Thursday, February 25, 2016

Odd behavior and effective budget constraints

When governments sell a lot of bonds, people think the government is sooner or later going to soak up these bonds with taxes, and do not spend. 
That is John Cochrane in his recent post on the "fiscal theory of the price level". I don't know about you, but I'd have to look up how many bonds the government has recently sold, if this represents an increase or decrease relative to the past rate of increase or decrease, and then calculate what that should mean in terms of my spending. I have done this exactly never times.

Yes, there is Friedman's "as if" metaphor, but then that means Cochrane's statement should just be treated as a metaphor. However, it is used to formulate a mathematical model in terms of agent expectations. These aren't expectations, but metaphorical expectations.

A information equilibrium argument is more plausible:
When governments sell a lot of bonds, the state space of individual consumption changes such that individual agents do not on average move to states of increased consumption in future time periods.
This is at least consistent with the empirical observation that people don't behave the way Cochrane says -- they could just behave "as if" they expect future taxes.

However, the state space description above is equivalent to an intertemporal budget constraint, which is only a valid assumption near an equilibrium. Therefore we shouldn't act "as if" Cochrane's statement is true in general. Which makes sense of our intuition that Cochrane's description of human behavior is very odd.


PS Blogging via mobile. Will add links later.


Update +6 hours

Updated and added links.


  1. Err, what empirical observations are you talking about? Cochrane's assertion is, as far as I can tell, nonsense. What observation is your hypothesis based upon?

    BTW, I find your assertion more plausible, except that when the government sells bonds, they usually increase spending at the same time, which puts money into people's hands. In that case, I think it plausible that people increase their spending, on average.

    1. Hi Bill,

      There are many papers on how humans are not rational maximizers. Thaler's book is supposedly a good history of the research from his point of view:

      I wasn't saying that was my assertion -- it was just Cochrane's assertion worded in an information equilibrium model. It may well hold when an economy is near equilibrium -- we don't really know the answer.

      When we are away from equilibrium, then evidence does suggest that fiscal stimulus increases spending. But that is somewhat tangential to my point ... which is that even the equilibrium behavioral relationships are odd, and it becomes clearer that they shouldn't always hold if we phrase them in terms of information equilibrium.

    2. Hi, Jason,

      Thanks for the Thaler reference. :) And thanks for clarifying your point.

      I said that Cochrane's assertion, because that's all it is, as far as I can tell -- and it's not even his --, is nonsense because it isn't even rational in itself. It is a false datum in an argument against the ability of the government to stimulate the economy by borrowing and spending. And why might the government attempt such stimulation? Because the economy is in a recession, which we might think of as a disequilibrium condition, or in a depression, which we might think of as a sub-optimal equilibrium. But the argument assumes that the economy is always in equilibrium, including when it is in a recession, and that if there are multiple equilibria, there is no path between them, because that would be a non-equilibrium path.

      Let me illustrate my point about the nonsense. Suppose that I was a medieval merchant in Europe and learned that the local lord was in hock to the Medici for a whole lot of gold because of gambling debts. I might rationally fear that he would impose a special tax levy and cut back my spending. But that is far from what happens with modern government taxing, borrowing, and spending, except perhaps in the Eurozone.

      Here is something more like it. :) The local lord borrows money from the city council to build a cathedral. The money is local coinage, with either his image or his father's or his grandfather's on it. I get hired as a carpenter to work on the cathedral, which means that I have money to spend. Do I hoard it against future tax levies? Hardly. For one thing, what future tax levies? The lord and his ancestors have been taking out such loans for a long time, and they always roll over their debt. (Adam Smith would point that out later. ;)) True, in times of war and unexpected expenditures, they have levied special taxes, but that is a different matter. For another thing, even if the lord levies taxes to pay the debts, why should he tax me in particular? He is going to tax people who have the money to tax. I can spend it and let the people who get it worry about the later taxes, if any. For another thing, even if the lord later levies taxes to pay the debts, all he is doing is redistributing the money to the city council. If need be, I can go to work for one of them. Also, I can view the money I get from the local lord as a loan from the city council, something that would not be easy for me to get myself. If I got a loan from them myself, would I just sit on it so that I can pay it back later? That wouldn't make any sense, would it?

  2. There is no end-to-end spending analysis in this. Spending generates induced tax, much like an electricity circuit.

    People keep conflating the total tax take with the distribution of the tax take. The two are largely separate and certainly should be considered separately.

    If government spends £100 then the recipient receives that money and pays some tax - in return for something or other. The recipient then spends again with somebody else, who receives the money less some tax - in return for something or other.

    That process then continues at a pace until the money is entirely taxed away. This is the case for *any positive tax rate*.

    It's a simple arithmetic progression.

    So the question actually is why is there a deficit at all? And that is because the money never gets spent entirely to destruction within the budget period - due to people saving rather than spending.

    The act of people saving *causes* borrowing on the other side of the accounting ledger (that's why you are in 'credit' at a bank - despite credit being the accounting term for a liability. The bank is 'borrowing' from you when you force your financial assets on them).

    So the deficit is entirely caused by the change in the private sector financial saving requirement, less the change in the private sector borrowing requirement. The government isn't borrowing. The private sector is saving and wants safe assets.

    You can't really change the total tax take very much by adjusting rates because it feeds back into the spending and borrowing decisions. All you can really do is affect the distribution of the tax take amongst the entities in the economy.


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