Deficits should be cut in a recession. Not!

Several readers have written to me asking about the Ricardian equivalence theorem, which is increasingly getting mentioned in the media and public policy reports. As I will explain, the theorem is used by anti-government proponents to argue that fiscal deficits are counterproductive and that cutting deficits in the middle of a recession will actually be good for the economy. They never really give up, do they? The theorem is a good example of the general mainstream approach where stark policy conclusions are derived which capture the popular debate but the underlying assumptions that are required to generate those conclusions are rarely widely known or mentioned in the popular press. Of-course, if the public understood these underlying assumptions then they would not take the conclusions seriously.

In the Guardian last week (November 25, 2009) there was an article written by a Larry Elliot entitled A deficit of patience which carried the subtitle “Cameron isn’t all wrong about Britain’s finances. But to slash spending now would be madness”.

It is a classic example of a journalist using material to make a point without fully disclosing the full story. The point is that if full disclosure was made (and I understand that the word demands of his editor probably preclude it) then the public would have a very different interpretation of the material and the conclusions.

If the word demands are such that a full disclosure is not possible then the person should not write the story as it only serves to push an particular ideological viewpoint.

Elliot who writes as a “progressive” starts by saying that that David Cameron (British conservative opposition leader and probably, spare the thought, the future PM) has been talking big about the need to “start cutting Britain’s budget deficit” with “a decisive plan that starts now”. Elliot concludes that:

This sounds strong. It sounds purposeful. And it has an appeal on the doorsteps. After all, if individuals are paying down debts, doesn’t it make sense for the government to be doing so? Actually, no. The alternative to state spending would be weaker overall demand and an even more painful recession. What Cameron is suggesting is dangerous and economically illiterate.

So while he concludes correctly that state net spending is essential at this stage to underwrite the very weak aggregate demand conditions in the UK, he leaves the first notion standing.

Did Elliot then tell his readers that the analogy between an individual which uses the currency and the national government which issues the currency under monopoly conditions is fallacious at the most elemental level? No mention of it.

So from the outset he promotes the most basic flaw in mainstream economics that there is meaningful analogy between household or individual budgets and the national budget of a sovereign government. There is no such analogy. It is plainly wrong and that conclusion does not reflect my ideology or opinion but is rather ground in the basic function of the monetary system.

Why not relate the second point (which is correct) to an outright rejection of the first point. That would be educative.

Elliot then says that:

… the recession has lasted for six quarters … Britain has a zombie banking system, kept alive by periodic injections of cash from the Bank of England but seemingly incapable of getting money to struggling businesses – where it is most needed.

Again, for someone who concludes that others are spreading “dangerous and economically illiterate” analysis, Elliot seems to buy the line that banks are liquidity constrained. The correct conclusion is that the banks are fully capable of “getting money to struggling businesses” but are unwilling to do so under present circumstances because (a) aggregate demand is so weak that they cannot find credit-worthy customers worthy of extending loans to (relating to his earlier point); and (b) the budget deficit is currently not sufficient to engender any confidence among borrowers that the things they might produce by expanding production (with working capital borrowed from the banks) will be sold.

In other words, a stalemate exists because the UK government has relied to heavily on monetary policy and too little on fiscal policy as its policy response, and, moreover, has encouraged the hysteria surrounding the increasing deficit by its own comments (talking about exit plans etc).

Elliot reports that “Cameron says immediate action on cutting the deficit would keep Britain’s creditors sweet and prevent “crowding out”, the notion that high government borrowing pushes up long-term borrowing costs and makes private sector investment less attractive.”

Cameron seems to have been influenced by a recent report by the right-wing “think-tank” Policy Exchange which claims that deficit cuts in times of crisis stimulate growth.

The Report is an excrutiating 121 pages and I wish I had saved my time and not read it. But curiosity is the lifeblood of a researcher and sometimes that takes one down dead-ends. The Report uses data selectively, confuses causality and makes conclusions that cannot be defended by a proper understanding of the data. So read it with care.

Elliot, himself, recognises the dodgy nature of the Report when he says it is a “perverse reading of history” – an understatement. For example, the 1981 Howe Budget during the Winter of Discontent which Margaret Thatcher championed as the exemplar of conservative reasoning was accompanied by:

… a triple boost from a 30% depreciation in the pound, a slump in oil prices to below $10 a barrel, and lower interest rates. It was not deficit reduction that made lower borrowing costs possible; it was the fact that the Thatcher government’s monetarist experiment had wiped out a sixth of UK industry and set unemployment on course to hit three million.

The rest of Elliot’s article is “tear your hair out” material so for all the readers that haven’t enough hair to spare …. I will save you the agony.

But the Report is worth further analysis and fits into the requests from several billy blog readers who have asked me about the mainstream notion of Ricardian Equivalence (RE).

The Report (page 25) says this:

In an efficient economy, with financial markets working well and forwards-looking, reasonably-well-informed households who do not face credit constraints, we would not expect funding government spending through debt (a deficit) rather than funding it with taxes, should stimulate additional demand in the economy. The reason is that, in that sort of economy, households will understand that if the government borrows extra today, it will have to raise taxes tomorrow to pay off that borrowing. In anticipation of those extra taxes tomorrow, households will save extra today – each additional pound of government borrowing should lead to one extra pound of saving. So there will be no “stimulus” from running a deficit. (This effect is called “Ricardian equivalence”, after the British economist David Ricardo who first pointed it out.)

If there is no boost to the economy (even in the short term) from running a deficit, then there will be no reduced boost from reducing the deficit – and so we should not expect fiscal consolidation to reduce demand even in the short term.

While they acknowledge that RE is unlikely to hold in a deep downturn because “financial markets have ceased to work well, or in which the future job prospects of households have become so uncertain that workers have indeed become credit constrained” they imply that in the absence of a severe market malfunctioning it would apply.

I will come back to that in a moment. But note they say things like “markets working well” and “reasonably-well-informed households”. As you will see below RE requires much more than this. As you will see when I deal with the required RE assumptions, their depiction is not a correct rendition of the academic literature on this topic.

But the Report then argues that given RE is unlikely to hold in a deep downturn, a more complicated version of how budget deficit cuts promote growth is needed:

The mechanisms by which demand may be affected are through (1) effects on the expected growth rate of the economy; (2) other wealth effects on consumption; (3) credibility effects on interest rates. We will consider these in order. First, growth effects. If spending reductions are seen as permanent, they may be associated with more rapid growth in the economy in the future. If growth is more rapid, then wages and other sources of income will also grow more rapidly. So over their lifetimes as a whole, consumers will be richer. Hence, reduced public spending may make consumers feel richer and so more willing to spend, even in the short term, boosting demand. (Note that this effect is associated with fiscal consolidation through spending cuts, not tax rises.) Turning now to other wealth effects. Even if the economy were not expected to grow more rapidly when public spending is lower, when spending cuts are perceived as permanent, consumers anticipate a reduction in their future tax burden (relative to what they had expected) and so a permanent increase in their lifetime disposable income. If the value of these reduced future taxes is greater than the value to consumers of the public spending not now expected to happen, consumers will feel wealthier. In such a case (typically a case in which public spending begins very high or is very inefficient), consumption may increase when government spending is cut (contrary to the Keynesian expectation). (Again, this mechanism is not applicable to fiscal consolidation through tax rises.)

Let’s consider these first and then I will return to RE in particular.

First, why would permanent spending reductions promote faster expected future growth? How would that work. Real output growth responds to aggregate demand growth. The components of aggregate demand are interdependent via expecations and employment. So given consumption is induced by faster growth which in turn responds to public spending and investment is dependent on, among other things, expectations of future revenue, you can quickly see the interdependencies.

It is clear that growth builds on itself. But when private spending is stagnant and expectations are very pessimistic what external force will change that? Why will investors once again assume the risk and start building new capacity?

In some of my earlier work (with Joan Muysken) – for example, here is a working paper you can get for free (subsequently published in the literature) – we developed a model based on the notion that investors facing endemic uncertainty make large irreversible capital outlays, which leads them to be cautious in times of pessimism and to use broad safety margins.

Accordingly, they form expectations of future profitability by considering the current capacity utilisation rate against their normal usage. They will only invest when capacity utilisation, exceeds its normal level. So investment varies with capacity utilisation within bounds and therefore productive capacity grows at rate which is bounded from below and above. The asymmetric investment behaviour thus generates asymmetries in capacity growth because productive capacity only grows when there is a shortage of capacity.

This sort of model stands up very well against empirical scrutiny and is at odds with the model developed by the Policy Exchange.

Second, why will consumers feel richer if the budget deficit is cut? You will note that the “fiscal consolidation” they advocate comes from spending cuts not tax rises. The answer is that they do not have to pay the deficit back! This is the same sort of reasoning that underlies the RE theorem and of-course erroneously assumes that the sovereign government will raise taxes to “pay back the deficit”. There is no evidence that this occurs.

The government may raise taxes sometime in the future to balance nominal spending growth overall with the real capacity of the economy to respond to it to avoid an outbreak of inflation. But that has nothing to do with the need to finance the government spending. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

It is more likely that people feel less wealthy if the quality of public infrastructure is run-down; if the quality of public health care is poor, and if there is widespread unemployment.

Third, all wealth effects in consumption functions that are estimated by econometricians are typically very … very small relative to the income effects. This was a huge issue in the so-called real balance debate between Pigou and Keynes (I will write a separate blog about this another day). The point is that wealth effects are not sufficient, even if the transmission mechanisms outlined were valid (which they are not), to restore spending and engender renewed confidence to such a degree that it would offset the direct negative impact of cut in net public spending and underpin sustained growth.

Now back to Ricardian Equivalence briefly.

For non-economists (and even many economists) the short pithy policy statements that economists make in public and which attract headlines in the unequestioning media are often accepted on face value without any real understanding of what is behind them.

But all these statements are built up from models which, given the way mainstream economics builds its theories, are always based on some simple assumptions. Mainstream economics begins with some simple behavioural postulates such as individuals are always rational and will optimise at all times. These assertions are highly contested by behavioural scientists but the mainstream hang on to them like grim death.

Recall the blog – Islands in the sun – where Leonard Rapping (who wrote with Robert Lucas before recanting and becoming a progressive) spoke of his work and the approach they always took:

… we were in the Chicago tradition, so we assumed perfect competition and profit and utility maximisation. Every single proposition had to be consistent with those assumptions. There were certain rules of logic that had to be followed, and the discussions were very tight and logical. We would try to explain everything in terms of the competitive equilibrium models. (We had learned that from Friedman)

Upon that behavioral edifice, they then place conditions on their analysis – the perfect competition that Rapping mentions above.

So the mainstream methodology is an approach that uses deductive a priori reasoning – that is, assume a whole bunch of things then examine what would happen if something changed. You can readily appreciate that the solution to the problem is thus already embedded in the way the problem is structured from the outset.

Further, if the structure bears no relation to reality then you have another problem. The general equilibrium models that are still popular among mainstream economists assume that all contracts are agreed and monetised (paid for) with no mistaken trades. The future path is immediately determined from day one – via the satisfaction of the so-called transversality conditions – that is, all trades current and future are locked in at once because agents maximise lifetime real income.

There is a passage by Paul Davidson (who is a Post Keynesian that I generally do not agree with) which I like a lot. It was in the book by Bell and Kristol The Crisis in Economic Theory (Basic Books, 1981, p.157).

There are certain purely imaginary intellectual problems for which general equilibrium models are well designed to provide precise answers (if anything really could). But this is much the same as saying that if one insists on analyzing a problem which has no real world equivalent or solution, it may be appropriate to use a model which has no real-world application. By the same token, if a model is designed specifically to deal with real-world situations it may not be able to handle purely imaginary problems.

Post Keynesian models are designed specifically to deal with real-world problems. Hence they may not be very useful in resolving imaginary problems that are often raised by general equilibrium theorists. Post Keynesians cannot specify in advance the optionmal allocation of resources over time into the uncertain, unpredictable future; nor are they able to determine how many angels can dance on the head of a pin. On the other hand, models designed to provide answers to questions of the angel-pinhead variety, or imaginary problems involving specifying in advance the optional-allocation path over time, will be unsuitable for resolving practical, real-world economic problems.

As noted, I do not share all the claims that Paul makes about the merits of Post Keynesian analysis – for example, he advocates a Bancor system to reduce global financial instability – please read my blog – An international currency? Hopefully not! – for more discussion on this point. But his statement that mainstream economics uses methods and approaches that renders it unable to embrace real world problems is very sound.

But generally, Post Keynesian theory is weak at the macro level. It does not reflect a solid understanding of the way the modern monetary system operates and proponents tend to avoid discussing it when challenged by modern monetary theorists. But this blog is not about that issue.

The valid point that Paul makes in the quote is that much of the theory that results in these grand public pronouncements from mainstream economists relies on “angel on the pinhead” models and assumptions that the public rarely hear about and if they did would send a “helper in a white lab coat” to the economist’s office to “take them away”.

The point is that one always has to be cogniscant of the actual assumptions that are required for the logical conclusions to hold. If they do not hold then the logical conclusions cannot then be maintained with any “authority”. Despite Friedman’s famous “what if” claim that we should only focus on the predictions even if the assumptions are plainly wrong, you can be almost sure that if the assumptions are crazy then the conclusions will be worse.

What is Ricardian equivalence? The modern version was developed by Robert Barro at Harvard. First, start with the mainstream view that: (a) In the short-run, budget deficits are likely to stimulate aggregate demand as long as the central bank accomodates the deficits with loose monetary policy; and; (b) in the long-run, the public debt build-up crowds out investment because it competes for scarce savings.

I have written countless words to show how farcical this view of the monetary system is. First, deficits put downward pressure on the interest rate and central banks issue debt to stop that downward pressure from arresting control from them of their target interest rate. Second, there is no finite pool of saving except at full employment. Income growth generates its own saving (investment brings forth its own saving) and governments just borrow back the funds (drain bank reserves) $-for-$ that the deficits inject anyway.

But lets just start with the mainstream view. Barro then said 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.

For example, if each individual assesses that the government is spending $500 this year per head and collects $500 per head “to pay for it” then the individual will cut consumption by $500 because they are worse off.

Alternatively, if the individual perceives that the government has spent $500 this year but proposes to tax him/her next year at such a rate that the debt will be cleared then the person will still be poorer over their lifetime and will probably cut back consumption now to save the money to pay the higher 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.

The models suggest that individuals assess the total stream of income and taxes over their lifetime in making consumption decisions in each period.

On tax cuts, 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 accoutn that will be needed to meet those future taxes.

So what are the assumptions that Barro makes which have to hold in entirety for the logical conclusion he makes to follow? Note this is not to say that any of his reasoning is a sensible depiction of the basic operations of a modern monetary system. It just says that if we suspend belief and go along with him for the ride then the only way he can derive the conclusions from his model that he does requires the following assumptions to hold forever.

Should any of these assumptions not hold (at any point in time), then his model cannot generate his conclusions and any assertions one might make based on this work are groundless – meagre ideological raving.

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.

Barro’s theorem led to a torrent of empirical work, particularly after the US Congress gave out large tax cuts in August 1981, which was the first real world experiment possible (that is, if you consider the US as they do to be the real-world!).

The tax cuts were legislated to be given over 1982-84 to stimulate aggregate demand. Barro’s adherents 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.

But, 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).

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 is a dismal failure and cannot be used as an authority for the type of statements I noted earlier.


The conclusion is that Ricardian Equivalance, even within its own internal logic, fails to stack up.

But in the media you will continually see references to it – sometimes disguised. Statements like the deficits have to be paid back … and consumers are taking that into account now.

They never tell you “when the pay back” is coming. They just imply it is sooner rather than later. Such statements have no historical application.

Moreover, and leaving the ridiculously stylised world of the angels-and-pinheads that Barro and his ilk occupy, such statements fail to recognise the operational realities of the fiat monetary system.

They make erroneous assertions that debt actually pays for spending. It does not. They make statements that governments have to raise revenue to “pay back the debt”. They do not. Governments just pay back debt in the same way that they make all their spending decisions – adding reserves to the banking system (crediting bank accounts).

The repayment of debt is functionally (operationally) equivalent to any spending decision the government makes and is accomplished on a regular basis without us really knowing one way or another what is happening (other than those who enjoy the interest income when they see it popping up in their bank account).

Further, taxes rates rise or fall depending on whether the government wants the private sector to have more purchasing power or less (excluding allocative-targetted taxes that attempt to alter our demand for particular goods and services – for example, tobacco taxes). These tax changes bear no historical relationship to the debt-repayment schedules that governments follow.

Cutting net public spending at the height of a major economic downturn brought about by the collapse of private spending will, unless there are accompanying and extraordinary circumstances (like a major and immediate net exports boom) will be extremely damaging to immediate output levels and to the future growth path of the economy.

The longer-term costs of such a strategy would be permanent and significant.

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    4 Responses to Deficits should be cut in a recession. Not!

    1. RSJ says:

      Hi Bill,

      Suppose you do increase public spending, but little of that spending “trickles down” into good paying jobs. I.e. when a store receives more sales, they just call up their chinese suppliers and order more goods shipped here, or otherwise they manage to produce more goods and services without increasing hiring substantially, or if even they do increase hiring, they do not increase wages. Productivity just keeps rising and rising, and the stock markets take off, but we still have 8-10% unemployment.

      In that scenario, is the only other tool in the toolbox an $8/hr jobs program? A family of 4 really needs much higher household income to be even lower-middle class: e.g. healthcare, shelter, transportation, college tuition, and a bit of retirement savings. On the coasts, they would need about $20/hr and in the central areas (which are de-populated), perhaps $12/hr would be enough. This assumes two working parents and two kids.

      In that case, do you have any other ideas on what to do, or do you believe that this scenario will never happen with enough fiscal spending? If it is the latter, then what is the mechanism to prevent such a scenario from happening?

    2. Alan Dunn says:


      Draw the bridge the neo-philes are here.

    3. RSJ says:

      Heh, I have never been called a neophiliac before.

      However I do have experience in high value-add manufacturing, and I understand that when you get a huge order, you do not hire a bunch of people to fill the order, but call up China/India and say “ship 1000 more boxes” for next quarter. You may need to hire a few more support staff, test engineers, etc., but it is nowhere near a 1-1 ratio with the increase in sales. So the traditional measures of capacity utilization are compromised by outsourcing. Calculated Risk recently ran a regression in which they argued that the ISM would need to rise about 20% in order to achieve a 1% increase in employment, so this is not just an anecdotal observation.

      Certainly for services, these may have better spillovers into employment, but the majority of these jobs are lower paying jobs, barring health-care and financial services — no need to go there now.

      So I do see a real risk that we can run stimulus after stimulus with the not much spill-over in terms of well-paying jobs. In fact, this has been happening — huge boosts in labor productivity in an environment of falling employment and declining median personal income.

      This means that large deficit spending + Job Guarantee would still fail to do the job in terms of improving the economic life of the majority of the nation. I was wondering whether Bill or some of the others was concerned about this or whether they had some other rationale that such a state could not be reached.

    4. Michael says:

      Very good article, Bill. A couple of points:

      1. It shouldn’t be necessary to deconstruct Ricardian Equivalence in an elaborate manner. Any predictive principle asserting that reducing a deficit will lead to growth, which begins its argument (as The Policy Exchange does) with the statement “If spending reductions are seen as permanent, they may be associated with more rapid growth in the economy in the future”, is not describing, demonstrating, or explaining anything. It is simply a tautolgy.

      2. Your many excellent explanations of the empirical fact that banks decide to lend – or not lend – based solely on the anticipated profits and the risks of each loan (or bundle of loans), and then deal with reserve ratios afterward makes a perfect analogy for the way that federal governments decide to spend – or not spend – solely on the anticipated benefits (to themselves, the direct beneficiaries of the spending, or the society as a whole) and the (political) risks of each spending item, and then deal with budget balancing, deficits, or surpluses afterward.

      3. I’m not sure if you are aware how psychologically attached the general populace is to the enterprise business model (which you refer to as the household model) of government budgeting. Although everyone likes the fantasy of finding a money tree suddenly in their own back yard, almost no one outside MMT wants to empower their federal government to account only for spending with no balancing accounting for income. Taxes are not the only form of possible federal government income (unless you define all federal government income as taxes ipso facto), and they certainly introduce complications and opportunity for unfairness and corruption, all of which is currently rampant. But a no-revenue-required government spending system is just too exotic for most people, when we can’t point to an existing example of a government operating in this manner to see how it works. In other words, your criticism of neo-classical abstract theory based on predetermined assumptions that are superimposed as “facts” on the operation of real economies is valid, but MMT is also an abstract model in which the most questionable assumption is that without balanced-budgeting requirements (of some at least rhetorical kind), and without any other explicit mechanism that would provide inherent constraints on government spending, spending would somehow be restrained. A model that relied on the rational and objective judgement of politicians to control their spending to keep it productive would be as questionable as the models that rely on the rational and objective judgements of consumers, borrowers, and investors to produce a stable economy.

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