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Thursday 21 June 2012

Tax Notes To An Unborn Grandchild

Dear Grandchild,

You’re probably wondering why I've saddled you with huge taxes to pay for debts run up before you were born.  As I write today, the total US debt is about 5 times the average personal income,  about $250,000 per person, and growing, rapidly.

The reason is, fortunately for me, that I won’t be paying the debt off.  Unfortunately for you, you will.  You probably think this is unfair but by the time you figure this out I’ll be dead.  Good luck with that.

Social Contracts

Although this game of pass the debt parcel to the next generation no doubt seems wrong to you it’s part of what is known as the intergenerational social contract.  Under this contract I, and my generation, have paid for our parents and grandparents’ social benefits and pensions.  You, in turn, are expected to pay for ours.  The problem, of course, comes because we’ve run up a ton of debt, eaten all the fish and melted the polar ice caps by using up all the oil along the way.  In fact, arguably, we’ve broken the contract by borrowing money to pay for our side of the bargain which you’ll have to repay, rather than paying for it ourselves.

Of course it isn’t quite as simple as you might think.  After all, we have had a couple of hundred years experience of economic growth so we might reasonably expect you to be richer than us.  If that’s the case it doesn’t make that much sense for us to invest for you now: it would be like poor people giving money to rich ones (we do that as well, it’s called “investing” to make people think they’re doing something for themselves rather than making rich people even richer).  There’s a technical economic term, the social discount rate, which determines how much we should invest in your welfare.

Calculating the social discount rate is quite difficult, because we have no idea how much wealthier than us you’re going to be.  One report estimates that in 2200 global per capita consumption will be $94,000 a year compared to $7,000 a year now: given how much richer you’ll be than me does it really make much sense for me to invest for your future?

Ethical Welfare

We can also look at history.  That $250,000 per person you’ll be paying back is equivalent to $40,000 back in 1962, 50 years ago, when average household income was $6,000.  You can see the effect of inflation and wealth creation: $40,000 per person is a lot of money, but not mindbogglingly impossible to pay off over a career.  Of course, that’s a false comparison, firstly because my parents weren’t stupid enough to get in this much debt, and secondly because the current levels of debt are continuing to increase, rather rapidly.

Nonetheless it shows that you may be able to afford the debts we’re running up.  But, of course, we don't know that for sure and there’s a big argument about what the proper value of the social discount rate, because economists can’t agree on how we should value your welfare.  Come to think of it, they can’t agree on anything

One philosophical argument is that it’s ethically wrong for us to value your welfare at less than ours, so the social discount rate should be set to zero.  Another, more practical view, says that we’re actually not that nice and our behavior reveals that we care more for ourselves than we do for you: we don’t save very much, for instance, and we’re merrily depleting the world’s natural resources without worrying too much about the consequences for you (See: Peak Oil: The Revenge Of Planet Earth?).

Stern Economics

We’ve also been having a bit of a debate about those environmental concerns.  In Nicolas Stern’s report on the economics of climate change for the UK government he effectively set the discount rate to zero.  Well, actually he set it slightly above zero, to take into account the possibility that we might actually exterminate ourselves before you ever get to read this: so he thought that people next year are only 99.99% as important as people this year. 

In effect this means that we should be prepared to spend $1000 now to mitigate $1000 worth of damage in 100 years time.  A higher discount rate would mean that we would only be prepared to spend today’s net equivalent of $1000 – so, for instance, a 5% discount would mean we would only be prepared to spend $7.60 now.

The result of Stern’s near zero social discount rate was a recommendation that we spend 1% of our global GDP on your welfare; stabilizing the world’s temperatures at levels below those calculated to damage your economic welfare. In general this proposal hasn’t gone down too well; we’re far more interested in protecting our own standard of living than worrying about whether you’ll have any at all. 

Black Swan Environments

Also Stern doesn’t address the possibility of an environmental collapse due to global warming – the low probability, catastrophic events we call Black Swans, and which are very common in financial markets. There are plenty of commentators around who think that this is more important than carrying out unquantifiable cost benefit analyses around your future welfare; rather we should worry about whether you have a future at all.

At the heart of these debates, about the amount of debt we’re saddling you with and the environmental depletion we’re handing on and how much richer than us you will be is the question of intergenerational justice, the so-called “social contract”.  To be frank we’re not very good at planning for our own futures – it’s been shown that we fail to save for our own retirements at least partly because we don’t think about the person retiring as being ourselves.  How much harder is it, then, to consider your futures when we don’t even know you? (See: Be Kind To An Old Person - Start With Yourself)

In any case, if we gave you loads of money you’d probably just waste it on recreational drugs, terrible music and visits to shady clubs staffed by people of dubious sexual proclivities.  After all, that’s what we did.

Theories of Justice

Our general lack of savings reveals that we really don’t value your futures at anything like the level we value our present, but this isn’t necessarily ethically correct.  John Rawls has attempted to create an intergenerational theory of justice, which argues that we should act towards you as we would have wished previous generations to have acted towards us. 

Unfortunately, as we’re all experiencing just about the best living conditions in the history of the world, while busily laying down debt and environmental damage for your generation, this appears to be more about hope and expectation than reality.  Most democratic governments aren’t very keen on making us pay for our lifestyles, and prefer to push the problems out to future generations.  We’re all already quite upset we have to work a few years longer to get our state pensions, and aren’t interested in the fact that pension ages were set in an age when most people didn’t live long enough to draw on them (See: The End Of The Age Of Retirement).

Who's The Prisoner?

Hence it appears that we’re playing an intergenerational game of the Prisoner’s Dilemma: if we care for the previous generation then the next generation will look after us.  Unfortunately this doesn’t appear to meet the basic criteria laid out by Robert Axelrod and William Hamilton in their seminal paper The Evolution of Co-operation: the problem is that if we defect, you can’t punish us.  It’s a sequence of so-called one-shot games, not a properly iterated version where you can retaliate: we’re dead, it’ll be hard to punish us (See: Altruism: Signalling Corporate Fitness).

So I hope you can see that this isn’t quite as simple as you might have thought.  We may be laying down debt for you to repay, using up irreplaceable fossil fuels and over-exploiting renewable resources but we can console ourselves with the thought that you’ll be far richer than us.

Only, of course, we don’t know that.  Global economic growth only took off about 200 years ago and we can’t guarantee that it will continue, especially if we destroy capital stocks with debt and wreak environmental damage with our high carbon lifestyles.  Still, if it all goes wrong it won’t be our problem.  But you’ll know who to blame.  

Love, Grandad.


  1. Very nice. Like for format.

  2. * like the format

  3. Dear Granddad,

    Fortunately, unlike you, I had the benefit of an education. A particular interesting course was System Thinking 101. I know your brain is not what it used to be, and it's hard for you to concentrate more than five minutes, so I'll try to explain in the simplest possible terms.

    Debt is a contract that says that some time in the future a party will pay another party. Someone gives money, someone else receives it, and the amounts match to the penny. As you'll be dead by then, you cannot be the one who gets it. So basically someone of my generation will pay someone else of my generation. So as a generation we'll be even.

    It could be that the arrangements you've setup for us lead to transferring resources to undeserving members of my generation. This is only truly unfair if the recipients are a minority, but this makes it easy to solve: the majority will then just enact law to either cancel your old contracts, or, if it happens to be more convenient, tax back the unfairly distributed monies, and redistributing them back in a fair manner.

    In other words, there's no scenario where you can cock up so much as to inconvenience us. You need not worry, and can go back to watch daytime TV.

    I'll explain how your profligacy with fossil fuels is of similar irrelevance to us, once you had some rest.

    Your grandkid.

  4. Yeah. I usually find the posts on this blog extremely interesting. But this post is based on a flawed understanding of how a monetary system works. Sorry, I'm with cig on this one.

  5. The government debt is the total sum of money that the government has issued and not yet reclaimed. That government debt is in the hands of private citizens, both domestic and foreign, to whom it acts as government credit. When we buy stuff, we exchange government credit (money) for goods and services. The credit is extinguished when we use it to pay our taxes.

    When the government debt goes up, it means that the total amount of government credit in circulation (money) goes up. This inflation of the money supply leads to inflation of the general price level of goods and services with a two year lag period.

    Grandpa is causing damage, but he's wrong (maybe suffering from self-serving bias) in assuming that his grandson will pay the bill. The increasing government debt increases the money supply, which within two years causes inflation of grandpa's pension and savings.

    In contrast, by the time grandson starts to work for a living, society will be operating under a new price level based on the total amount of government debt at that period. Grandson will be used to price levels that would have sounded outrageous to granddad, but his wage will also be calculated at the new price levels. Grandson's future purchasing power isn't affected by granddad's foolishness today. Although if granddad intended to pass some savings onto his grandson, the money will be worth a lot less than what graddad had envisioned.

  6. Yes, the assumptions of this blog post are wrong. To help you understand why, here is a link to a simple analysis:

  7. Two points.

    As the paper quoted above makes clear, of the current estimate of US government debt ($80 trillion) the majority ($67 trillion) is the form of unfunded obligations for social security, healthcare etc. Arguments based purely on bond issuance are really marginal, but are understandable, given that government accounting is really a vast and opaque Ponzi scheme.

    In any case the work of Rogoff and Reinhart suggests that when debt levels get to 90% of GDP then growth stalls: see Triumph of the Pessimists. The empirical evidence, as opposed to the economic theorising, suggests that our debt levels will matter in the future.

  8. What I wrote doesn't contradict Reinhart & Rogoff. If we can agree that debt issuance expands the money supply and that expanding the money supply pushes up the general price level. GDP is a summation of market values (price levels) over a given period. A rising price level leads to rising GDP. Since debt/GDP is a ratio, if issuing debt causes the price level to rise which causes GDP to rise then increases in absolute debt levels don't necessarily cause debt/GDP to rise. The numerator and denominator of the ratio are correlated, the transmission mechanism is debt inflation -> price inflation -> GDP inflation.

    Anyway, I love your blog. One of the things you've taught me is that confirmation bias together with bias blind spot makes it unlikely that people will convince each other on a blog. I agree with the general gist of the article, which is that all this debt will hurt us. We just disagree on how. Keep up the good work!

  9. Dear Grandpa,

    Try again. I was aborted by your daughter after she found out her unemployed, crackhead boyfriend was also cheating on her.

    See you in hell!

  10. Hi Kev

    Actually I have no idea how debt will hurt us, or even if it will. I just thought it was an interesting topic :)

    By coincidence I was listening to Niall Ferguson's Reith lecture this morning, which covers some of the same ground. Which doesn't make it any more right, of course, but his US debt figures are even more mind-boggling ... The Human Hive

  11. I think that the problem of the household debt is being more exposed lately. I assume it is due to the fact that housing prices are falling and people who thought that they will have their assets always protected and increased by the (ever) increasing housing market (which is of course an economic blasphemy) are now exposed to the fact,that their property may become too cheap to pay their own debts.

    I think that economic irresponsibility is not a matter of rational behavior but rather matter of confusion and misinterpretation of economic facts (thanks to big banks and governments, who tells us to spend more). My evidence for this is that even the best educated and advanced nations are struggling with the high levels of debt. In Canada the problem of debt consolidation became an issue of the central government.

    The most important thing is that banks and governments stop lying to people about the situation. The other is to promote new economic behavior, which will have enough room for individualism, but will also merit more community building and social cohesion.