Does the federal deficit matter? Oceans of ink track and report this monster tally (current estimates for fiscal year 2006 stand at $260 billion), yet Jerry Green of Harvard Business School and Laurence J. Kotlikoff of Boston University contend that the deficit and related fiscal measures are arbitrary terms with no intrinsic meaning, a lesson that even economists have not learned.
"On the General Relativity of Fiscal Language," a working paper for the National Bureau of Economic Research, provides a mathematical proof that the deficit, taxes, and transfer payments are no more than labeling conventions—representing, in the words of the authors, "an exercise in linguistics, not economics." Like Einstein's General Theory of Relativity, which concluded that concepts like time and distance depend on one's reference point, current fiscal language "represent numbers in search of concepts that provide the illusion of meaning where none exists."
To see their point, consider your FICA contributions. The government calls them "taxes," but it (or you) could equally well call them "loans to the government," say the authors. The future benefits you receive for your contributions are now labeled "transfer payments" or "expenditures" by the government. But they could, in part, equally well be called "repayment of principal plus interest." This alternative set of labels is no less economic in terms of everyday usage. Were it used, this year's reported deficit would be some $750 billion higher.
What is real about economic policy is the massive redistribution of spending power from young and future generations to older ones.
Green points out that while the level of "taxes" that the government reports is arbitrary, the net economic benefit to each generation is well-defined. "We hope that our paper will direct attention toward the real effects of economic policies and away from statements about magnitudes that can easily be manipulated," he says.
Words Signifying Nothing
Exposing the deficit as an economically meaningless figure is not a new position, the authors say. What is different about their paper is that it shows that this proposition is completely general—it applies to the standard framework for economic analysis used by economists worldwide.
"There are a zillion different ways of labeling government receipts and payments," says Kotlikoff. "All are equally arbitrary and don't tell you anything about underlying fiscal policy."
Consequently, legislation and proposed legislation pegged to specific deficit numbers are using, as Kotlikoff puts it, a map of New York to drive in Los Angeles. As examples, the authors cite the ongoing movement for a U.S. balanced budget amendment; the IMF's use of the deficit to assess fiscal prudence; the Gramm-Rudman-Hollings Act to limit U.S. deficits; and the Stability and Growth Pact sanctioning EU members with deficits above 3 percent.
"What is real about economic policy is the massive redistribution of spending power from young and future generations to older ones that has been going on for five decades," states Green. "Unfortunately, the 'deficit' doesn't measure this. But generational accounting does, and in terms that are the same no matter what labeling convention one adopts.
"We aren't being nihilistic," says Kotlikoff. "There are real government policies that affect the distribution of spending power across and within generations, the incentives people face to work and save, and the amount of direct government consumption. But each of these policies can be measured with no recourse to ill-defined terms, such as 'taxes,' 'transfer payments,' and 'deficits.'"
Developed by Kotlikoff (in collaboration with Alan Auerbach of the University of California, Berkeley and Jagadeesh Gokhale of The Cato Institute), generational accounting indicates in present value what the typical member of each generation can expect to pay to the government, minus benefits from the government, both now and in the future. The method also requires looking far into the future in order to forecast what future generations are likely to pay. That's not easy, but it's imperative, Kotlikoff says. Otherwise, the answer one gets about policy will depend on the labels being used.
If this paper and others before it have shown the deficit and terms related to it hold no meaning, why do governments persist in using them as a gauge of economic health and as an impetus for policy? Why do economists follow along?
"I've been hammering this point for twenty years and it still hasn't gotten through to the public consciousness or even a very wide academic audience," Kotlikoff laments. "We hope this paper will reacquaint younger economists with the concept."
"This is an emperor's new clothes situation," he continues. "Many economists have a vested interest in this form of tailoring." However, he notes that many countries around the world, including the U.S. government, have done generational accounting. It's catching hold, but it hasn't yet vanquished economic voodoo.
"So that's some measure of its acceptance," says Green. "Governments have recognized that their own accounting hasn't caught up to the best economics and have provided an alternative system, which I believe is the correct way to measure generational policy. It's a start."
Kotlikoff is professor of economics at Boston University and the author with Scott Burns of The Coming Generational Storm: What You Need to Know About America's Economic Future.