We refer to the idea that government must ‘tighten its belt’ as a necessary policy response to higher indebtedness as the household fallacy. We provide a reason to be skeptical of this claim that holds even if the economy always operates at full employment and all markets clear. Our argument rests on the fact that, in an overlapping-generations (OLG) model, changes in government debt cause changes in the real interest rate that redistribute the burden of repayment across generations. We do not rely on the assumption that the equilibrium is dynamically inefficient, and our argument holds in a version of the OLG model where the real interest rate is always positive.
Figure 1 will be helpful if you know something about difference equations. What this illustrates is the dynamics of debt adjustment in a model with two generations where preferences are relatively standard. The picture illustrates a case where the interest rate is positive and where governments do not need to actively balance their budgets. Unlike some examples where this happens, we are not relying on the idea that forward looking agents select the only equilibrium that uniquely pins down the price level and prevents debt from exploding. In other words, we do not appeal to what the literature refers to as the Fiscal Theory of the Price Level (FTPL).We claim that this situation is not a crazy way to think about the world; it is a generic and common property of a large class of overlapping generations models. That fact is an embarrassment for the FTPL since it implies that, in monetary models where the dynamics are described by Figure 1, the FTPL is incapable of selecting a unique equilibrium. Stay tuned for two more papers coming soon on this topic with more realistic preference and endowment structures.
Lets also be clear about what we are NOT saying. We do not claim that governments do not face constraints: They do. In our model, the government runs a primary surplus on average as a fraction of potential GDP just as it does in the real world. What we claim is that the government does not need to actively alter the fiscal surplus in response to booms or recessions.