I am all done writing letters – at least for today. I forgot to send both. I noted someone mentioned that he had never read any admissions of error from me. True enough. Over the course of my academic career I have made many predictions and none have turned out to be qualitatively wrong (sometimes the quantum us shaky but the direction is correct). But I am not trying to sell tickets for myself. Economists like me who comment regularly on current affairs are always subject to empirical scrutiny. So I am regularly putting my neck on the line – in written word (blog, Op-Eds etc) and speech (presentations, media interviews etc). So far so good. I note that a correct empirical observation doesn’t mean the underlying theoretical explanation which might have motivated the prediction is correct. But it is a lot better than missing the empirical boat altogether and suggests that there is some worth in the theoretical framework being employed. From a personal perspective the current period of economic policy is very shattering (if you share my values about the dignity of work etc). But from an intellectual perspective, as an economic researcher, the current period is very interesting. It is providing us with real world data which directly relates to theoretical statements made by economic schools of thought. So I am keeping a running tally of how the laboratory rats are going? You can judge which theoretical structure you consider useful yourself when thinking about what is happening at present.
Governments are in full-scale austerity mode at present. Neoliberals claim that governments, like households, have to live within their means. They say budget deficits have to be repaid and this requires onerous future tax burdens, which force our children and their children to pay for our profligacy. They argue that government borrowing (to “fund” the deficits) competes with the private sector for scarce available funds and thus drives up interest rates, which reduces private investment—the so-called “crowding out” hypothesis.
And because governments are not subject to market discipline, neoliberals claim, public use of scarce resources is wasteful. Finally, they assert that deficits require printing money, which is inflationary.
But they go further than this. They claim that quite apart from these alleged negative impacts, deficits are not required to achieve the aims of the Keynesians. It used to be considered non-controversial that government deficits could stimulate production by increasing overall spending when households and firms were reluctant to spend. In a bizarre reversal of logic, neoliberals talk about an “expansionary fiscal contraction” – that is, by cutting public spending, more private spending will occur.
This assertion comes with the fancy name of “Ricardian Equivalence,” but the idea is simple: Consumers and firms are allegedly so terrified of higher future tax burdens (needed, the argument goes, to pay off those massive deficits) that they increase saving now to ensure they can meet their future tax obligations. So increased government spending is met by reductions in private spending—stalemate. But, neoliberals argue, if governments announce austerity measures, private spending will increase because of the collective relief that future tax obligations will be lower and economic growth will return.
I could provide quotes from leading politicians (from the UK Prime Minister down) and leading economists (Nobel Prize winners and up – ooh, sorry to be so disrespectful) supporting this logic.
These conservatives, some of whom were direct beneficiaries of bailout packages in the early days of the crisis, tell us that our governments are bankrupt, that our grandchildren are being enslaved by rising public debt burdens and that hyperinflation is imminent. Governments are being pressured to cut deficits despite strong evidence that public stimulus has been the major source of economic growth during the crisis and that private spending remains subdued.
Austerity will worsen the crisis, because it is built on a lie. Public deficits do not cause inflation, nor do they impose crippling debt burdens on our children and grandchildren. Deficits do not cause interest rates to rise, choking private spending. Governments cannot run out of money.
But the empirical world is continually spitting out data that allows us to judge the veracity of these claims and counter-claims.
In that context, the neoliberal narrative has run into some inconvenient facts. Interest rates remain low. In most of the developed world, inflation is falling and where it is rising, it is due energy and food costs rising rather than excessive deficits.
But what about Ricardian Equivalence?
Should we not be seeing private sector confidence and spending rising by now – especially in the UK which is now 2 budgets into austerity and in Ireland which has been hacking away in the name of Ricardo since early 2009?
If you are familiar with the theoretical discussion relating to government budget constraints, debt dynamics etc leading to Ricardian Equivalence then you can now skip down to the section headed “How is this theory stacking up?” The conceptual part of the blog is for those needing a refresher or some more advanced understanding.
The theory in a nutshell is this. Government deficits have to be backed by debt-issuance. In the mainstream framework this is drawn from the government budget constraint (GBC) literature which considers a national government to be like a super-household – that is, facing the same constraints but just bigger in scale.
I have outlined the logic before but to make sure readers understand it here it is in summary.
In the mainstream approach, the GBC framework is used to analyses the so-called “financing” choices governments face when spending. The GBC equation says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:
which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
However, once we strip this off the erroneous theory (that governments are like households and have to “finance” their spending) then the GBC is a n accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been correctly added and subtracted.
So in terms of Modern Monetary Theory (MMT), the previous equation is just an ex post accounting identity that has to be true by definition and has no real economic importance.
But for the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
In fact, the mainstream economists know that there is no constraint – what they really want to say is that using ΔH to fund government spending is inflationary and therefore undesirable. They should be more open about that so that we can move beyond it being a debate about constraints and discussing when inflation becomes possible.
So in mainstream economics, money creation (ΔH) is depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money. The reality might be that the treasury would instruct the central bank to credit some bank accounts and some intra-government accounting record would be altered. The accounting is of no interest to us economists in this context.
The mainstream however claim that if governments increase the money growth rate (they erroneously call this “printing money”) the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”! Of-course, we know that proposition is only valid if there is full employment of all resources. Most economies are typically constrained by deficient demand (defined as demand below the full employment level) and they respond to nominal demand increases (growth in spending) by expanding real output rather than prices. There is an extensive literature pointing to this result.
So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases. You will also appreciate that the inflation risk comes from the spending – not what accounting gymnastics are performed – that is, whether the government “borrows from itself” (exchanges of accounting information between treasury and the central bank) or borrows from the public (swapping a bank reserve for a bond account).
These operations neither increase or decrease the risk of inflation associated with the spending. What matter is whether there is spare capacity in the economy to increase production when a spending increase enters the economy. If there is then the inflation risk is low to non-existent. If there isn’t then the inflation risk is high – bond issuance or not!
But not to be daunted by the “facts”, the mainstream claim that because inflation is inevitable if “printing money” occurs, it is unwise to use this option to “finance” net public spending.
Hence they say as a better (but still poor) solution, governments should use debt issuance to “finance” their deficits. Thy also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be “paid back”.
This last claim is the basis of Ricardian Equivalence. I have covered the arguments in detail in the following blogs – Will we really pay higher taxes? and Will we really pay higher interest rates? and so won’t repeat them here other than to keep context.
The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to “prove” that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt.
A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach (which can be derived from the GBC is you have mathematical skills):
In English, this just says that the change in the debt ratio (the term on the left of the equals sign) is the sum of two terms on the right-hand side of the equals sign which are:
- The difference between the real interest rate (r) and the real GDP growth rate (g) times the initial debt ratio.
- The ratio of the primary deficit (G-T) to GDP.
The real interest rate is the difference between the nominal interest rate and the inflation rate. Real GDP is the nominal GDP deflated by the inflation rate. So the real GDP growth rate is equal to the Nominal GDP growth minus the inflation rate.
This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (the doves) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.
So the GBC says that the change in government debt over year t (which is just a general index for the current period, so t-1 is last period and so on.) is equal to the budget deficit in year t. The GBC links the change in debt to the initial debt outstanding (Bt-1, government spending (G) and taxation (T).
Usually the deficit is decomposed into two constituent parts as depicted in the following graphic:
So the change in debt (Bt-Bt-1 equals the deficit (D) which can be further decomposed into the interest payments on the past debt outstanding (rBt-1) plus the primary deficit (second line of the equations).
This gives the current debt level (third line of the equations) equal to (1+r) times the starting debt plus the primary deficit:
That is all background.
The Ricardian Equivalence idea goes back to David Ricardo’s C19th discussion as to whether households (more generally the private sector) considered government debt as part of their net wealth. Ricardo argued that they might not because they would also factor in that they would eventually have to pay it back via higher taxes.
This idea was revived in 1974 by Robert Barro who added some mathematics to the idea and if they face “perfect capital markets and infinite horizons” will accurately anticipate all future taxes and discount the debt holdings as wealth.
So the idea is clear – the government runs a deficit (tax cuts and/or spending increases) to stimulate the economy and the non-government sector, anticipating that over the lifetime of the agents within this sector taxes will have to rise to exactly pay the deficit back (manifested as the public debt), start saving now. The net effect is that there is no stimulus.
There are various ways of depicting this. Here are some of the stylisations. Take a case where the private sector has to pay back the debt in its entirety after say t periods.So the government waits t years before it increases taxes and repays the debt back.
Start with zero public debt after a long period of balanced budgets. In Year 0, the government cuts taxes by 1 (billion). At the end of the year public debt rises to 1 billion. What happens as a result?
In Year 1, the primary deficit is zero (tax cut occurred in Year 0) and the outstanding debt at the end of year 1 is the outstanding debt in Year 0 (= 1 billion) plus the interest paid on that debt (r).
In mathematical terms (for those who prefer it) the GBC gives the following result:
In English, the current stock of public bonds outstanding at the end of Year 1 (B1) equals the stock of bonds carried over from Year 0 (B0) plus the interest (r) paid on those carried over bonds. The 0 is the assumed primary budget balance. So only interest payments on debt in Year 0 are adding to the debt in Year 1.
I can show the maths for the next several years leading up to Year t but it is a trivial exercise. The important understanding that despite the fact that taxes were lower in only the first year and the primary budget balanced thereafter, debt has steadily accumulates at a rate equal to the interest rate.
Despite the fact that taxes were lower in only the first year and the budget balanced thereafter, outstanding public debt has steadily accumulated at a rate equal to the interest rate. The reason is that even though the primary deficit is zero each year and not adding to debt, the debt servicing on outstanding public debt is positive. Each year the government must issue more debt to pay the interest on existing debt.
The following graphic shows what happens in a five-year payback sequence if r=0.10 (as an example). You can see that in Year 5, the primary surplus has to be much greater than the initial deficit.
In general, the mainstream claim that an increase in the deficit in the past must eventually be offset by an increase in taxes in the future. The higher the real interest rate or the longer the government waits to increase taxes the higher is the eventual increase in taxes.
What happens in the government merely aimed to stabilise the debt from Year 1 onwards? Again I could write this out succinctly in mathematical form but in the interests of inclusion the following explanation arises.
In order to avoid the debt growing, each subsequent primary surplus must equal the debt servicing costs. This means that taxes are permanently higher from Year 1 on and it doesn’t matter if the government waits until Year t to stabilise. All this assumes that spending is unchanged.
The following graph captures this scenario. The point is that the mainstream claim that the government may not actually pay the debt off for the higher taxes to be punitive. Even with debt stabilisation they says taxes have to be higher in the period after the deficit.
So the mainstream claim that the legacy of past deficits is higher debt (because of their bias against Δ. To stabilise the public debt, the government must eliminate the deficit and then must then run primary surpluses equal to interest payments on the existing debt forever.
When an economy is growing it makes more sense to consider the ratio of debt to GDP rather than the level of debt per se. Which is the GBC framework presented above (I repeat the equation here):
Say the primary deficit is zero. Then public debt level increases at a rate equal to the interest payments as explained before. But the public debt ratio (that is, the level of the debt scaled by GDP) increases at a rate equal to the difference between r and g (g is the real growth of the economy). So the growing interest payments drive the top of the ratio (debt) while the growth of the economy deflates that numerator (debt). So a growing economy can absorb more debt and keep the debt ratio constant.
It follows that the public debt ratio will be higher:
- The higher is the rate of interest.
- The lower is rate of real GDP growth.
- The higher is the initial debt ratio.
- The higher is the primary deficit to GDP.
Which isn’t rocket science is it?
The mainstream then uses this analysis to argue that high government debt leads to lower capital accumulation and ever-increasing taxes.
Assume a debt ratio of 100 per cent. Let r = 3 per cent and g = 2 per cent. Also assume a primary surplus of 1% of GDP. What does this economy face? If you substitute the assumptions into the model you will see that this is a debt ratio stabilising position – the primary surplus exactly offsets the interest payments (as a percent of GDP).
But what if the financial markets suddenly demanded a risk premium on domestic public bonds. The mainstream argue that the interest rates will rise. If the rising rates also push down the real GDP growth rate you can see the logic emerging.
Now the primary surplus has to rise further to stabilise the debt ratio and the so-called vicious circle of debt arises. The sharp fiscal contraction leads to recession. The government becomes unpopular and uncertainty drives further rate rises. It becomes even harder to stabilise debt as interest rates rise and real growth falls.
What Barro said was that the government does “our work” for us. It spends on our behalf and raises money (taxes) to pay for the spending. When the budget is in deficit (government spending exceeds taxation) it has to “finance” the gap, which Barro claims is really an implicit commitment to raise taxes in the future to repay the debt (principal and interest).
Under these conditions, Barro then proposes that current taxation has equivalent impacts on consumers’ sense of wealth as expected future taxes.
So the government spending has no real effect on output and employment irrespective of whether it is “tax-financed” or “debt-financed”. That is the Barro version of Ricardian Equivalence.
Taking tax cuts as an example, Barro wrote (in ‘Are Government Bonds Net Wealth?’, Journal of Political Economy, 1974, 1095-1117):
This just means that lower taxes today and higher taxes in the future when the government needs to pay the interest on the debt; I’ll just save today in order to build up savings account that will be needed to meet those future taxes.
Ricardian Equivalence can be attacked on two fronts: (a) theoretical; and (b) empirical.
On a theoretical level, the theory imposes highly restrictive assumptions which have to hold in entirety for the logical conclusion Barro makes to follow? Even without questioning whether his reasoning is a sensible depiction of the basic operations of a modern monetary system, we can examine the plausibility of the assumptions.
Should any of these assumptions not hold (at any point in time), then his model cannot generate the predictions and any assertions one might make based on this work are groundless – meagre ideological statements.
The assumptions that have to hold are: First, capital markets have to be “perfect” (remember those Chicago assumptions) which means that any household can borrow or save as much as they require at all times at a fixed rate which is the same for all households/individuals at any particular date. So totally equal access to finance for all.
Clearly this assumption does not hold across all individuals and time periods. Households have liquidity constraints and cannot borrow or invest whatever and whenever they desire. People who play around with these models show that if there are liquidity constraints then people are likely to spend more when there are tax cuts even if they know taxes will be higher in the future (assumed).
Second, the future time path of government spending is known and fixed. Households/individuals know this with perfect foresight. This assumption is clearly without any real-world correspondence. We do not have perfect foresight and we do not know what the government in 10 years time is going to spend to the last dollar (even if we knew what political flavour that government might be).
Third, there is infinite concern for the future generations. This point is crucial because even in the mainstream model the tax rises might come at some very distant time (even next century). There is no optimal prediction that can be derived from their models that tells us when the debt will be repaid. They introduce various stylised – read: arbitrary – time periods when debt is repaid in full but these are not derived in any way from the internal logic of the model nor are they ground in any empirical reality. Just ad hoc impositions.
So the tax increases in the future (remember I am just playing along with their claim that taxes will rise to pay back debt) may be paid back by someone 5 or 6 generations ahead of me. Is it realistic to assume I won’t just enjoy the increased consumption that the tax cuts now will bring (or increased government spending) and leave it to those hundreds or even thousands of years ahead to “pay for”.
Certainly our conduct towards the natural environment is not suggestive of a particular concern for the future generations other than our children and their children.
If we wrote out the equations underpinning Ricardian Equivalence models and started to alter the assumptions to reflect more real world facts then we would not get the stark results that Barro and his Co derived. In that sense, we would not consider the framework to be reliable or very useful.
But we can also consider the model on the basis of how it stacks up in an empirical sense. When Barro released his paper (late 1970s) there was a torrent of empirical work examining its “predictive capacity”.
It was opportune that about that time the US Congress gave out large tax cuts (in August 1981) and this provided the first real world experiment possible of the Barro conjecture. The US was mired in recession and it was decided to introduce a stimulus. The tax cuts were legislated to be operational over 1982-84 to provide such a stimulus to aggregate demand.
Barro’s adherents, consistent with the Ricardian Equivalence models, all predicted there would be no change in consumption and saving should have risen to “pay for the future tax burden” which was implied by the rise in public debt at the time.
What happened? If you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84).
In other words, Ricardian Equivalence models got it exactly wrong. There was no predictive capacity irrespective of the problem with the assumptions. So on Friedman’s own reckoning, the theory was a crock.
Once again this was an example of a mathematical model built on un-real assumptions generating conclusions that were appealing to the dominant anti-deficit ideology but which fundamentally failed to deliver predictions that corresponded even remotely with what actually happened.
Barro’s RE theorem has been shown to be a dismal failure regularly and should not be used as an authority to guide any policy design. Please read my blog – Deficits should be cut in a recession. Not! – for more discussion on this point.
How is this theory stacking up?
I last examined this question towards the end of last year. Please read my blog – Ricardians in UK have a wonderful Xmas – for more discussion on this point.
Business confidence in the UK
We have been observing business confidence falling steadily over the last year in the UK after showing signs of picking up as the fiscal stimulus supported economic growth in late 2009 going into 2010.
A Bloomberg financial report (March 27, 2011) – U.K. Business-Confidence Index Falls to Lowest in Two Years – says it all in the title.
The Report says that:
U.K. business confidence declined in March to the lowest in two years, suggesting the economy may struggle to gather strength in the second quarter … The share of companies that were less optimistic about economic prospects increased to 44 percent from 36 percent in the previous month.
The article noted that there might be some modest “weather-related bounce” in growth “after the fourth-quarter contraction”. But across the economy – companies, manufacturers, retailers – confidence has collapsed.
By now, all these “tax payers” should be feeling strongly positive given the UK Government’s austerity push and demonstrating that they are ready to fill the spending gap left by the public withdrawal.
They are not. They are not Ricardian!
In the UK Guardian article (March 29, 2011) – Grocery sales slow as UK shoppers economise – we read that:
Britons have been cutting back on groceries, data showed on Tuesday, adding to signs of a rapid deterioration in consumer confidence which, economists fear, could derail an economic recovery …
British retailers have reported a sharp slowdown in demand since the start of the year as prices climb and government austerity measures start to bite.
By now, the British consumer should be expanding their spending. You might say that the rising inflation (driven by supply factors and stupid austerity measures – VAT increases) is causing the loss of confidence.
But economists always note that inflation discourages saving and promotes consumption – because things get more expensive the longer you delay the purchase (there is more detailed explanations but that is it in a nutshell).
So grocery shoppers are not Ricardian!
In the UK Guardian article (March 29, 2011) – Thomas Cook – UK demand for foreign holidays is slowing sharply – we read that:
Demand for foreign holidays has fallen sharply in the UK in recent months as weak consumer confidence continues to bite, Thomas Cook warned on Tuesday …
Although the UK recession officially ended more than a year ago, consumer confidence has slumped to its lowest level in nearly two years – due in part to growing inflationary pressures and austerity cutbacks. Economists have warned that this means many “big ticket” purchases are being shelved.
So travellers are not Ricardian!
I also point out that the Irish economy has been contracting for the last three years and its banks are now requiring further capital injections so bad is the situation in that country.
All the evidence shows that firms are currently very pessimistic and will not expand employment and production until they see stronger growth in demand for their products. Consumers are also pessimistic because they worry about losing their jobs. They are also heavily indebted and are trying to save to reduce risks should they become unemployed. By cutting public spending, this pessimism will only deepen.
The greatest neoliberal lie is in denial of all the facts relating to human psychology.
The on-going indicators from Ireland and now Britain – poor growth figures and surveys indicating growing pessimism among private firms and consumers – are already undermining the substance of their respective government’s austerity strategy.
The only way economies grow is when companies expand in response to increasing demand for their products. When private demand is subdued, the only way to increase growth is for government to spend, via deficits. Austerity will just withdraw the lifeline that has been keeping our economies growing in the past year or so.
The current period is thus providing a very good arena for assessing some of the key notions. There has been a polarisation in the predictions coming from various schools of thought. The mainstream economics position is fairly clear. The narrative is being destroyed by the facts as they emerge. Sooner or later people will realise that.
For MMT, so far, it provides the best explanation of what has happened and remains concordant with the facts as they emerge.
Judge for yourselves.
That is enough for today!