The Economics of the Grim Reaper

I am on a roll with wonkish posts. So here is another one.  I am going to explain the difference between two kinds of macroeconomic models, representative agent (RA) and overlapping generations (OG) models. And I will explain why OG models provide an explanation of why central banks should intervene in asset markets that is different, and in my view stronger, than any argument that might be leveled using the RA model as an organizing principle. Because the OG model assumes that people die and new people are born, I have called this post: The Economics of the Grim Reaper.

Macroeconomists have two "workhorse" models. In one, they assume that the world works "as if" there were a single representative family making all decisions. The head of that family has superhuman perceptions of all future possible outcomes and he/she makes plans accordingly. This is called the RA or "representative agent" model. In the second workhorse model, we assume that population consists of a sequence of overlapping generations of selfish individuals. This is called the "overlapping generations", or OG model. You can find a simple (as simple as any graduate text can get) introduction to these two kinds of models in my graduate textbook The Macroeconomics of Self-Fulfilling Prophecies.

The RA model may sound unrealistic, but it is more reasonable than it at first seems. For instance, many of the strong results that are known to hold in the RA model, also hold if there is a finite number of infinitely lived families all of whom trade with each other in the financial markets. The really strong assumption, which is added on top, is that people know the probabilities of all future events and they trade with each other, contingent on these events.

If we want to understand why government should intervene in financial markets, and I do, we must explain why government can do something that private markets cannot. Perhaps the reason is that the public really does not have superhuman perception of future events. Perhaps, that is, the rational expectations assumption is wrong. But that, in itself, is not a reason for governments to intervene in financial markets.

Hold your nose for a moment, and suppose that people can, and do, trade securities contingent on all future events. In order to argue that government should intervene in the financial markets, you must be able to show that treasury or central bank mandarins have superior knowledge. That seems a stretch. After all, we do not insist on shutting down gambling on horse races. But people only bet on horse races because they have different opinions as to the probabilities as to which horse will win. Rational expectations, in this context, is obviously false. If we assume the same is true of the financial markets, that people disagree about future probabilities, that in itself is not an argument for intervention. Government must be shown to have an advantage that allows them to intervene in a way that improves social welfare. And in my view, individual human beings are still the best judges of what is, and what is not, in their own best interests.

Absence of rational expectations, I will argue, is not a reason for government to intervene in financial markets. Death, on the other hand, is such an argument. To make that case, I need to say more about the OG model.

It is well known that the OG model behaves very differently from the RA model, For example, Paul Samuelson, in a seminal article that introduced this model to the English speaking world, showed that the overlapping generations model sometimes allows a role for governments to improve the arrangements that are made by private agents. That role relies on what economists call 'dynamic inefficiency' and it occurs when interest rates, in the model, are 'too low'.

If interest rates are too low, government can take resources from future generations, give them to current generations, and make everyone happier. Although the real world is looking more and more as if that might be a good assumption, it is not the reason I will emphasize in this post, for treasury and central bank intervention in financial markets. There is a second reason why death matters that was first pointed to by David Cass and Karl Shell in article that appeared in 1983 called "Do Sunspots Matter?"

The second reason why death matters is quite distinct from the property of dynamic inefficiency and it occurs, even when interest rates are high and all market exchange is dynamically efficient. This second reason occurs because, in OG models, economic activity can fluctuate as a consequence of self-fulfilling beliefs. Financial cycles arise in these models because people engage in self-fulfilling bouts of optimism and pessimism that cause fluctuations in output and employment. And the government DOES have an advantage over private agents (wonkish example here, and here). It can make trades on behalf of the unborn that can smooth out these cycles.

In my forthcoming book, Prosperity for All, I make the case that this second reason for inefficiency is important and is the main reason that financial cycles are so destructive for human welfare. By implementing the financial reform that I propose in my book, we can ensure that next time really will be different.