Useful illusions

money, debt and debt restructuring

Hank Conner

The homo economicus cannot be cheated. The fictive person that economic science gave birth to is averse to illusions. Instead, for each decision to make the homo economicus weighs all alternative options and selects without exception that option that is considered the best. Which of course does not mean it is also the best choice for society. But the homo economicus does not bother about that. He or she – the homo economicus has for good reasons always been sexless, will not refrain from selecting the option with lower taxes or a better local environment even if that corresponds to much higher taxes for others or a far worse environment at greater distance.

The concept of the homo economicus has proven to be useful. It helps to understand the economic effects of tax reform and those of a liberalization of world trade. It also helps to see why possible future developments can have effect today. Think of financial crises that from time to time shake up the global economy. Think of announcements of policy changes that change the economy before they have come into force.

Yet, the homo economicus is not more than a concept

Yet, the homo economicus is not more than a concept, a concept that has great value in some cases, but little value in others. An example of the latter is the case of money illusion. A homo economicus considers the cases of a freezing of nominal wages when price inflation amounts to 2 percent and of a nominal wage cut of 2 percent when there is zero inflation as perfectly equal. In reality, the cases are totally different. Workers are much more willing to accept a real wage decline when this takes place without a cut in the nominal wage. This is one of the reasons that many economists consider moderate inflation a good thing: moderate inflation facilitates processes of economic adjustment that characterize the dynamic economies of today.

Another illusion is about the danger of public debt

Another illusion is about the danger of public debt. Many consider public debt an evil, just like private debt. They wish the government would behave as disciplined as themselves or even better in order to set a good example (which means zero or little public debt). Obviously, this is an illusion: public debt, even it is huge, may be harmless as long as it is accompanied with sizeable future primary balances. And why is this illusion useful? Because policymakers are inclined to spend and not to tax, thereby disrespecting the interest of future generations. The illusion of public debt helps to ensure that public finances will not derail.

Yet another illusion is about debt restructuring

Yet another illusion is about debt restructuring. The current clash between Greece and the holders of Greek bonds (primarily official institutes like governments and central banks) is a perfect illustration of this illusion. Greece asks for debt restructuring in order to direct domestic economic policies to economic growth. Debt holders ask Greece to fulfil its obligations. A compromise might be a reduction of the coupon rate or a rescheduling of the debt, a lengthening of the time of debt repayment. Such measures have often been applied in history and were also part of the Greek bailout package of November 2012. That reducing the coupon rate or prolonging debt maturities does not diminish the value of the debt, is an illusion. But if this helps to reach a compromise between the parties involved and avert a Grexit or Greek bankruptcy, a very useful one.