Monday, April 18, 2011

Generational Accounting and Why The West Needs Emerging Countries: The Work of Larry Kotlikoff

Introduction
In this contribution we pay attention to the work of Boston University professor Larry Kotlikoff. Kotlikoff is a well-respected economist, but one with relatively negative views when it comes to the future of the rich, developed world. Already in 2006 he wrote a paper entitled ''Is the United States Bankrupt?'' that more or less foresaw a lot of what was about to happen 2-3 years down the road during the Global Financial Crisis, albeit that his paper was more general and longer-term (link to this article at the bottom of this page). In his work Kotlikoff suggested that the Western financial system was one in which beggar's acted as choosers in an environment in which the amount of saving was structurally too low. That was not a global problem, but a Western developed world problem. The global economy was and isn't doing that bad with a real growth rate in excess of 4 percent. However, liquidity is leaking out of the developed world into emerging markets who now run huge savings surpluses. Unless we find a way to re-establish equilibrium the system in the Western world will burst.

 Larry Kotlikoff: Agent of Doom?
Yes, if you count out Emerging Markets. No, if you accept a growing role for them.

Generational Accounting
An important part of Kotlikoff's work about Government Finance is about flawed Public Accounting. Concepts like Budget Deficit, External Debt, Tax Burden et cetera don't mean anything according to Kotlikoff, the reason being that they are very sensitive to labeling. Idea: when the government would label its revenues as 'tax income' it would reduce its debt and run a lower deficit. It could then say that for the taxes now future transfers would be handed over to these taxed citizens. The other way round: if it would like to keep the tax burden low, it could finance things by borrowing. This would increase 'debt' and lead to a larger deficit. In the future it would then have to repay principal plus interest. At that time it could finance things by increasing taxes, or again finance by issuing debt. The government could always 'finance its way out' by issuing money and/or ensuring that inflation is high enough. But what it is all about is simply that the paper in these transactions - 'money' - will lose its value thereby adding to the generational mismatch: earlier generations enjoyed a good life with stronger value money and a better balance between lifetime resources and taxes than future generations will.

Inflation high enough? Financing your way out by printing money? QE2? Hmm....aren't we going through a period of money printing and inflation creeping up?

The above does also imply that it is not possible to simply evaluate the external debt burdens of countries and based on that conclude who is closest to 'bankruptcy'. The debt of Japan far exceeds that of the USA, but does that mean that the US is safe and Japan not? And what about the European PIGS nations? 

The analysis of Kotlikoff is mainly US oriented and came to the conclusion that - when using Generational Accounting - already back in 2005 the overall shortage of the US was USD 65.9 trillion (i.e. more than 4 times more than its external debt, its government deficit and the size of the economy!) (for more information see the 2006 paper in our LMG slideshare account). Similar exercises can be done for other countries of course and they will lead to similar conclusions: Generational Accounting - when done the proper way - will show problems far bigger than what governments in Western nations tell us these days. Basically what it is all about in Generational Accounting: 

Lifetime resources of a generation have to be linked to the lifetime fiscal burdens of generations. 
And whenever there is a mismatch, you get inter-generational wealth transfers. 
And these wealth transfers in itself can already may lead to problems for the system.

The models of Kotlikoff, Auerbach, Gokhale and others are ultra-long-term, incorporating and adding up the situation per age group (vintage group) over many decades into the future. True, technically the models are infinite but when analyzing things you have to apply a discount rate so as to bring things back to its net present value as a result of which the first couple of decades are relatively most important. However, with any reasonable discount rate - except for ultra-high ones! - we are still talking about an analysis that urges us to take into account the situation of at least 20-30 if not 50 years into the future.




 Why Generational Accounting is not in synch with day-to-day Political Practice
Now when we match that with democracies that turn into short-term media circuses more and more, in which the average politician is already afraid to look further than 4-5 years into the future, there is a huge mismatch. Taking into account that young people, who are just starting their career or enjoying growth on their career ladder, care less about situations that arise when they are in their retired years than do older people, most policies 'sold' by politicians these years in developed economies are policies that imply a transfer of wealth from the younger generations to the older ones.

The older generations get more than prudent financial policy warrants. Political rationale: the moment the financial system seems to burst, you can always increase borrowing, taxes or print money and finance yourself out of the problems, again misusing future generations. But wait a minute! What are we saying here? That sounds like the situation of a once glorious firm that is now gradually but slowly losing its dominant position, seeing its cash flow position weaken by the year.

Evaluation
Kotlikoff's calculations show that most developed nations, and especially the United States, have reached the point of no return. A point where - when they want to continue doing things the way they always did - the end will be substantially lower real wage rates, unemployment problems and a demographic situation that will make our Western economies resemble large macro senior citizens homes. In that kind of situation successful firms with a product that they can sell globally will increase their foreign direct investments, thereby creating employment abroad - mostly in emerging nations - and sooner or later growing numbers of younger workers will follow the market drums and leave the country, thereby increasing the ratio elderly/workers even further.

The interesting thing is that Kotlikoff c.s. did also run calculations in which they added China - with its long-term policy, hunger for knowledge and technology and its huge savings surplus - to their models. When using realistic empirical input values the result was that China (and other Emerging Nations, especially those with big Sovereign Wealth Funds) could make the picture look less dim. Even when over time - with ongoing development - their savings rates diminish it would still be the only way out for Western governments to allow Emerging Countries a larger role in a global system, with that role implying that those nations would be allowed more direct investments in the Western world without immediately blocking them as being 'strategical' (as is done so often when it is about investments by companies, wealth funds or governments from China, Russia or the Middle East) but also a continuously growing role in the arena of financial investing. The role of Sovereign Wealth Funds will further increase and through their transfer of investment money (savings surpluses) into Western capital markets they will ensure that the amount of available capital per worker in Western countries will one or the other way translate into productivity growth that is sufficient to avoid the collapse of real wages.

But unfortunately....Western governments do still think they can 'solve' it the old way. I.e. do it themselves. Without the rich Emerging Markets. But the only way that that will work is by using all the instruments that Kotlikoff warns against and that will in the end lead to burdens on growing numbers of people in current and new generations that will outweigh a reasonable percentage of the resources available to them.

It is indicative that Kotlikoff - working together with various scholars that were linked to the US government as adviser (including himself!) when coming up with a proposed new tax system consisting of a retail sales tax of 33 percent that should replace income taxes (including all kinds of deductions that would lead to an opaque system that is prone to fraud), a restructuring of the health care sector and social security system  - was not received with a warm welcome. On the contrary, the direct influence of him and co-scientists expressing this kind of ideas on the government went actually down! They did not want to hear this kind of stories about governments facing bankruptcy unless they overhaul the fiscal, health care and social security system.

Interesting stuff, that confirms that Emerging and Frontier Markets are the place to be. It also makes it clear as to why so many Western nations do not want to stop colonializing the Middle East.

But what we don't understand
Is the work by Kotlikoff that of a visionary that so far was not as well received as some of the others (e.g. Taleb and Roubini) were for the nomination as Professor of Doom? To a certain extent yes. We believe that the main reason for this is that the others translated their warnings into a so-called 'short'-selling strategy in which investors bet against the growth of the system. Kotlikoff feels that the Western financial system - taking into account the financial state of the system - is basically a pyramid game and going against that in short transactions would be way too dangerous and maybe even immoral. His solution would probably be increased pressure on governments and increased investments in Emerging Markets, with the reason for the latter being that the longer Western governments refrain from going for the 'only' solution the lousier their bargaining power when they will have to accept a large-scale entrance of EM investors to their markets. At that time the latter can acquire stakes in firms at a lower price per share, thereby further improving the relative position of EM investors and the firms they represent. Over the last 10-20 years the willingness to invest in EMs was lower than the willingness to invest in short positions. Maybe that explains.

And what we also don't understand - actually, we think it is the only big flaw in Kotlikoff's work - is why he did not touch the issue of Military and Defense spending. That is about one-third in the US. Why immediately go for Health Care and Social Security cost cutting when the policy of trying to rule the whole world your way through a dominant military force is so much against your longer term interests when knowing that you are - by doing this - acting against the interests of the nations that in the longer run are the only ones that can save you financially. This would only be rational in case you want to follow a colonialist strategy of gaining control over foreign resources (while telling the rest of the world it is because of security reasons that you act the way you act) and when you are indeed willing to go all the way with a policy that is so much against what you stand for as a country politically. With Western nations in the longer-run not willing to go all the way against bigger nations (China, Russia, Iran etc) it is clear that the cost of the military apparatus is way too high a burden when taking into account the state of the economy. Dialogue with giants - even the ones that you don't like - seems to be far more efficient and through international trade it could lead to a safer world with a larger amount of financial and political equilibrium. Let's hope that Kotlikoff in one of his future paper's will also address this issue.  

References
For more information on all of this, visit Kotlikoff's Wikipedia page or his own personal website with a lot of interesting information.

And click here for the link to LMG's slideshare page with the original 2006 article by Kotlikoff.

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