The Household Fallacy
We refer to the idea that government must 'tighten its belt' as a necessary policy response to higher indebtedness as the household fallacy. We provide a reason to be skeptical of this claim that holds even if the economy always operates at full employment and all markets clear. Our argument rests on the fact that, in an overlapping-generations (OLG) model, changes in government debt cause changes in the real interest rate that redistribute the burden of repayment across generations. We do not rely on the assumption that the equilibrium is dynamically inefficient, and our argument holds in a version of the OLG model where the real interest rate is always positive.
We would like to thank, without implicating, seminar participants at the Bank of England, Deutsche Bundesbank, Glasgow University and Narodowy Bank Polski. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.