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February 17, 2009

Automatic Destabilizers

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The day after Leeds City Council announced the loss of 650 local authority jobs because of "lower government grants and the economic downturn," it's Coventry's turn. According to a news release on Coventry City Council's website, our city faces a "budget gap" of £13.5 million. More than £9 million of savings have been identified. These include, in addition to "efficiency reviews of services," "a £469,000 reduction in publicity and advertising budgets, 3% cuts in grants to voluntary organisations and £530,000 through increasing charges in some social care services." It is expected that 190 posts could disappear. Councillor Kevin Foster, Deputy Leader of Coventry City Council, is quoted:

The Council, like all councils, is facing a number of challenges over the coming year. Clearly the recession is having a major impact on our finances ...

Oddly enough, this is not what is supposed to happen in a recession.

As I wrote here, faced with the current collapse of aggregate demand, "the government faces a bitter choice. It can stabilize its budget, or it can stabilize the economy, but it cannot do both." The recession is plunging the budgets of central and local government alike into deficit. Stabilizing the budget means cutting government spending and jobs as revenue falls. Stabilizing the economy, in contrast, means maintaining spending and jobs, borrowing to cover the widening budget gap. In the interests of us all, including the interests of tomorrow, the government should choose the latter course.

In theory, some stabilization of the economy should happen automatically. In our economy, taxation is progressive; this means that, when personal incomes fall, the government's tax take should fall more than proportion. As a result, personal incomes should fall by less than the country's national income, and this should to maintain spending and employment. Part of what the government spends is also progressive: as jobs and family incomes fall away, the government should automatically replace part of what is lost by meeting entitlements to unemployment benefits and other income support. These "automatic stabilizers" don't make things better. They just make things a little less bad than they would be otherwise.

Think about that word, "otherwise." It means: in the absence of the automatic stabilizers. If, say, the government always spent every penny it received, but never more, the government would continually add to the natural volatility in the economy. Every time there was a boom, the government would experience a rise in its revenues and, by rushing out to spend them, heighten the boom. Every time there was a slump, the government would respond to its lost revenues by spending less and so deepening the recession. It doesn't just sound like a bad idea: it is an absolutely terrible idea.

Yet this idea is currently being put into effect by local authorities up and down the country. As property values and business and personal incomes fall, city councils are losing revenue from council taxes and charges. At the same time, for exactly the same reason, local claims on services and benefits are growing. But our cash strapped cities not only cannot meet these rising demands; they must cut back provision.

Rather than mitigating the jobs crisis, they are adding to it and deepening it.

This is the result of a policy failure on the part of central government -- a failure of scandalous proportions. While Westminster plays the blame game -- who should be punished for the failures of our banking system? -- the real economy is sliding down into depression. The solution is well known: a strong fiscal stimulus. But, while Westminster talks, what our country is actually experiencing is the exact opposite: a powerful fiscal brake that is spread by the collapse of local government finance and adds to the burden on us all.

The failure is scandalous because the solution could be put into effect overnight. The Treasury must promise now to stabilize local government funding at its pre-recession level. Local authorities should be enabled to plan for the future without adding to the pool of the unemployed. When the economy recovers, the additional subsidy from the centre can be gradually withdrawn.

I can see two obstacles to this simple course of action.

First problem: Purists may object that our cities are subsidy junkies already; if the subsidy from central government is temporarily increased, it may be politically difficult to withdraw it later when conditions improve. I acknowledge this danger. It is an example of what, on January 20, Bank of England governor Mervyn King described as

the paradox of policy at present – almost any policy measure that is desirable now appears diametrically opposite to the direction in which we need to go in the long term. Spending now supports the economy, but in the long run we need to save more and borrow less. Public borrowing sustains spending, but in the long run needs to fall. Banks are encouraged to run down their capital to enable them to absorb losses while continuing to lend, but in the long run they will need more capital. Interest rates have fallen to unprecedented levels, but in the long run will need to rise to more normal levels.

In the same way local government in the UK must be allowed to spend its way through this crisis, yet in the long term become fiscally more self-reliant. But there are ways to achieve this; for example, local authorities could take out loans from the Treasury with repayment contingent on local incomes or employment rates returning to their pre-crisis levels. But the time for complicated solutions may be already past; this is, after all, a crisis.

Second problem: The Westminster government may positively not want to do this. Whitehall is full of spending ministers. If there is to be a stimulus package, they will want to monopolize it and claim the credit for it. Scattering central funding across many local authorities, many (like Coventry) managed by parties that are in opposition in Westminster, may not look like the best way for Labour to prepare for the next general election. I suspect this is the most important obstacle to the action that our country needs. If so, it makes the failure to act even more scandalous.

Let me repeat: allowing local authorities to keep up their spending during the current recession is not a solution to the crisis. It is just a way to neutralize a mechanism for destabilization, one that is currently making the crisis worse than it needs to be.

February 12, 2009

Stupid After the Event

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We're all wise after the event.

The public would have like it better if more of us had been wise before the event. The bankers that are sorry now didn't see it coming. The politicians and regulators won't say they are sorry, but they didn't see it coming either. Who else should have seen it coming? Anatole Kaletsky (in The Times, Feb. 5, 2009) says that economists should join the others in the dock; they are "the forgotten guilty men." By economists, he adds,

I do not mean the talking heads (myself included) employed by the media and financial institutions to “explain”, usually after the event, why share prices or currencies have gone up or down. Nor do I mean the forecasters whose computers churn out scientific-looking numbers about what will happen to growth or inflation, but whose figures are revised so drastically whenever something “unexpected” happens - as it always does - that their forecasts are really nothing more than backward-looking descriptions of recent events.

What I mean by “economists” are the academic theorists who win Nobel prizes, or dream of winning them.

Why economists? The financial crisis, Kaletsky notes, was caused by practical men, not academic scribblers. But Keynes wrote, as Kaletsky reminds us:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

This seems harsh to me. Not all economists were stupid before the event. I'm not well enough connected to have conducted a census, but Robert Shiller was writing about irrational exuberance in financial markets ten years ago. In 2002 my colleague Andrew Oswald predicted the great UK house price crash of 2003 to 2005. (If only he'd been right; we would all be hurting a lot less now.) In the same year other colleagues past and present – Marcus Miller, Lei Zhang, and Paul Weller – warned in the Economic Journal of the "Greenspan put," a "one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk." Yes, some were wise before the event. They are people I can only bow to.

What about Kaletsky himself? Two years ago, on March 9, 2007, Kaletsky gave the Colliers CRE annual economist briefing. This is just some of what he said:

Kaletsky firmly believes that there is 'good news' supporting long-term trend growth in the global economy ... A 'mid-cycle slowdown', rather than a recession, is now overdue ... Kaletsky believes that we will experience a slowdown rather than an outright recession. This means we will not see a sharp rise in unemployment and bankruptcies ... The US housing market has undergone a strong slowdown ... Kaletsky is confident that we are much more likely to see a soft landing in the US housing market than a collapse ... Kaletsky firmly believes new home sales have reached a bottom in the US and is confident that 2007 will see signs of a pickup ... The UK will stand out against the tide of slowing growth in Europe ... the financial sector - led by London - will go from strength to strength ... Although a number of commentators have focused on the risks of a house price crash, Kaletsky believes these to be overstated.

In January 2008 I attended an AEA panel in New Orleans where Shiller, along with Paul Krugman and Nouriel Rubini, academic scribblers all, acurately predicted the coming huge bust in the U.S. housing market. A month later, on February 5, 2008, Kaletsky told Colliers CRE:

We are approaching the end of the credit crisis in terms of time, if not necessarily pricing, and that it will be resolved one way or another in the next month ... The US is experiencing its worst economic downturn since the 1990s, but Kaletsky believes the worst may be over, although the risk of recession remains.

Of course, Kaletsky said a lot more than I have quoted, and I have quoted very selectively. If you prefer to read the full texts of his briefings, they are both here. Let me add that, in his 2008 remarks, Kaletsky made one other very important point: 

in 2005, the International Monetary Fund (IMF) conducted a study of recessions around the world. Of the 74 recessions studied, only four were predicted in the preceding year. Furthermore, only one third of forecasters interviewed in a recession year actually spotted the recession in that same year.

So what? Here's what.

Nearly everyone has been wise after the event, not before. Don't get me wrong: being wise after the event is very important; let's not undervalue it. Being wise before the event is best, but being wise after the event is the next best thing. And being wise after the event definitely dominates being stupid after the event. This is a danger that I'll come to.

If we want to be wise after the event, it's time to rethink. What are the parts of economics that need rethinking? According to Kaletsky it is our concepts of

the “efficiency” of markets and the “rationality” of the investors, consumers and businesses who inhabit them.

I agree! We should rethink the way we use the rationality assumption. As an economic historian, I use it in all sorts of peculiar context. I have argued (here for example ) that the value of the axiom lies partly in helping us draw a line between what we do and do not understand. If we assume that individuals behave with full rationality, subject to constraints, and our models works in terms of simulation or prediction, then we can at least kid ourselves that we have understood that behaviour in the sense that we don't need anything more complicated to analyse it. If the model doesn't work, it tells us we failed to grasp something – some constraint on behaviour or some bound on rationality – that is missing from our model. In short, the rationality assumption helps us draw a line between what we understand and what we don't.

Recent events are shifting that line, but in different ways for different people. First is a relatively narrow group, those (not all) financial economists that bought heavily into the efficient markets hypothesis and rational expectations; they have seen their frontier with the unexplained collapse inwards. Second are a much wider group, the macroeconomists that did not buy the efficient markets hypothesis, but nonetheless believed that in the event of market failure governments had the power, the monetary and fiscal instruments, the capacity for international coordination through G8, G20, IMF, and so forth, and the will to avert the worst consequences. We are watching events unfold, but I am much more pessimistic than I was.

The main problem for economics that I see is this. Most professional economists are clever people. Clever people have one weakness: they are clever in many ways. One of these is getting at the truth. Another is being contrarian. In fact, because they are clever, and often highly motivated, clever people tend to be good at denial. They can think up a thousand sophisticated arguments to defend manifestly absurd ideas. My rule of thumb is that everyone, including me, believes in at least one completely crazy idea; the trouble is, I don't know which one it is. So look out for a lot of clever economists who are going to be stupid after the event, because of some idea they are wedded to and will continue to defend while the world walks off in the other direction.

If I'm clever enough, I may well be among them.

The main problem for politics is different. It is that it is much more fun to play the blame game than to do something – something for which, in future, you may be blamed. As a result, politicians and journalists in our country (and no doubt elsewhere) are now sitting around throwing accusations at bankers, economists, journalists, and each other – particularly at bankers, which is fine in a way because monetary policy can currently do nothing more to make things better, so why not?

Except that it is a diversion from the one thing that can now make things better, the promised fiscal stimulus. We are losing 100,000 jobs a month – and unemployment is a lagging indicator. To make a difference, the fiscal stimulus was needed six months ago. It seems that we cannot even count on the automatic stabilizers that should limit recession. While local authorities lose revenue, for example, councils are cutting jobs and services that they can no longer afford but the community needs ever more desparately. The current lack of fiscal action on the part of our government is scandalous. Stupid after the event.

January 22, 2009

The Fiscal Stimulus: Catch 22

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Paul Krugman has made the following point: for the United States, one dollar added to the federal debt by new public spending will save three dollars' worth of jobs. This is despite the fact that the Keynesian multiplier for the United States is only about 1.5. Why? Because every job saved will generate tax revenues that should offset some of the implied increase in the federal deficit.

There's a couple of assumptions in that. One is that interest rates won't change much, which makes sense because right now they are on the floor and likely to remain there. Another is that, oddly enough for a guy that won the Nobel prize for contributions for trade theory, Krugman doesn't mention foreign trade. That makes sense because the United States ratio of trade to GDP is only 10% (exports) to 15% (imports).

The same idea should work for Britain. But it is much less favourable, because we are more heavily taxed and also have a much more open economy. Unless I misled several generations of first-year students, the Keynesian multiplier for an economy with direct and indirect taxes and foreign trade is 1/(1 - c(1 - t1) + t2 + m) where c is the marginal propensity to consume (say 0.6 in the short run), t1 is the direct tax rate (say 0.25), t2 is the indirect tax rate (say 0.15 since Darling's VAT reduction), and m is the import propensity (say 0.25). That gives us a Keynesian multiplier of 1/0.95 which for present purposes is about 1.

Let's assume that interest rates stay low, and the exchange rate stays where it is. Then, every extra pound of public spending generates about one pound of effective demand for goods and services. But then, each extra pound spent will bring back 40p to the Treasury in direct and indirect tax revenues, raising the national debt by only 60p. That makes 60p of new indebtedness the price we will pay to create one additional pound of GDP.

Think about jobs. In the UK economy each person employed generates about £50k of GDP. We are currently losing around 100,000 jobs a month from the economy; to be conservative let's put that at a round million jobs over the next year. To save those million jobs should take a fiscal stimulus of £50 billion a year, starting now, but it will add only £30 billion to our national debt, because if those jobs can be saved there will be a clawback to the Treasury of £20 billion in tax revenues.

There are some catches.

Catch 1. The government is proposing a stimulus of £20 billion over the next two years. Oh – and it hasn't even started yet. Jobs are being lost now. A fiscal stimulus doesn't work instantaneously. Fixated on blaming the banking sector for what is about to happen (in addition to what has happened already), the government is still trying to revive lending rather than to revive spending directly. 

Catch 2. Britain, unlike America, can't ignore the rest of the world. The reason exports don't figure in the Keynesian multiplier is that they're outside our economic system: if our export markets are falling off the same shelf as us, that will have an adverse multiplier effect that works against the multiplier effect of our own public spending.

It is critically important for small open economies like the UK to have a fiscal stimulus that is coordinated internationally. We all make up each others' export markets! If every country would stimulate demand at the same time, and in the same proportion, the trade balance effects would be neutral, but the collective stimulus would be far more powerful. Every country would see a double bonus, the first coming from its own public spending, and the second coming from the public spending of its trading partners, reflected in exports.

Catch 22. The European Union was constituted on the assumption that the problem of deficient demand had been solved. Coordination was needed only for monetary policy (so we have a European Central Bank) and to ensure fiscal restraint (so the Eurozone is supposedly governed by the deflationary rules of the Growth and Stability Pact). There's no mechanism to coordinate a European fiscal stimulus!

So it's up to the G8 and the G20. Let's think about that.

Generations of students of international economic history have learned that a major part of the Great Depression was the failure of international coordination. Our ability to coordinate a response to the greatest economic challenge since the Great Depression is being tested now. Until recently, we thought we knew how to avoid bank runs. Then we had the first major run in 150 years. We also thought we knew how to avoid a major recession. I was about to write: "Watch this space." Depressingly, I'm not sure you need to.

January 14, 2009

Three Myths of the Credit Crunch

Three myths are current in public discussion of the credit crunch and the recession that we face today: "We should make the banks lend out the money we've given them." "We can't spend our way out of this recession." Worst of all, "We are burdening our children with debt." What's wrong with them?

We should make the banks lend out the money we've given them.

Since November the following story has been in circulation; it started from Downing Street, but has found wide support. It goes like this: We, the government, have given the banks billions of pounds of your (the taxpayers') money. Instead of translating your cash into new lending, the banks are sitting on it. This is helping to drive cash-strapped businesses into insolvency, and is not fair. The banks are breaking a moral contract. We should now set targets for bank lending and punish banks that fail to meet them.

The story's wrong. We're forgetting something. Question: What was the worst case that the bank bail-out was designed to avoid? Answer: Bank failures on a catastrophic scale. And this has been averted. Our government bailed out the banks because the alternative was a financial Armageddon on the scale that ushered in the Great Depression. So far, this worst case has been avoided. For example, no British saver has yet lost a penny from deposits in a British bank. If the worst had happened, there would be ruined savers in every neighbourhood in the country. Conclusion: the banks are doing what the bail-out intended: they are holding our cash, because they need it to hold in order to stay afloat.

If we want bank lending to increase again, our government must increase the cash available still further, or at least extend its promises. That is approximately what the government is doing now, through credit guarantees to small businesses, for example.

Another version of the same fallacy goes like this. The Bank of England's discount rate is at a record low of 1.5%. Banks (including some mortgage lenders) are unfairly increasing the margin above this level at which they are willing to lend. Public pressure or legislation should bring lending rates down. But one cause of the credit crunch is that banks have underestimated the risks of lending. As a result, the gap between their borrowing and lending rates, which includes their evaluation of risk, has been too narrow. Restoring the banking system to health must provide for larger risk premiums than before.

At this point, pressure for more bank lending and lower lending margins may not be for the best. We are in this mess because banks lent unwisely. Pressing or guaranteeing them to do more of the same, especially for the sake of small businesses that have a high failure rate even in good times, does not seem to point a way back to prudence. As has been commonly observed, monetary policy in Britain as in the United States is simply running out of ammunition. Public spending may now be more effective as a way of keeping viable businesses afloat, and should take up the burden. Which leads us to the second fallacy:

We can't spend our way out of this recession.

In 1976, prime minister James Callaghan famously remarked: "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step." This has been widely cited recently by critics of the government such as (but not limited to) John Redwood.

If more public spending is the right answer today, why was it the wrong answer then? The reason is that that our economic predicament today is wholly different from that of Callaghan's time. In the 1970s, inflation and unemployment were rising together. That was the signal that the UK economy's problem lay on the supply side, not the demand side. The economy was rigid and uncompetitive. Industry was dominated by loss-making firms that were kept in existence by public ownership and public subsidy. The difficulties of the time required supply-side solutions: better incentives through increased competition and lower taxes.

Today, unemployment is rising and inflation is falling. This signals that the UK economy faces a deficiency of demand, not supply. Moreover, the loss of demand at home and abroad is on a scale not seen since 1929. A demand deficiency can be countered by monetary measures to some extent, but for the next few months the overworked cliché is correct: cutting interest rates is like pushing on a piece of string. (The cliché is overworked because, over a somewhat longer period, the monetary relaxation should have a powerful real effect through a more competitive sterling exchange rate.)

When demand is deficient, the quickest way to restore it may be through increased public spending. Tax cuts may be preferable in theory, since each of us knows better how to spend our money than the government does, but in the grip of current uncertainties it is likely that households will save most of any tax cut will be saved, and so the tax cuts will not contribute much to higher demand.

Rapid increases in public spending are likely to be inefficient since there is not enough time to plan them. The composition of any increase is likely to be determined more by competitive lobbying than by cost-benefit calculation. There may well be some degree of consensus that we need to invest in green technology, transport, and IT. As soon as you look at these in detail, you can watch the vested interests line up -- for and against nuclear power and carbon capture, motorway and airport expansion, and so on. However, if our immediate goal is to combat the worst consequences of the crisis, it may not matter if some projects are ill-chosen; at least they will create jobs and cash flows to replace those that are now being destroyed.

Here are two things that could and should be boosted right away -- and it would be efficient to do so.

  • UK local authorities are planning for catastrophic shortfalls in council tax revenues at the same time as demands on their services are multiplying from citizens faced with losing their jobs and houses. It is shameful that local government cutbacks should be contributing to the economic downturn, rather than softening it. The government should immediately commit central funding to neutralize the effects of the recession on local government revenues.
  • Iraq and Afghanistan have taken a heavy toll on the combat readiness of the UK's armed forces. The Ministry of Defence surely has a long shopping list of equipment that is needed just to reset the armed forces to their pre-conflict readiness. There is absolutely no reason to think we will need our armed forces any less in the 2010s than we did in the 1990s. We should start this restocking process now, and this will incidentally make a large contribution to the revival of UK manufacturing.

Can we use public spending to mitigate the recession? The answer lies with Obama, not Callaghan: Yes, we can.

It's true that using public spending in this way will widen the excess of spending over taxes, and cause public debt to balloon. This takes us to the third fallacy:

We are burdening our children with debt.

British politics needs an effective opposition. Just when I hoped the Conservatives were becoming one, George Osborne has come up with this: "Every child in Britain is born owing £17,000 because of Labour’s Debt Crisis."

This story is misleading, rather than false -- but it is deeply misleading on several different levels. It is true that higher public debt must be repaid sometime. As I noted here, however, the implied increase in Britain's debt implied by present policies is relatively modest and sustainable. The government deserves blame for the fact that Britain entered the recession with its current deficit in a bad way, but the accumulated level of public debt was modest, and we can easily withstand a proportionally large increase in it.

But the idea that we are burdening our children with debt is misleading at a deeper level. For one thing, they will inherit our private debts too. What is happening today will eventually lead to a considerable reduction in private debt, whether through repayment or default. At the same time public debt will be higher. So our children are likely to inherit more public debt, but less private debt.

And another thing: Our children will be better able to shoulder the public debt we will pass onto them in the future, if we don't burden them (and ourselves) with a Great Depression now. The last Great Depression impoverished families and children and threw millions of workers on the scrapheap of long-term unemployment. Worse, it paved the way to global economic disintegration and global war. Do we want to burden our children with that?

And a final thing: If it works, our children will live better than we do. As adults, they should share the burdens we face today. But I won't tell my children that. They'll say it's not fair.

December 30, 2008

In 2009, Let the Poor Have Debt

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Too much debt is bad. There has been too much borrowing and lending. Now we are all paying the price in bankruptcies and layoffs.

Coupled with that, a big reaction is under way against the idea of debt and the people who make debt possible: the lenders. There's a lot of anger around that is being directed against bankers. There's also a lot of ex post moralizing: the recession is poetic justice, collective punishment for past collective excess.

It's transparently obvious that we need to adjust to some painful lessons. When they created assets or bought assets that others were selling on, many bankers forgot about exercizing due diligence. They misunderestimated the risk. Those that made the biggest mistakes will have made the biggest losses, so the market has now delivered rough justice. The trouble is that, because market justice is rough, we will all suffer with them.

How far should we all adjust? When people are in a fix and feelings are running high, reactions can go too far. Over Christmas there has been a lot of opinionating about debt. Interviewed before the holiday on Radio 4, the Archbishop of Canterbury said that debt cannot be the foundation of sustainable prosperity. Although he agreed it would be "suicidally silly" for him to start dispensing economic advice, this did not stop five other Anglican bishops from issuing a Boxing Day fatwa against the "buy now, pay later" society.

So, it's time to speak up for debt. Too much debt is bad. But too little debt is bad, too. Even today, if you look at economic conditions around the world, it's almost certainly the case that the damage caused by too little debt hugely exceeds the suffering caused by too much of it.

How's that?

Scattered around the world are many profitable investment opportunities. Many of these are in poor countries; these countries are poor, precisely because many opportunities are not exploited. The poor can see many of the opportunities just as well as the rich -- in fact, often enough, better than the rich, because the opportunities are close by where the poor live: the returns to educating children and to small enterprises, for example. But can the poor take advantage of these opportunities?

It's easy to see how the rich might jump in. After all, they are rich and can afford it. The rich might not want to, though. For one thing they may not see the opportunities hidden in the midst of poverty. For another, they may not see how to make a profit for themselves; it takes a philanthropist to want to educate a stranger's daughter, or fund a competitor's business.

So, if the rich people don't jump in, what about the poor? The problem of poor people is: they're poor. 

The only way the poor can take advantage of these opportunities is by borrowing. The poor need to be able to go into debt

In fact, often enough, it is being unable to incur debt that keeps the poor in their place. While the poor cannot borrow, their children stay illiterate, their land stays unfertilized, and their talents remain idle.

In 2006, Muhammad Yunus was awarded the Nobel Peace Prize for his work in bringing debt to the poor. Here are the opening words of the Prize Committee's citation. "Professor Muhammad Yunus established the Grameen Bank in Bangladesh in 1983, fueled by the belief that debt is a fundamental human right. His objective was to help poor people escape from poverty by providing loans on terms suitable to them and by teaching them a few sound financial principles so they could help themselves."

(Oh -- I changed one word in the quote. Where the original reads "credit," I wrote "debt." You can check the original here. Get the difference? Bring "credit" to the poor -- you're a saint. But those who bring "debt" to the poor -- which is exactly the same thing -- are often seen as in league with the devil. Hmm.)

In poor countries, bringing debt to the poor can be immensely liberating. Poor people that cannot borrow are condemned to live in impoverishment and insecurity; they must remain at the mercy of the existing power structures. Debt lets the poor invest; it has the potential to raise the poor above their station and enable sustainable, long-run development. Yes, real development! It's true, investment is risky and not all investments will pay off. But without debt, the poor will lack even a chance of escaping poverty, for it is then certain that the poor will invest nothing and get nothing.

Yes, it's still true that too much debt is a bad thing. But no debt at all is bad too! In fact, it can be even worse!

Again: in rich countries, even poor people would sometimes like the security and pleasure of living in their own homes. They can have it, but only if they borrow. If you don't let the poor borrow, what you are saying is: Hurray for the landlords! Long live buy-to-let! Keep home-owning for the rich! For people who cannot put down the full value of a house, being able to get a mortgage is productive in a real sense: it is productive of things that we all value, of security and family life, in fact, of exactly the same "non-material" values that the bishops think has gone missing from British culture.

No, it's not a great idea to give poor people borrow more credit than they can ever repay. But to go to the other extreme and tell the poor they must wait until they have earned it -- forever, that is -- is Victorian values of the wrong kind.

The main problem our own rich country will face in 2009 and the years beyond is not too little debt. It is the composition of the debt. A huge shift is under way in Britain from private debt to public debt. Households will tighten their belts, reduce their outgoings, pay down their mortgages, and rent new homes instead of buying them. As a result, private net indebtedness will fall.

Meanwhile, the government will splurge on unemployment benefits, housing support, and capital projects. Because of the expected fall in tax revenues, the government will pay for it by borrowing. Public debt will balloon. While short term interest rates are now at an all time low, long term rates will remain high. In the future this will be a barrier to renewed growth of private indebtedness.

And that's a good thing! When anyone borrows, they should do so in the expectation of a personal gain that exceeds the interest rate; otherwise, don't do it! Making everyone, rich and poor, leap over a higher interest rate hurdle before they borrow is not a bad idea when the problem has been too much debt.

But that's just to ensure that debt performs its proper function: to sustain development. If the poor are to participate in development, they must be able to borrow. The poorest places in the world are the places where the poor cannot borrow.

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.

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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