big black box, containing magic. In fact, its high-wire acrobatics must not be allowed to fail. Nevertheless, it may be time to consider revising or replacing it.

Five Macroeconomic Myths

{top quote}
It's a myth that Government debt is a burden on our grandchildren {bottom quote}
Wall Street Journal

Myth No. 5: Government debt is a burden on our grandchildren. There's no better way to get people worked up about something than to call on their sympathies for their beloved grandkids. The last thing that I want to do is to burden my own grandchildren with the sins of profligacy. But we should stop feeling guilty -- at least about government debt -- because we are in better shape than conventional wisdom suggests.

Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. This assumes 1% population growth, 2% productivity growth, 4% real after-tax return on investments, and that people work to age 63 and live to age 85. Currently, privately held public debt is about 0.3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt.

What's going on here? There are not enough productive assets -- tangible and intangible assets alike -- to meet the investment needs of our forthcoming retirees. The problem is that the rate of return on investment -- creating more productive assets -- decreases as the stock of these assets increases. An excessive stock of these productive assets leads to inefficiencies.

{W.P. Carey School}
W.P. Carey School

Total savings by everyone is equal to the sum of productive assets and government debt, and if there is an imbalance in this equation it does not mean we have too little or too many productive assets. The fix comes from getting the proper amount of government debt. When people did not enjoy long retirements and population growth was rapid, the optimal amount of government debt was zero. However, the world has changed, and we in fact require some government debt if we care about our grandchildren and their grandchildren.

If we should worry about our grandchildren, we shouldn't about the amount of debt we are leaving them. We may even have to increase that debt a bit to ensure that we are adequately prepared for our own retirements.

* * * There are at least three lessons here. First: Context matters. Take what you read in the paper with a many grains of historical salt. Second: Current data often provide poor guidance for effective policy making. To make forward-looking policies you have to understand the past. Finally: Establish good rules, change them infrequently and judiciously, and turn the people loose upon the economy. Booms will follow.

Mr. Prescott is senior monetary adviser at the Federal Reserve Bank of Minneapolis and professor of economics at the W.P. Carey School of Business at Arizona State University. He is a co-recipient of the 2004 Nobel Prize in economics.

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If we don't have enough debt to generate the income our grandchildren need, the Greeks seem to have far more debt than they can ever pay off, so the market won't buy their debt, even when it is disguised as Euro debt which the Germans will pay off. Your formula seems to ignore the bond vigilantes, who could care less about my grandchildren's welfare.
Posted by: G.R. Fisher   |   Nov 11, 2011 2:09 PM

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