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Guest Post: Goodbye Keynes - Hello Ricardo!
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Submitted by Frode Haukenes of Econotwist
Goodbye Keynes - Hello Ricardo!
The world has been fighting the financial crisis by using every possible trick according to John Maynard Keynes‘ playbook. But, as The Great Depression taught us, extreme government spending
tends to cause about as much problems as it solves. Perhaps it’s time
to put Keynes back on the bookshelf, and pull out the 200 year old
theories of David Ricardo.
“While budget stimulus measures are intended to boost demand from financially constrained consumers, it may for others – the majority – result in the emergence of Ricardian behavior.”
Philippe d’Arvisenet
For
those not too familiar with economic theories; Ricardian behavior is
basically increased consumer spending due to expectations of higher
taxes in the future. This effect has been shown to emerge more
widespread in countries with large governmental debt, and lead to
significant difference in the recovery process among nations.
The increase in public debt registered over the last few years is without precedent.
In each of the main OECD countries, public debt is not on a sustainable path, BNP Paribas chief economist, Philippe d’Arvisenet writes in a research paper.
This contrasts with past periods, during which emerging markets have appeared more at risk from this perspective.
The majority of developed countries will have a public debt ratio in
excess of 90% in the middle of the decade, BNP Paribas estimates.
However, according to the IMF, from 2007 to 2014, the debt ratio in
these countries is expected to rise by an average of more than 30
points of GDP, reaching an average of 110% of GDP.
Philippe d’Arvisenet points out that of this increase, 3 points will be related to supporting the financial system.
- 4 points to the increased cost of debt.
- 10 points to automatic stabilizers.
- 3.5 points to budget stimulus measures.
- 9 points to losses of tax revenues relating to the decline in asset prices.
“The widening of deficits
is largely structural in nature. The deficit ratio adjusted for
cyclical variations is 4.4% in the euro zone out of a total deficit of
6.7 points, with 9.8 points in the UK (out of a total of 13.3 points)
and 8.8 points in the US (out of a total of 10.7 points). In the past,
this structural deficit has shown a strong tendency to persist,” the french chief economist writes.
For the time being, surplus production capacity limits the risk of
public debt having a crowding-out effect on private investment.
Ricardo, Who?
About 200 years ago British economist David Ricardo presented his “theory of equivalence” in a newspaper essay.
In
Ricardo’s view, it does not matter whether you choose debt financing or
tax financing, because the outcome will be the same in either case.
Flip a coin if you like, because in terms of the final results, raising
taxes by $1,000 is equivalent to the government borrowing $1,000.
According to traditional economic theory, like the Keynesian, public
debt has a significant effect on the overall economy because consumers
regards public debt as net wealth.
The Ricardian equivalence theory, on the other hand, suggest that is has no effect so ever.
While budget stimulus measures are intended to boost demand from
financially constrained consumers, in their case the classic system
of budgetary multipliers (Keynesian style economics) takes full effect.
But for others – the majority – the result will most likely be widespread emerging of so-called Ricardian behaviour.
Ricardian behavior is a term economists use to describe growth in
consumer saving to cope with the costs of expected increasing taxes in
the future.
The consumers expectations are usually fulfilled, and often extended, later research have shown.
In most cases, government borrowing ends up being more expensive for the citizens when inflation, higher borrowing costs and interest rates are taken into account.
The theory of Ricardian behavior is controversial, as it assumes that people think and behave financially rationally.
We know we don’t.
But other factors can trigger similar behavior, like lack of
transparency in the state finances and mistrust in the governments
economic policy.
In any case; Ricardo’s main point that government borrowing is
nothing more than a way of delaying tax hikes, seems to be accepted by
many leading economists today.
No More Free Lunch
It should be clear by now that the public finance situation calls for credible recovery measures.
“While the conventional crowding-out effect does not have an
impact, the budget situation – contrary to the situation before the
financial crisis – now affects the assessment of risks and may inflate
risk premiums. This results in a higher cost of debt, making adjustment
even more difficult,” Mr. d’Arvisenet writes.
Adding that this situation could make an end to the until now
observed developments characterized by rising debt with no impact on
interest payments because of falling interest rates – a kind of “free lunch”.
“A high level of debt increases the probability of an interest
rate or growth shock resulting in unsustainable debt, with higher debt
ratios and a widening gap between the apparent real interest rate and
the rate of growth. This configuration makes adjustment even more
difficult and in any case presents a number of threats (snowball effect
of debt).”
Recent data clearly call for immediate action.
BNP Paribas points to the fact that, as a direct consequence of the
financial crisis – with an increase in the cost of capital and
structural unemployment and a decline in economic activity – the
potential level of GDP in the OECD region is around 3.5 points below
the pre-crisis level.
In addition, unless there is an increase in taxation, the higher
cost of debt means that some public services will have to be sacrificed.
An increase in taxation is frequently synonymous with fiscal distortions that can harm growth.
Debt then eliminates the ability to implement new support measures if needed.
A Credible Exit Strategy; Fact Or Fiction?
Ricardo’s theories might very well be correct, but only in a
perfect economy with free markets and responsible, rational people.
However, by understanding Ricardo’s line of arguments, it becomes more clear what’s wrong with the current economic policy.
BNP Paribas chief economist writes:
“In addition to purely budgetary considerations, deterioration
in public finances is a potential challenge for central banks. The
level of debt may result in not only increases in inflationary
anticipations, but also uncertainties about the success of
consolidation measures, making steering of monetary policy
more complicated (what is the appropriate interest rate?). The
weighting of the cost of debt may result in pressures favoring
monetisation, casting doubt on the independence of central banks, not
taking account of the fact that these institutions – which have
increased the share of public debt securities in their balance sheets –
are therefore exposed to greater interest rate risks.”
According to the IMF, a primary structural surplus of 8 points of
GDP from 2011 to 2020 (from -4.3% to +3.6% of GDP) would be necessary
in order to bring the debt ratio to 60 points of GDP in 2030, although
with significant differences between countries: one-fifth of developed
countries would have to make an adjustment of more than 10 points and
two-thirds would have to make an adjustment of less than 5 points.
The adjustment would be halved for a target of stabilizing the debt ratio at the 2012 level.
The IMF estimates that over 10 years, and assuming growth of 2%, the
end of stimulus measures could contribute 1.5 points of GDP.
In addition to the freeze on public spending excluding health-care,
which implies priorities and efforts to improve efficiency,
stabilization in expenses relating to the aging of the population
proportional to GDP would provide a contribution of 3-4 points of GDP
and tax deductions would provide a contribution of around 3 points.
“In the shorter term, as suggested by recent research,
displaying a credible budgetary consolidation policy concerning
primarily expenditure can enhance the effectiveness of support measures
in place, by means of both consumer behavior (Barro-Ricardo effect) and
also interest rates,” Philippe d’Arvisenet writes.
The Ricardian Union (Formerly Known As E.U.)
Research by Antonio Alfonso at Universidade Tecnica de Lisboa, published in 2001, concludes that debt hardly will become neutral. And he’s probably right.
But Alfonso’s finding, based on studies of 15 European countries,
indicates that government debt has a considerable stronger effect on
consumer spending in highly indebted countries, as compared to the less
indebted nations.
There seems to be a limit around 50% of GDP; a debt-to-GDP ratio
over 50 tends to make people more aware, and cautious, about their
financial situation. They become Ricardian.
The prospect of a return to sustainable debt allays fears of
inflation and therefore anticipations of a hike in interest rates,
which helps to contain the rise in long-term rates, BNP Paribas argues.
“A budgetary exit strategy is a difficult exercise. The change
in the primary balance needed to ensure a similar level of debt to that
observed before the crisis – which would avoid transferring the
consequences of the crisis to future generations – is considerable but
not unprecedented.”
“Recourse to inflation” as dreamed of by some, does not
seem to be the solution, according to BNP Paribas, refering to analysis
of successful experiences of budgetary consolidation shows that a
significant reduction in the debt ratio has been achieved in 10 or so
countries, mainly by means of the primary balance.
The contribution of growth was negligible in this respect (apart
from in Spain and Ireland), chief economist Philippe d’Arvisenet says.
“We can therefore see that consolidation measures are taken with a
long-term view – one or two years has not been enough. This does not
mean that it is not necessary to continue with the reforms intended to
support growth,” he adds.
However, there are just too many uncertainties relating to this matter to be able to count considerably on this factor.
What About Fiscal Illusions?
Among the uncertainties are another – rarely mentioned – theory called “fiscal illusion.”
“Fiscal Illusion” is a public choice theory of government expenditure first developed by the Italian economist Amilcare Puviani in 1897.
“Fiscal Illusion” suggests that when government revenues
are unobserved or not fully observed by taxpayers then the cost of
government is perceived to be less expensive than it actually is.
Examples of fiscal illusion are often seen in deficit spending.
CATO Institute economist William Niskanen, has noted that the “starve the beast” strategy
popular among U.S. conservatives wherein tax cuts now force a future
reduction in federal government spending is empirically false.
Instead, he has found that there is ‘a strong negative relation between the relative level of federal spending and tax revenues.
Tax cuts and deficit spending, he argues, makes the cost of government appear to be cheaper than it otherwise would be.
Paulo Reis Mourao at Australian National University presented in 2008 an empirical attempt to measure fiscal illusion for almost 70 democracies since 1960.
The results obtained reveal that Fiscal Illusion varies greatly around the world.
Countries such as Mali, Pakistan, Russia, and Sri Lanka have the
highest average values over the time period considered, while Austria,
Luxembourg, Netherlands, and New Zealand have the lowest.
But, as you know; some illusionists are better than others.
The French Solution
The greatest increase in public debt forecast for the next few
decades relates to the aging of the population, BNP Paribas concludes.
“The matter of health-care and pension reforms is crucial
(without reform, the associated cost would be 4-5 points of GDP between
now and 2030,” according to the French banks research.
“Reforms in this area are even more important as their effects
become more significant with time and their initial cost is limited.”
Based on lessons of other recent research, BNP Paribas notes:
“The greater effectiveness of rules that are easy to implement
(public spending versus deficit), as demonstrated for example by the
failure of the Gramm Rudmann Hollings Act of 1985 and the success of
the Budget Enforcement Act that succeeded it;”
* The increased effectiveness of automated mechanisms, compared with
discretionary practices such as those relating to sanctions for
excessive deficits in the euro zone;
* The appeal of anti-cyclical measures (rainy day funds etc.).
The bank make the following suggestions:
(1) To stabilize the public debt ratio (debt to
nominal GDP), it is necessary to generate a primary balance equal to
the product of the debt ratio by the difference between the real rate
of interest on debt and the rate of growth.
(2) Not forgetting that inflation is not
manifesting itself and that inflationary fears alone are likely to
provoke a rise in real interest rates.
(3) From this viewpoint, the change in
retirement age has substantial effects both directly (increase in tax
revenues, reduction in expenditure) and indirectly on potential growth
(working-age population and participation rate).
»
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Sad, but true.
Sorry to hijack top spot but I'm sure this should read "...Ricardian behavior is basically increased consumer saving due to expectations of higher taxes..."
As you imply Ricardian Equivalence does not hold in empirical data, except in the context of the savers-spenders theory i.e. the only people who behave this way already behave this way and the unwashed masses are going to keep trying to consume everything they make and, if possible, more.
In retrospect, the Reagan tax cuts only allowed the Ponzi to live longer. That's not a partisan attack, I backed the Reagan tax cuts. Also, this thread is just waiting for a Mako post....
CATO Institute economist William Niskanen is an idiot.
Starving the beast obviously works--over time--since the beast cannot live without food.
The tax revolt didn't start with the Reagan administration but with Proposition 13 in California, in 1978. The idea is that a rational government, when it has insufficient funds, will logically pare back its scope. Problem is the government--and by extension, the public--did not act logically and instead borrowed lots of money to keep the government Big.
I'd like to believe we are at the end of that phase; that the government can't borrow any longer and will have to reduce its size. Unfortunately the public has changed so much over the last 35 years that they now see Big Government as a good thing and will support higher taxes and less personal control and responsibility. Thus the flaw is not in "starve the beast," it is in the stupidity of the polis.
Yeah, so "starve the beast" (and, look, I've said it a thousand times) acted as an enabler of Big Government. Running deficits allowed us to kick the can down the road. You are correct about Prop 13 and, in retrospect, I realize that political leaders are usually the ideological embodiments of the socio-economic trends. Reagan rode that wave to great success. The flag waving was a lot funner then, though.
Yes. And I supported Reagan too. But I was bigger dumbass peasant then and actually beleived.
The Reagan tax cuts were supposed to be accompanied by spending cuts on the part of congress but those never happened.
As to the "starve the beast" theory, well look at the states. The states with the worst debt situations are those that are big blue spenders, CA, NY, IL. These states also had plenty of revenue coming in. It didn't matter. The problem is almost entirely one of undisciplined spending. More revenue. Less revenue. Doesn't much matter. They're simply places where everyone connected tries to steal quietly from all the rest of us. And the feral government's barely different. Proposing to attack the problem indirectly sounds nice but it eventually seems a bit cowardly. There's one way to stop it, don't spend.
I guess by now it's evident that taxes will rise in the whole world. The EU is signaling to their fiscal reform, while USA tries a monetaristic approach. At the end everyone knows that taxes will be higher so I guess Ricardo was right.
Well... I think that reading David Ricardo is much better and worth much more than reading charlatans like Jevons, Walras, Alfred Marshall, Hayek or Friedman...
David Ricardo is a good reading... Enjoy it..
You may start by here:
http://dev.econlib.org/library/Ricardo/ricP1.html
Thank you
Obrigadão!
And you don't have a Consumption tax (a tax you pay to them so you may live)-------- YET
Then they will waste the theft from your working/ producing pocket to support their spending /non productive life
Perhaps people don't always save in the face of expected tax hikes, but what they ALWAYS do is find ways to evade taxes.
Shiver me timbers, ya mean black markets, Blackbeard! Why eons of scalawags got rich by that scheme! Capone, Mexican drug cartels......
Yargh!
Ricardo's theory of Babalu economics:
http://www.youtube.com/watch?v=rAV3bOJaQuY
lol,Ricky, he was such a hippie
Actually, Ricky Ricardo had an execellent economic philosophy. . .
"Aye Yai Yai Yai Yai! Looooosy, we can't afford dat!"
Correct me if I'm wrong, I'm no expert on Keynes, but I don't think Keynes advocated deficit spending for 5 consecutive decades. What we have been practicing since the early 1960's should have another name. Keynes to the Umpteenth Power or Keynes on Red Bull. I don't think what we have been doing falls under any accepted theory.
Who cares? What has to be destroyed is the State. West world can no longer advance as fast as it used to on the State while rivals are in a stage of developpment they will benefit fully from the State. Any cheap shot on the State is welcome. From the issue of debt, people are navigating now to the issue of public debt only, even though this crisis started in the private sector.
Like a nuclear bomb. When in position of nuking others, nuke is good. When in a position of being nuked, nuked is no longer good.
Let me take a wild guess: Are you trying to justify your own opportunism as you sip beer in a Yangshuo Western-style cafe along the Li River? Do you feel guilty?
One need only google China + duplicity to see its contribution on the world stage. Or, ask Sima Lu, a renowned historian of the Chinese Communist Party who is currently living in New York City. This venerable revolutionary was a comrade-in-arms of Chinese President Jiang Zemin's foster father, Jiang Shangqing, said, „on the basis of his nearly 70 years of contact with the CCP that the more the party is publicizing something, the less it can be believed.“ http://www.asianresearch.org/articles/1114.html
Or, as David Bandurski From The Australian puts it „Yes, certainly China's leadership. It has demonstrated again and again that its promises are little more than fetching slogans it can interpret as suits its broader political ends.“
No judging here brother, we are all, including you, in the words of Blaise Pascal, „un monstre incompréhensible.“ And, the US, and all others, are now following China’s lead, going headlong into State Capitalism. Give it a rest.
And besides,
n? zhège xi?obáili?nr!
"its promises are little more than fetching slogans it can interpret as suits its broader political ends"
and ours aren't? really?
That is my point, duplicity is human nature and therefore applies to all human institutions. In other words, the US is not the only duplicitous nation.
TD: it's not Antonio Alfonso (Spanish form), it's António Afonso (Portuguese form), as your source clearly shows.
Germany has a 19% VAT. According to this the US could get away with a 10% VAT.
Pay the public sector twice as much as the private sector - let them retire early with a huge pension and there isn't a financial theory that addresses the problem. The fuse on the demographic time-bomb is also burning. A theory from 200-years ago never had to consider a wave of 80-year old's bludgeoning the economy.
It was a GREAT ZH weekend - Thank You
Hee, hee. Correct. These are political problems, not financial/economic problems.
I thought you meant Ricky Ricardo, you know, Lucy's husband.
Don't these sort of debt crises end up with financial disaster, war, and resolution?
CORRECTION:
As pointed out by above, the intro should read: Ricardian behavior is basically increased consumer savings - (not "spending").
A stupid typo on my account, same goes for Antonio Afonso. Sorry.
Thanks for your comments :-)
econotwist
Luuuucy... you got some 'splaining to do!
Unintended consequences is the problem that continues to bite all central bankers on the azz. For instance; as Mr Faber points out in this video, when the Fed cut interest rates to zero in Sept 2007 the US costs of crude went up from $500Billion to close to $1Trillion. The doubling of oil prices caused by speculation in oil caused an additional 'tax' on consumers of $500Billion, not an insignificant amount on an economy of $13Trillion. While the Fed was attempting to cushion the downturn with rate cuts, the outcome was an unforseen 'tax' increase on the US economy via oil doubling in price via the loose monetary policy of the Fed.
Did the Fed see the speculation (bubble) in oil prices coming due to their cut of interest rates to zero? I think not, since they can add 'money' to the economy by pushing a button but they cannot determine where that money will flow.
Mr Faber also points out that Paul Krugman, Bernanke, and pals, do not like to mention excessive leverage or excessive credit growth, even when they are writing articles titled: 'How Did Economists Get It So Wrong'.
As contraction in private sector credit surges, the government increases credit expansion...This is the rinse and repeat cycle we find ourselves in now.
Mr Faber offers the opinion that the Fed will never again effect tight monetary policy...'They will print, and print, and print'...Interest rates, in real terms, will remain at zero 'as far as the eye can see'...
US economic policy has been a disaster for the US and a boon to emerging markets.
Buy gold, productive land outside cities, hold some assets abroad.
Mr Fabers points are aimed at unintended consequences and the last slide of the presentation should be well known to all of us...
'There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of futher credit expansion, or later as a final and total catastrophy of the currency system involved.'
Ludwig von Mises
http://paul.kedrosky.com/archives/2010/05/marc_faber_mirr.html
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