December 01, 2008

We are All Ricardians Now

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The country needs a fiscal stimulus. In the economics of John Maynard Keynes there is a clear rationale. The economy is going into a serious recession. When that happens, the government faces a bitter choice. It can stabilize its budget, or it can stabilize the economy, but it cannot do both.

  • Stabilizing the economy means cutting taxes and increasing spending in order to compensate for the fall in aggregate demand. In addition to first-order effects, this will put more purchasing power into the hands of consumers, who will hopefully spend it, so multiplying the effect of the initial injection -- but the lower taxes and higher public spending will cause the budget to swing into deficit (in the case of the UK, it was in deficit already).
  • Stabilizing its budget means that the government must raise taxes and cut spending, but this will make the recession worse, since households will lose even more purchasing power than they are already losing because of the credit crunch and the recession.

Wisely, the government has chosen to try to save the economy, not its budget. And, in fact, so has the opposition. The difference between them is that the government will spend more, and cut taxes less; the opposition would shift the focus somewhat to tax cuts. In practice the difference may not matter hugely.

In addition to bringing forward some capital projects, the government is cutting VAT temporarily, deferring an increase in corporation tax, making permanent a recent increase in the tax threshold, and increasing pensioners' and children's benefits. The total shift in the Treasury's underlying fiscal stance is a net stimulus of £21.5 billion over two years, the current year and next year. But, because the economy will go into recession anyway, eating away at tax revenues and pushing up spending on benefits, public borrowing will rise by much more.

As a result the ratio of debt to GDP will rise from 36% in the last financial year to 57% in 2012/13 (figures are in this week's The Economist). This is causing huge political concern. Who will pay for it, and how will we pay? At the moment we have only a few clues. The VAT reduction is temporary. National insurance contributions will rise for everyone, and marginal tax rates will rise for the highest earners. The capital spending that has been brought forward will also come to an end earlier than planned. Bankers are rich and unpopular, so the rich are a tempting target, but in the medium term the rich will be fewer and poorer than recently so the average tax payer will probably make the main contribution.

The concern over how to pay for the debt is odd in two ways. First, at 57% the British debt ratio would still be within the limits of the EU Stability and Growth Pact, below the current EU average, and far below today's ratios for France, Belgium, Germany, and Italy. A 57% ratio is also quite sustainable; in steady state, financed at 3%, it would imply a permanent increase in the UK tax burden of about 0.6% of GDP.

Second, the concern looks counterproductive. This is where Ricardo comes in.

Does it matter whether you finance extra government spending by extra taxes, or by running a budget deficit and borrowing to cover it? In Keynesian terms, the purpose of the fiscal stimulus is partly to replace households' lost purchasing power. If taxes rose now, that purpose would be frustrated. That is why the stimulus should be financed by borrowing.

In 1820, David Ricardo asked what difference it would make to finance a given amount of government spending by borrowing or taxation. The burden of taxes required would be £X. Alternatively, the government could borrow £X from the public as a perpetual loan. The only change in the burden of taxes then would be £X times the interest rate -- but this would have to be levied in every future year. The present value of the stream of future taxes, discounted at the same interest rate, would be ... Oh, £X.

In other words, borrowing is simply deferred taxation, and the present value of the two burdens is equivalent, so this idea is sometimes called Ricardian equivalence. (In the 1970s Robert Barro revived the idea as a major contribution to the new classical macroeconomics.) 

In Keynesian economics, households receiving the stimulus of extra government spending feel better off when it is financed by borrowing, since they have more current purchasing power as a result. Therefore they go out and spend more, and there is a multiplier effect that boosts the economy further. If Ricardian equivalence holds, however, rational households perceive that the extra borrowing arising from the stimulus is just deferred taxation of the same value as the government spending, and feel no better off as a result. There is no further boost.

Ricardo did go on to point out that households might not be fully rational; there would be a natural tendency to see £X times the interest rate (say £3) forever as a much smaller burden than £X (say £100) now. And most empirical studies of the postwar period have tended to show that the multiplier does work, in the short run anyway.

Most politicians are unlikely to know anything much about David Ricardo, and only the few that studied economics at degree-level may have heard of Ricardian equivalence. Yet today we see that politicians on both sides, apparently intentionally, are trying to instruct the electorate in Ricardian equivalence. Government and opposition are alike emphasising that today's fiscal stimulus is only temporary and must be paid for with higher taxes in the future.

To the extent that ordinary people are listening, they will surely respond less to the fiscal stimulus as a result; being told to expect higher taxes in the future, they will spend less of the extra purchasing power they receive and will save more of it than if they had not received the warning. The overall effect of the stimulus will be less.

Why are the politicians doing it? The government is doing it in order to manage expectations of its policy can achieve. The opposition is doing it to undermine the credibility of the government. It comes to the same thing. We are all Ricardians now.

- One comment Not publicly viewable

  1. Ralph Mugrave

    The flaw (and the irony) in the Ricardo argument is that if households are totally rational and clued up about economics (which I think is an absurd idea), they’ll see the flaws in the Ricardo argument (!), which are thus.

    First, if the monetary base and national debt are to remain constant as a proportion of GDP (in real terms), they will have to be constantly topped up as they are constantly declining in real terms because of inflation. To illustrate, if nat debt and mon base are say 50% of GDP and inflation is 2%, you need a constant and never ending deficit of 2×0.5 = 1% of GDP. That portion of the deficit is NEVER paid back. I.e. it is not “future tax”.

    Second, and more important, there is no point in paying back nat debt till the economy looks like overheating if it is not paid back. I.e. it is paid back in a scenario where households cannot effectively spend any more (on pain of causing inflation) unless they are taxed more. This means it is TOTALLY POINTLESS saving up to pay the tax because when the times comes to pay it, the average household will not even see the money because government will grab it before the household sees it. That’s because most income tax ( i.e. for wage earners) is deducted before wage earners see the money (at least that’s the case in the UK and most Western countries). And as to sales tax, that is added before consumers make their purchases.

    So any household that “saves up” to pay this tax is double counting.

    13 Oct 2010, 19:36

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I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).

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