Deficits and intergenerational welfare in open economies

The paper extends Diamond’s (1965) overlapping-generations model — itself built on Samuelson’s (1958) consumption-loan construction — “to deal with a small open economy as well as an international equilibrium of two large economies” (Abstract), in order to study how debt-financed fiscal deficits redistribute welfare across generations once an economy is open to international borrowing and lending. Persson notes that Diamond’s own treatment did allow for external debt, but only by assuming “only the government but not the private sector can borrow abroad,” which the paper judges “not very plausible today” and which trivializes the interaction between government-budget deficits and current-account deficits. Existing open-economy OLG extensions are also judged insufficient for the question: Buiter’s (1981) model has only private international borrowing and so “cannot be used to address the questions pursued here,” and while Dornbusch (1982) does include public debt, “the process whereby this debt is generated — government deficit spending… — is not explicitly modelled,” only the long-run effects of debt are studied, and production, capital, and investment are left out of that analysis entirely.

The experiment is a one-time, unanticipated cut in lump-sum taxes on the currently young generation, financed by issuing public debt, with future per-capita debt then held constant by setting taxes in all later periods to cover just the additional interest cost. Persson notes that financing a transfer to the old generation, or financing increased government consumption or investment, “would be slightly more complicated but yield qualitatively similar results,” and that the entire comparison with tax-financing is clean because “with tax finance net taxes paid by the young are unchanged and there are no effects either in the long or in the short run” — so the paper’s results isolate the effect of debt issue itself, not of the underlying fiscal action it finances.

The currently young generation unambiguously gains, since it receives both a lower tax bill and — because the extra government borrowing creates excess demand in the capital market — a higher return on its own savings as the domestic interest rate rises. The welfare of the generation born immediately afterward is genuinely ambiguous, because it faces two offsetting forces: a lower gross wage (since the higher interest rate reduces the capital-labor ratio it works with) and a still-higher interest rate on what it manages to save — “it is not clear whether in fact there is a burden on that generation.” However, once the economy has fully adjusted to its new stationary state, the welfare change for all later generations is unambiguously negative, reflecting three combined effects: higher taxes to service the permanently larger debt, lower net wages from the lower long-run capital-labor ratio, and a partially offsetting gain from the higher steady-state interest rate on savings — the first two dominate because, as Persson notes, “the economy underaccumulates capital relative to its golden rule capital-labor ratio… already in its initial position,” and the debt increase pushes the capital stock down even further from that already-inefficient level.

In the small open economy, which takes a given, constant world interest rate r* as fixed, the currently young generation still gains from the deficit, “although not as much as in the closed economy, since there is no magnifying effect from a rise in the interest rate.” Because the economy’s capital-labor ratio (and hence the gross wage) is now pinned down entirely by the fixed world interest rate and is therefore independent of the government’s domestic borrowing, the ambiguity found in the closed-economy case for the next generation disappears: “it is now clear that the young generation born in t+1 has a lower welfare,” since its net wage falls while there is no interest-rate rise to compensate it. The paper summarizes this contrast explicitly: in the small open economy “there is no ambiguity about gainers and losers… the young generation in the deficit period being the only one to gain and all future generations having to bear the burden of the higher public debt,” and because there are no effects on domestic factor prices, “both the welfare gain of the first generation and the long run welfare losses are smaller than in the closed economy.”

The excess private demand for funds created by the government’s borrowing, which would have raised the domestic interest rate in a closed economy, is instead absorbed by increased foreign borrowing at the fixed world rate, so the initial government deficit shows up as an increased current-account deficit on impact. The current-account deficit is larger again in the following period, because the now-higher-taxed young generation saves less while the previous generation (now old) dissaves more, having saved more when it was young and received the tax cut. Persson shows that “the whole adjustment to the higher foreign debt is accomplished by the current account deficits we have already investigated, and the economy has reached its new stationary state only two periods after the initial deficit episode” — a sharp, exactly two-period adjustment that follows from the fact that nothing about the small economy’s domestic factor prices is changing to smooth the transition.

With two countries of comparable size linked by a single world capital market, a deficit in the home country now raises the common world interest rate — “positive… and less than in the closed economy” — rather than leaving it fixed as in the small-open-economy case or raising it by the full closed-economy amount. Because gross factor rewards are unaffected in the period of the shock itself (the capital stocks that determine current wages are already predetermined), both the currently young generation at home (who pays lower taxes) and the currently young generation abroad (whose net wage is unchanged but who benefits from the higher return on existing savings) are made better off. The welfare of the generation born in the following period is, as in the closed-economy case, ambiguous in both countries, since gross and net wages fall in both while the interest rate continues to rise.

Unlike in both the closed economy and the small open economy, “here, however, this is no longer a necessary result” that future generations in the deficit-running home country are worse off. The reason is a terms-of-trade channel: a sustained rise in the world interest rate redistributes income from debtors to creditors, and “if the home country is a net creditor… this intertemporal terms-of-trade effect instead redistributes income in its favor which alleviates the burden of increased taxes and a lower capital-labor ratio on future generations. When [the home country’s net foreign asset position] becomes sufficiently high, the net result is even a welfare gain.” Persson stresses this is not a degenerate special case: “the probability of the home country being a long-run creditor is higher, the lower the rate of time preference of consumers… the lower the initial government debt, and the worse the investment opportunities in the home country,” so for realistic parameter configurations a country’s own debt increase can end up benefiting its future generations at the expense of the rest of the world. Future generations in the foreign country face a comparably ambiguous outcome, combining their own capital-labor-ratio loss with the same uncertain terms-of-trade effect, so “the result is even more uncertain than for future generations in the home country.”

No — Persson shows in a footnote that total world welfare, defined as the sum of the wealth-equivalent welfare changes in both countries, “unambiguously declines” even in the two-country case. The terms-of-trade effect is a pure transfer between the two countries’ future generations, layered on top of the same underlying efficiency loss present in the closed-economy case (debt crowding out capital relative to an already underaccumulated, non-golden-rule level); it can make the debt-issuing country’s own future generations better off only by making the foreign country’s future generations worse off by more.

As in the small open economy, the home country’s current account deteriorates on impact and again in the following period, but the adjustment process is slower: because the world interest rate itself “converges only asymptotically to its new equilibrium” (rather than jumping immediately, as the small open economy’s fixed world rate effectively allows), “the adjustment process with deficits in the current account will be much longer than the small economy’s two-period adjustment.”

Persson notes explicitly that both main sets of results “hinge crucially on the absence of operative private gifts between generations,” and that if private, non-market intergenerational transfers of the kind analyzed by Barro (1974) are in fact operative, they “can compensate for government, non-market, intergenerational transfers and thereby leave the welfare of future generations unaffected,” turning each generation’s problem into that of an infinitely-lived dynasty for which a debt-for-tax substitution leaves consumption — and, in the open-economy extension, the current account — unaffected (citing Sachs 1982). The paper does not adopt this framework because, as discussed by Buiter (1980), the conditions required for such private compensating transfers to occur in full are “quite restrictive,” and because of “the unclear empirical support for the dynastic savings hypothesis” — which is why Persson judges a life-cycle overlapping-generations approach, with its genuine intergenerational redistribution, “by all means warranted” as the framework for this question.