In 1989, Dr. Stanley Pons and Dr. Martin Fleischmann “discovered” cold fusion — the ability to produce essentially free, unlimited energy. Pons and Fleishmann became overnight celebrities. Part of the story's drama was two, upstart chemists revolutionizing the staid field of physics. It was, according to the New York Times, a story of David and Goliath. Sadly, there was no proof in the pudding. Instead, a misreading of temperature underlay the heralded results.
Fast forward three decades to renowned economist Olivier Blanchard’s pronouncement, in his American Economic Association Presidential address, that “public debt may have no cost.” Blanchard was elected president of economics’ 20,000-member club for good reason. After an illustrious career as MIT’s top macroeconomist, Blanchard served as chief economist of the International Monetary Fund.
Blanchard’s 2019 address shook the economic policy world. His apparent blessing of deficits was covered by the global media. Economics Nobel Laureate Paul Krugman and famed economics columnist David Leonhardt devoted separate New York Times columns to endorsing it. Jared BernsteinJared BernsteinMore than 7 million Americans to lose jobless benefits on Labor Day Job openings hit 10.1 million in third straight record-breaking month Deficit Ponzi schemes meet cold fusion MORE, former chief economist to then Vice President BidenJoe BidenUN meeting with US, France canceled over scheduling issue Schumer moves to break GOP blockade on Biden's State picks GOP Rep. Cawthorn likens vaccine mandates to 'modern-day segregation' MORE, did likewise in the Washington Post.
The medium, in this case, Blanchard, was not the only message. Blanchard mathematically proved that, under the right conditions, governments can run successful Ponzi schemes — generational chain letters, leaving all current and future generations better off.
Blanchard’s paper harkens back to a classic 1958 “Consumption Loan” article by the late economics giant Paul Samuelson. Samuelson showed that economies with unproductive investment could do better by perpetually taking from the young and giving to the old. How much better depended on the economy's growth rate, specifically the growth of wages, which could be taken from successive workers and given to successive retirees. Deficit finance is one form of such take-go policy. But, in our country, most take-go policy is run under the rubric of Social Security and other intergenerational transfer programs. Samuelson’s paper is a classic, but also a curiosity given that, on average, the return on investment vastly exceeds the growth rate.
Blanchard address reprieved Samuelson with a one-two punch. He first documented the long postwar history of safe rates – the real (after-inflation) return on government bonds -- underperforming growth rates. He then argued that in a risky world, the safe rate, not the average return on risky assets, is the right investment rate to compare with the growth rate. And since the safe rate lies below the growth rate, Samuelson was right. The government can run a Ponzi scheme after all.
Economic models matter. No matter how abstract and unrealistic, their conclusions can permeate policymakers’ minds and actions. Yes, the federal debt has risen from 35 percent of GDP to 100 percent in just 13 years with further major increases likely. Yes, Social Security’s trustees report a $53 trillion unfunded liability. Yes, putting everything on the books suggests the U.S. is in worse fiscal shape than any advanced country. But, over time, the economy will outgrow its debt, official and unofficial.
In two National Bureau of Economic Research working papers, my co-authors and I demur. The first paper shows that Blanchard overstated his model’s findings and misread their source. Getting Ponzi schemes to work requires extreme and implausible assumptions. And when they work, the gains are due entirely to improvements in risk sharing across generations. Moreover, once the government optimally shares generational risk in a bilateral manner – sometimes redistributing from young to old and sometimes doing the opposite – the scope for win-win Ponzi schemes evaporates. In short, Blanchard’s model has a problem, which deficits can, on rare occasions, ameliorate. But like prescribing the wrong antibiotic, they can dramatically worsen the patient's condition.
The second paper presents three alternative models with government borrowing rates running below the economy’s growth rate. Yet Ponzi schemes have no purchase. The first model has low safe rates due to economic uncertainty across households. The fix is not intergenerational redistribution – taking from the young to give to the old – but using progressive taxation to redistribute from winners to losers in the same generation.
The second features government-generated risk. Here, uncertainty about when the government will end an unsustainable social security policy makes holding government debt highly attractive. This produces a vicious cycle in which fiscal profligacy lowers the government’s borrowing rate, encouraging yet more profligacy.
The third has households on the borrowing as well as lending side of the credit market — households that face safe rates far above the growth rate. In this realistic setting, Blanchard’s Ponzi scheme makes lenders better off but borrowers worse off.
The message in our missives is clear. Low safe rates signal risk — economic and political risk that needs to be understood and mitigated. Suggesting deficits are free is cold fusion redux. Deficits and other take-go policies endanger the next generation's economic future, pure and simple.
Laurence Kotlikoff is a professor of economics at Boston University.