Sunday, July 16, 2006

The United States in Bankruptcy?

Although I am very interested in economics and intended this blog to cover certain economic issues, I have not written very much on the topic. This morning, a Google alert informed me that the Federal Reserve announced that the United States was headed for bankruptcy. Now everyone knows I have a soft spot for bankruptcy, so I read with interest the story. First, the story indicates that the headline comes from a paper written by a researcher from the Federal Reserve Bank of St. Louis. Although the paper does not indicate any association by the author with any Federal Reserve Bank. Be that as it may, the initial story points to the paper here and off I went.

Laurence Kotlikoff is a Professor of Economics at Boston University and a research associate at the National Bureau of Economic Research.

Kotlikoff makes the following issue a central premise to his findings:

"..whether or not technology will continue to advance is an open question."

His scenario/model:

The amount of corn produced is determined by the labor and capital available. Capital is determined as the amount of corn that can replanted for future harvests. Of course, a certain amount of corn is necessary to feed the aging population that no longer contributes to the labor required to produce the corn.

By restricting productivity increases, only labor changes are going to have an impact on his two cycle process. The need for more people to increase production is a long term failure as at some point the number of people that have aged out of the production cycle will grow well beyond the ability to obtain more people to feed the labor pool. This is of course analogous to the retiring baby-boom generation that he seeks to model. The simplicity of the model is consistent with his need to constrain almost all the variables except the ones he is most interested in:
labor productivity and capital.

These limitations doom the 'society' he seeks to model. Such a restricted model is not capable of mimicking even the most basic issues facing our economy and government. Any model seeking to deal with labor must include some way to deal with technology issues. Kotlikoff's initial premise clearly defines both his bias and his failure.

Kotlikoff understands the issue, but refuses to consider it: "The point at which a country goes bankrupt depends, in general, on its technology and preferences as well as it's openness to international trade."

Once Kotlikoff makes his case that the increasing non-working population dooms society, he addresses the only issue left to him: capital. I found the leap he makes to be very unsatisfying. First, he considers the elderly population to be the 'creditors' in his scenario. He takes his formerly open economy allowing trade and credit flows and closes it. This little slight of hand includes the change of creditors from inside the economy to outside it. Now we have foreign creditors and his model restricts their ability to fund our economy. He supports this by asserting that foreign creditors will have no incentive to lend to the government because it has already proven its inability to produce sufficient for its own growing needs.

Of course, his original creditors subsist on the production and they have an interest in its continued existence. Failure is not an option, they can not just cut their losses and move to greener pastures. Conceptually, Kotlikoff can not allow the continued expansion of capital in his model if he seeks the conclusion he first set out to prove. The creditors have no alternatives to his 'economy'. By moving the creditors outside the closed economy, he can allow them the freedom of choice his original creditors (the non-working elderly population) do not have.

Kotlikoff further complicates matters by assuming the government will have been told by it's constituents (the soon to be or already elderly) to set their cut of production as high as possible. There is no feedback on this position, nor limits. While I might agree our social security system has certain similarities to Kotlikoff's model on this issue, it does not consider that some elderly will have hoarded some of their earlier production and have an alternative source in their non-working years. As the non-working population grows and demands an ever increasing cut of production, younger workers rebel, cease working, capital can not be borrowed and the system fails, bankruptcy.

He uses Argentina as an example of a country at or near bankruptcy for almost a century. He makes no attempt to address any systemic differences between the US and Argentina over the last 100 years. An analysis that would probably render the comparison useless and might even call into question the structure of his model.

In his first note, Kotlikoff uses the phrase "steady-state". This caught my attention because it indicates he is aware of attractors and non-linear/chaotic behavior in economic systems. He further acknowledges that the initial conditions determine whether the system will establish a steady state or crash. Only the elderly's cut of production determines the results of his model and only an increasing or very high cut produces the result his is concerned with.

The next section of Kotlikoff's paper concerns debt as a benchmark. He objects. It is the future production burdens that concern him. But in his original model, it was the elderly and their production burden as creditors he waves out of existence in favor of creditors with claim on production in the form of debt. As long as the debt is being serviced, investors will continue to lend. Consider that my opinion, but the billions lent to the US economy over the last 20 years would seem to give me some support.

Kotlikoff finally exposes himself:

"unfortunately the focus on government debt has no more scientific basis than reading tea leaves or examining entrails. To see this, let us return to our small open and entirely bankrupt Country X, which,when we left it, was setting h [cut of production] at the maximally expropriating value (1+r)w/r. Can we use Country X's debt to discern its insolvency?

"Good question, particularly because the word "debt" wasn't used at all in describing Country X's fiscal affairs. Neither, for that matter, were the words "taxes" or "transfer payments". This, by itself, indicates that the value of "debt" as a precursor or cursor of bankruptcy, namely zero."

This is simply amazing. Because he didn't use the word debt in his analysis, debt has no meaning to it.

Kotlikoff stated early in his paper that "government must further limit what it can pay it's creditors." I am unsure what Kotlikoff would classify as "pay it's creditors" other than as a debt. Whether it is in the form of usury or a cut of production, a demand upon the production of a country is a debt owed. Using a number to keep score is actually more consistent in these days of digital notes and agreements than it might have been, say in Mesopotamia.

Kotlikoff opens his paper with a paraphrase definition of bankruptcy from the Oxford English Dictionary: "is the United States at the end of its resources, exhausted, stripped bare, destitute, bereft, wanting in property, or wrecked in consequence of failure to pay its creditors?"

The answer is of course no. The paper could have ended in the first paragraph, but that is not what and Kotlikoff has determined. Kotlikoff believes countries can go bankrupt, but debt is not a factor, only the burden on production can determine a country's bankruptcy state.

I have addressed only the initial premise of Kotlikoff's paper and it would take many more pages to do so to the rest, but let me leave you with the following quote and some final comments:

"...the proper way to consider a country's solvency is to examine the lifetime fiscal burdens facing current and future generations. If these burdens exceed the resources of those generations, get close to doing so, or simply get so high as to preclude their full collection, the country's policy will be unsustainable and can constitute or lead to national bankruptcy."

Kotlikoff does not address insolvency and the United States. His concern is unfunded obligations and their increasing size. I and a great number of conservatives share his concern but his claim of bankruptcy while ignoring every facet of its definition prevent any serious consideration of his recommendations to 'solve' the problem. (And I agree with two of the three he makes.) Is the United States bankrupt is a catchy headline and would surely scare some, but after 16 pages, Kotlikoff failed not only to answer the question but to even address it.

Finally, please consider me a complete idiot. Trillions of dollars is big numbers so let me use smaller ones. If my annual income was $12,000 a year and I had $33,000 in assets, how much in future obligations would be ruinous. Not current obligations, but future ones. If I had $6,000 in current debt, could I add $500 in debt per year? According to Mr. Kotlikoff I am bankrupt. I am sure Todd Zywicki would be interested.

1 comment:

BizzyBlog said...

Very good work (no I didn't read it).

His variable-freezing work reminds of the study that some lib think tank did a couple of years ago on how we are all going to be broke in retirement. It assumed NO future contributions to retirement plans by employees/individuals, only employers. How stupid.

His point that it's not a good idea to put too much of a burden on production is well-taken, which is why people ought to get used to the idea, or at least the possibility, of working at least some during their "retirement" years.