# Debt and welfare in economies with land

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## Abstract

In a stochastic economy of overlapping generations subject to uninsurable risks, debt can implement Pareto improvements in welfare. This is the case even in the presence of long-lived assets and no short sales.

## Keywords

Long-lived assets Optimality Overlapping generations## JEL Classification

D52 D61## 1 Introduction

Sovereign debt has given rise to two branches of research; more or less independent, and cross-effects remain to be considered. One was initiated by Bulow and Rogoff (1989), who focused on incentives for default; here we take our cue from Diamond (1965), who argued that debt can restore optimality when, as in economies of overlapping generations, the market fails to guarantee it. Alternatively, long-lived assets suffice to restore optimality under certainty or compete markets in elementary securities, and debt becomes unnecessary, if not unsustainable, because of transversality. And Demange (2002) argued that this is also the case even with uninsurable risks in an incomplete asset market. Evidently, then, it is constrained optimality that is at stake. Our argument is that constrained optimality applies only in the case of two-period life spans and one, aggregate, commodity at each date: in economies with a richer commodity or demographic structure constrained optimality may fail and debt can implement Pareto improvements in welfare.

More precisely, long-lived assets, land or “Lucas-trees”, restore optimality in economies that extend over an infinite time-horizon. Wilson (1981) developed the argument for economies under certainty, and Santos and Woodford (1997) extended the argument to economies under uncertainty as long as the asset market is complete.

The possible failure of optimality has been studied extensively and is well understood. It derives from the failure of aggregate valuation or, equivalently, an aggregate budget constraint that obtains when the real rate of interest falls short of the rate of growth of output. Samuelson (1958) and Diamond (1965) first argued that aggregate debt or, equivalently, pay-as-you-go social security, may implement optimal allocations, low interest rates notwithstanding. Cass (1972) gave a condition, weaker than aggregate valuation, that is necessary and sufficient for a price path to support a Pareto optimal allocation.

In the presence of uninsurable risks, the optimality properties of competitive allocations are problematic even in finite economies. Not only do competitive allocations typically fail to be optimal, which is not surprising or even relevant, but, typically, they fail to be even constrained optimal: competitive markets fail to make optimal use of the restricted reallocations of risks that fundamentals allow. Geanakoplos and Polemarchakis (1986) showed that, typically, reallocations of the existing assets implement Pareto improvements; Carvajal and Polemarchakis (2011) extended the argument to economies with (purely) idiosyncratic risks. Importantly, constrained suboptimality occurs with multiple commodities or periods of economic activity, and it derives from the variation in relative prices that competitive markets fail to internalize.

Demange (2002) demonstrated an important and surprising result: in an economy of overlapping generations with life-spans of two periods and one, aggregate commodity at each period, long lived assets traded subject to a ban on short sales restore the constrained optimality of competitive allocations in the presence of uninsurable risks: there is no intervention that respects both the prevailing restrictions on risk sharing and the ban on short sales and implements a Pareto improvement. Here, we give a series of examples that demonstrate the dependance of constrained optimality on the restriction to life-spans of two periods and a single commodity. With multiple commodities or multiple periods in the economic life-time of generations, constrained suboptimality may arise.

Lucas and Stokey (1983) and Angeletos (2002) considered optimal fiscal policy under uncertainty, while Diamond and Geanakoplos (2003) and Dutta et al. (2000) characterized optimal financial policies for social security. The constrained suboptimality of competitive allocations provides a foundation for intervention. Here, with debt along with long-lived assets, aggregate debt policy implements Pareto improvements.

## 2 Land

The economy is stationary, of overlapping generations with life-spans of three periods. Each generation consists of a continuum, of mass 1, of initially identical individuals. There is one perishable commodity at each date. Individuals receive a deterministic endowment, \(e^y\), when young, a stochastic endowment, \(e_s^m\), when middle-aged, and, again, a deterministic endowment, \(e^o\), when old. Personal states, *s*, occur with probability \(\pi _s\); there is no aggregate risk. Land, in aggregate supply 1, produces a constant dividend, *f*. The cardinal utility index, *u*, satisfies standard curvature, smoothness and boundary assumptions. Consumption is *c*, and it is numéraire; holdings of land are *y* and the price of land is *q*. Time commences at \(t = 0\); we omit the subscript, *t*, that indicates dates, when no ambiguity arises.

We shall argue that there are robust situations in which a fiscal authority can implement a Pareto improvement relative to the stationary competitive equilibrium allocation; this, without short sales either before or after the intervention: \(y^y, y^m_s > 0\).

The policy instrument is an exogenous specification of investment in land by individuals when young: \(y^y\). Subsequently, individuals trade in competitive markets. In the absence of aggregate risk, and since individuals are identical at the beginning of their lives, the intervention does not go beyond allocations a market could implement.

*s*, of initial middle-aged generations, of size \(\pi _{s}\), with life-spans of two periods, preferences \(U^m_s(c^m_s, c^o_s) = u(c^m_s) + u(c^o_s) \) and aggregate endowments and initial holdings of land as all future middle-aged generations.

We fix \(u(c)=\log (c)\) and endowments \(e^{m}_{s}=e^{m}+\epsilon _{s}>0\), where \(e^{m}>0\), \(E_{\pi }(\epsilon _{s})=0\), and \(e^{o}=0\); the latter guarantees that the middle-aged cohort never short-sell land, while parameter values shall be such that, at the stationary equilibrium, young generations also do not short-sell.

An economy is specified by the parameters \((f, e^y, e^m, \ldots , \pi _s, \ldots \epsilon _s, \ldots )\), and a property is robust if it obtains for an open set of economies.

At all periods, a fiscal authority dictates investment in land, \(\widetilde{y}^y_t\), by young individuals; in addition, it redistributes wealth, but, *only* at \(t = 0\). Redistribution or transfers at \(t=0\) are \(\tau \). Young generations have no discretion on their consumption or savings. On the other hand, middle-aged generations do: they allocate consumption-saving optimally given the land holdings specified by the fiscal authority when young.

We do not restrict attention to stationary interventions, and, as a consequence, we specify *t* when necessary. Nevertheless, for a Pareto improvement, it suffices for the fiscal authority to set \(\{\widetilde{y}^{y}_{t}\}_{t=0}^{\infty }\), with \(\widetilde{y}_{t}^{y}>0\), and \(\widetilde{y}_{t}^{y}=\widetilde{y}^{y}\), for \(t\geqslant 1:\) the intervention is stationary after the initial date.

^{1}are \(\{\widetilde{q}_t\}_{t=0}^{\infty }\), with \(\widetilde{q}_t =\widetilde{q}\), for \(t\geqslant 2\): asset prices are stationary after \( t =1\).

We shall demonstrate that a Pareto improvement obtains for \(\widetilde{q}_{1}>q \) and \(\widetilde{q}< q\). Moreover, we restrict the analysis to marginal changes of land holdings and date 0 transfers that translate to marginal changes of prices, allocations and utilities. We outline the construction of a Pareto improving intervention; a complete derivation is in the Appendix. For simplicity, we use the notation *u*(*c*), keeping in mind that \(u(c)=\log (c)\).

*after the initial date*to make \(\mathrm{d}q<0\) and, as a result, make generations \(t\geqslant 2\) better off.

*at the initial date*to satisfy (2) and, with appropriate redistribution, make everyone at \(t=0\) better off.

*B*arbitrarily close to \(\Gamma \). Since \(A>\Gamma \), there exist interventions such that \(A>B\) and generation \(t=1\) is better off. This completes the argument.

The intuition behind the constrained suboptimality result can be best understood if we focus on the behaviour of generations after date 0. The young members of each generation, taking prices as given, invest too much in land (over-save) to insure against the bad realisation of uncertainty. The fiscal authority, by decreasing investment in land by young individuals, induces a non trivial change in asset prices. The latter effect induces a reallocation of wealth among members of each generation that is welfare improving. Effectively, individuals invest too much in land because prices are not “set optimally” at the competitive equilibrium.

## 3 Debt

To focus on debt, we demonstrate the constrained suboptimality of equilibrium in a two commodity, two period life-span economy of overlapping generations, where individuals hold public debt and invest in land. Multiple commodities serve the same purpose as life-spans of multiple periods. Perturbations of public debt affect the relative price of commodities that, in turn, induces a reallocation of state-contingent wealth that improves ex-ante welfare. As before, there are no short sales of land at equilibrium.

Each generation consists of a continuum, of mass 1, of initially identical individuals. There are two perishable commodities at each date: 1 and 2. Individuals desire both commodities when old and only commodity 1 when young. Commodity 1 is numéraire and its price is normalized to 1, whereas the price of commodity 2 is *p*. Individuals receive a non-stochastic endowment, \(e_{1}^{y}\), when young, a stochastic endowment of commodity 1, \(e_{1,s}^{o}\), and a non-stochastic endowment of commodity 2, \(e_{2}^{o}\), when old. Notation and assumptions about land as before. There is a government that issues debt, *b*, pays interest on debt, *i*, and levies lump-sum taxes, \(\tau \). Time commences at \(t = 0\); we omit the subscript, *t*, that indicates dates, when no ambiguity arises. Notation and assumptions about personal states as before; there is no aggregate risk.

*s*, of initial old generations, of size \(\pi _s\), with preferences \(U^o_s(c_{1,s}^{o},c_{2,s}^{o})=u(c_{1,s}^{o})+u(c^{o}_{2,s})\) and endowments, holdings of land and debt as all future old generations.

At all periods, the government perturbs debt^{2} held by young individuals; in addition, it redistributes wealth, but, *only* at \(t=0\). Subsequently, individuals trade in commodity and land markets. We restrict the analysis to stationary marginal changes of debt.

*z*the following expression

*z*. To see this, rewrite (7) as

*z*.

*z*is positive; a restriction (inequality) that is satisfied at the stationary competitive equilibrium. Marginal changes of debt that induce \(z>0\) imply that the sum of perturbed utilities is positive.

*z*is positive; the second restriction (inequality) that is satisfied at the stationary competitive equilibrium. Since we require \(z>0\), marginal changes of debt induce a Pareto improvement.

### Remark 1

It is the pecuniary externality induced by \(\mathrm{d}p\ne 0\) and trade in the second commodity, \(e_{2}^{o}\ne c_{2,s}^{o}\), that drives the constrained suboptimality result. If \(\mathrm{d}p=0\) or \(e_{2}^{o}= c_{2,s}^{o}\), then the stationary competitive equilibrium is constrained optimal.

## 4 Capital

Finally, we introduce capital and demonstrate that improving interventions are characterised by higher levels of capital investment relative to the competitive level; the competitive allocation is characterised by under-investment.

*k*is capital and

*l*labor employed. Profit maximisation requires

*w*the real wage. Notation and assumptions about personal states as before; there is no aggregate risk.

*c*is for consumption and \(\varrho _{s}\) are shocks to individual capital efficiency; shocks are positive and satisfy the normalisation \(E[\varrho _{s}]=1\). First order conditions are

We demonstrate the constrained suboptimality of equilibrium with a robust example; as before, details are presented in the Appendix. An economy is specified by \((u,f,a,\overline{l},\ldots ,\pi _s,\ldots ,\varrho _s,\ldots )\). At all periods, a fiscal authority dictates investment in capital, *k*, by young individuals; in addition, it redistributes wealth, but, *only* at \(t=0\). Subsequently, individuals trade in commodity and land markets. We restrict the analysis to stationary marginal changes of capital.

*q*with respect to

*k*, it follows

*always*positive at equilibrium. As a result,

*only*a policy that increases capital investment relative to the competitive level, \(\mathrm{d}k>0\), can induce a Pareto improvement.

According to the previous argument, \((\partial q/\partial k)<0\) and \((\partial w/\partial k)>0\). Moreover, \((1+r-(f+q)/q)>0\) is the risk premium between the risky investment in capital and the safe investment in land which is positive at equilibrium. A positive risk premium implies \(r>0\). As a result, the term inside the parenthesis in (8) is positive.

### Remark 2

It is the pecuniary externality induced by perturbations of labor income of old members of each generation that drives the constrained suboptimality result. In particular, a small increase in *k* lowers *r* and increases *w*, scaling down the part of income of old individuals that is stochastic and scaling up one part that is deterministic. Also, a small increase in *k* lowers *q*, that, in turn, lowers the other part of income that is deterministic. For the parameter values that we specify to compute an equilibrium (see the Appendix), the increase of *w* dominates and an increase in *k* induces a Pareto improvement. Finally, if old individuals do not supply labor, then the stationary allocation is constrained optimal.

### Remark 3

Carvajal and Polemarchakis (2011) considered a similar economy where idiosyncratic shocks affect only the productivity of labor of old members of each generation. They gave an example where the competitive allocation is characterized by over-investment in capital. Krebs (2003) considered an infinite horizon economy with heterogenous infinite-lived agents that invest in physical and human capital and idiosyncratic shocks affect only the return to human capital. He argued that a reduction in idiosyncratic risk reduces investment in physical, but increases investment in human capital; the equilibrium is characterised by over-investment in physical capital and under-investment in human capital. Geanakoplos and Kübler (2015) considered a two-period economy with heterogenous agents and incomplete markets. They described mechanisms through which, at equilibrium, agents over-borrow.

## Footnotes

- 1.
The assumption of \(e^o=0\) simplifies the dynamics of asset prices. In particular, the asset price at

*t*is not a function of the asset price at \((t+1)\) but, instead, is pinned down only by the land holdings of young individuals. Our results extend to the case where \(e^o>0\). - 2.
As a consequence, lump-sum taxes have to be adjusted accordingly in order for the government budget to be satisfied.

- 3.
Expression (16) implies two extra roots: \(q=-9.19947\) and \(q=-0.240055\). Negative asset prices are not candidates for equilibrium.

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