Goodbye Keynes – Hello Ricardo!

The world have 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 savings 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 Afonso at Universidade Tecnica de Lisboa, published in 2001, concludes that debt hardly will become neutral. And he’s probably right.

But Afonso’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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