The impossible equation

Earlier this year I reported on what a wonderful Xmas all the Ricardian agents (consumers and firms) had enjoyed in the UK as a result of the government austerity program. Please read my blog – Ricardians in UK have a wonderful Xmas. It seems those “agents” just cannot get enough of it. Now, more than 15 months into the austerity program and with the cuts about to really bite, the British economy continues to go backwards. Our real world laboratory is providing priceless data upon which we can assess basic propositions that mainstream macroeconomics provides and which Modern Monetary Theory (MMT) contests. A nation cannot have a fiscal contraction expansion when all other spending is flat or going backwards. Britain is up against an impossible equation.

The current period is providing us with an excellent (though tragic) real world laboratory to test the dominant economic theories. Forget all the mathematical models and regression equations. We don’t need Matlab, Scilab or SpaceLab. We don’t need to argue whether some function is non-linear, specified, identified or deep fried. We don’t have to worry about transversality, homogeneity, boundaries or continuity. This is real life – we have Britain.

Britain is now been enduring fiscal austerity since May 2010 – so more than 15 months even though many of the cut backs and tax hikes are only now being introduced. But the British households and firms have known since the election result in May what was ahead of them and so have had time to make adjustments to their spending and saving patterns to take into account the expected future.

The mainstream macroeconomics paradigm predicted that the net public spending cuts (and the advanced notice to the public of the intention to make these cuts) would stimulate private spending. This is the notion of Ricardian Equivalence which claims that that private spending is weak because we are scared of the future tax implications of the rising budget deficits.

MMT predicted that as a result of the fiscal austerity plans, the British economy would slow down again as private consumers and firms cut back on their own spending driven strongly by the fear of unemployment and flat sales conditions that accompany that situation. MMT also predicted that an export-led growth strategy in a international environment of declining growth driven by similar fiscal austerity programs elsewhere would fail.

Please read my blogs – Deficits should be cut in a recession. Not! and Fiscal austerity – the newest fallacy of composition – for more discussion on this point.

There was thus a stark difference between the two predictive sets – they are so different that there is very little room to blur the outcomes so that the data fails to distinguish between the theoretical predictions. This was never going to be a case of observational equivalence.

Here is an impossible equation:

Cut private spending + Reduce Net exports + Cut net public spending = economic growth

The left-hand side of the equation is more or less what is happening in the UK. Which is why the real world right-hand side is showing declining real GDP growth.

When the new government came into power last year there was a confidence expressed that growth would continue as the Government took charge of fiscal matters and restored balance.

There were strong overtones in the conservative speeches and quotes leading up to the 2010 election of neo-liberal economic thought – the drowning future generations in debt arguments and the private sector want lower deficits because they fear higher tax burdens.

When he was still in opposition, the current Prime Minister David Cameron gave an interview for the BBC Radio 4 Today Program speech on December 9, 2008. He said:

The Government is putting the whole of the British economy at risk. Labour want to borrow even more spend even more tax even more. I’m worried we’re going to hit future generations with a tax bill.

There are many such quotes on the public record.

In the May 24, 2010 UK Budget the Government scrapped the Child Trust Fund (a scheme which in itself had strong neo-liberal overtones but involved government outlays) the short-lived Chief Secretary to the Treasury David Laws said in his Speech to the Commons said:

At present the Child Trust Fund is based on the claim that young people will build up an asset which they can use later in life. But since Government payments into this scheme are being funded by public borrowing, the Government is also storing up debts which will have to be re-paid by these same young people.

It is therefore a deception to claim that young people are being made richer by the Child Trust Fund. For every pound paid into this scheme there is an extra pound of public debt. By ending Government payments into this scheme we also save the £5 million annual cost of administering

His tenure in that position ended in scandal – him claiming public funds wrongly by renting accommodation from his partner! Another role model for British youth.

In his book 22 Days in May which is about the deals struck between the Tories and the Liberal Democrats leading to the formation of the Coalition, Laws also said that:

No longer would we be conning children that they were richer, by going out and borrowing money to give them at age eighteen, after which they would have to pay higher taxes to pay off the public borrowing incurred to fund the scheme.

The public message was very clear. The Tories, aided and abetted by the Liberal Democrats (who I expect to be wiped out next election for betraying their support base), all claimed that the public spending was stifling private spending. This is Ricardian Equivalence – a concept that mainstream economists put at the centre of their attacks on fiscal activism.

In George Osborne’s 2011 Budget Speech delivered on March 23, 2011 he said that “the annual forecast for 2011 has been revised to 1.7%.” and quoted the Office of Budget Responsibility as saying that the Government’s policies would create “scope for slightly stronger growth in later years”.

He also said that:

… we are able now to set off on the route from rescue to reform, and reform to recovery, is because of difficult decisions we’ve already taken. Those decisions have brought economic stability. And without stability there can be no sustainable growth or jobs … A Budget for making things not for making things up. Britain has a plan. And we’re sticking to it.

The problem is that it was the wrong plan when it was devised earlier in 2010 and remains manifestly wrong now.

The latest Markit Household Finance Index (HFI) for the UK is chilling. The Key points for August were:

– HFI falls for third month running in August to its lowest since start of survey in February 2009

– Faster declines in savings, income and cash available to spend

– Largest rise in debt levels for nine months

The HFI survey data for August “indicated that almost 40% of households saw their finances deteriorate since the previous month, compared to just under 6% that recorded an improvement. As a result, the headline Markit Household Finance Index (HFI)1 posted 33.2 in August, down from 34.4 in July and the lowest in just over two-and-a-half years of data collection. The index therefore signalled that the rate of deterioration in household finances was faster than the previous record low seen during the height of the UK recession in early 2009.”

The Survey showed that to support current spending households were increasing their debt levels and that “(s)trains on household finances from higher debt and lower income levels contributed to a deterioration in respondents’ willingness to make major purchases.”

Also driving low confidence was continued “widespread” concern for job insecurity.

Last week, the UK Office of National Statistics released the –Retail Sales Statistical Bulletin – July 2011 which showed that zero growth in the volume of sale over the last 12 months (from an already lower base):

July 2010 compared to July 2011 saw 0.0 per cent, year on year seasonally adjusted growth in volume of all retail sales

Zip = Zip.

While earlier in the year the falling growth performance was blamed on the weather that excuse no longer carries weight. It is clear that growth is slowing and it is only a matter of time before it contracts overall.

Last week, the UK Office of National Statistics released the Labour Market Statistics August 2011 which not only showed that unemployment was rising but also revealed that real wages are falling as nominal wages growth falls behind inflation.

The rising private debt, falling real wage scenario is exactly the reason the world entered crisis in 2007. But now they are cutting back on spending so that debt-driven consumption is no longer driving economic growth.

The UK-based Institute of Public Policy Research recently (August 22, 2011) released a report – Surviving the Asian Century: Four steps to securing sustainable long-term economic growth in the UK – which demonstrates that an export-led recovery is unlikely for the UK. I do not have enough time today to provide a full analysis of that Report.

Its message was summarised in the UK Guardian article (August 22, 2011) – Decline in family finances speeds up, Markit survey finds.

The Guardian said:

The latest government figures show that after growing strongly last year, exports stalled in the first half of 2011. The IPPR says fewer than 7% of UK exports are going to Brazil, Russia, India and China – the so-called Bric economies. It argues that Britain is missing out on trading with these emerging markets and is being left behind by Germany and the US.

The report shows the UK share of global exports has dropped from more than 10% in 1950 to less than 3% today. The percentage of UK exports going to Belgium and Luxembourg – 2.9% – is almost double the percentage of UK exports to China, and yet the combined GDP of Belgium and Luxembourg amounts to less than one tenth of China’s.

The Report also demonstrates that there are “low levels of business investment in the UK (it is bottom of the league in the G7 for investment as a percentage of GDP), and notes that Britain also ranks behind most other industrialised nations in terms of infrastructure quality.”

If you put all that together – plus other data that comes in almost daily pointing to the same end – you quickly realise that predictions of the mainstream economists – who strutted so confidently on the financial media programs and wrote Op Eds claiming that fiscal contraction expansion was possible – are in tatters.

The UK Guardian article (August 21, 2011) – So what do we do now, chancellor? – pretty much sums it up:

When George Osborne came to office, he made austerity his overriding priority. Now, as panic sweeps through the markets over the prospect of a double-dip recession, many observers – including some in his own party – are starting to believe he has made a profound misjudgment.

There is now a veritable phalanx of economists being paraded out in the media saying that they are revising their growth forecasts down as government cut backs start to bite.

I thought this New Statesmen article (March 24, 2011) – The perils of Ricardian-Osbornism – demonstrated foresight.

The writer, Simon Winchester was commenting on the 2011 British Budget:

The Chancellor’s Budget speech attempted to shift the discourse from austerity and cuts to growth and enterprise. But there was no escaping the shadow of the harshest fiscal retrenchment in modern times. There will be no turning back … [But now] … The facts have changed. The trouble for the Chancellor is that every economic indicator is heading in the wrong direction – growth has turned negative, unemployment is rising fast, inflation is at its highest rate for 20 years, consumer confidence has collapsed and average earnings are falling. Indeed, the Office for Budget Responsibility, set up by the coalition, has been forced to downgrade its growth forecasts for this year and next …

He quotes Robert Skidelsky who wrote that “Ricardian-Osbornism would be an excellent cure for unemployment if there were no unemployment to cure.”

The British politicians have invoked the economics concept of Ricardian Equivalence to justify their fiscal austerity.

It is the most basic neo-liberal lie which forms a core of mainstream macroeconomcis. The claim is that if governments cut their spending the private sector will fill the gap. Mainstream economic theory claims that that private spending is weak because households and firms are scared of the future tax implications of the rising budget deficits. But, the overwhelming evidence shows that firms will not invest while consumption is weak and households will not spend because they scared of becoming unemployed and are trying to reduce their bloated debt levels.

In my article for The Nation in April 2011 – Beyond Austerity – I noted that:

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 “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 noncontroversial 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 so they can meet their future tax obligations. Increased government spending is therefore 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 have noted in the recent public commentary that mainstream economists are ducking for cover about Ricardian Equivalence arguing that it is misunderstood and not well-framed by those who criticise it. That is the typical “response to anomaly”. When in doubt accuse your critics of getting it wrong.

Unfortunately, the concept, while rather opaque to those not trained in economics, is not rocket science and can be easily explained to a lay audience.

The modern version of Ricardian Equivalence was developed by Robert Barro at Harvard. For non-economists – this piece of neo-liberal dogma says that the non-government sector (consumers explicitly) having internalised the government budget constraint will negate any government spending increase whether the government “finances” its spending via taxes or borrowing. So if the government spends and borrows, consumers will anticipate higher future taxes and spend less now offsetting the stimulus).

The logic that the model is based on is as follows. 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 accommodates 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.

This view is patently false because 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. Please read the suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – for more discussion of that point.

Further, 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. Banks create deposits when they create loans not the other way around. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion of that point.

But let’s stick with the mainstream argument for the moment so we can understand what Ricardian Equivalence is about. 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 account that will be needed to meet those future taxes.

There are many assumptions that Barro made which have to hold in entirety for the logical conclusion he makes to follow. I outline those assumptions in detail in this blog – Pushing the fantasy barrow. As I explain in that blog the assumptions do not hold in the real world and so at a logical level Ricardian Equivalence fails to be applicable.

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.

We can also assess whether the model has any empirical traction. History tells us that its major predictions failed to be even remotely accurate soon after Barro published the work (in the late 1970s). At that time there was a torrent of empirical work from economists who became obsessed with the idea. 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. It has subsequently been regularly exposed as a dismal failure since then. It should never be used as an authority to guide any policy design.

In our real world laboratory (Britain) we can confirm that the principle predictions of Ricardian Equivalence are once again failing dismally.

But of-course the British Tories know exactly what is going on and one can easily suspect that the austerity program has nothing to do with stimulating growth and doing the right thing by the British people.

It looks more and more – that they just want to finish the neo-liberal agenda in Britain and wipe out National Health and public education etc. The appeals to Ricardian Equivalence are probably just a smokescreen.

The problem is that my professional colleagues think the pollies are serious – they have to think that because the economists actually believe this stuff.

More reasons to hate economists

The US National Association of Business Economists just put out their August Economic Policy Survey and the headline of the press release read:

NABE Economists Concerned About Rising Deficits, Favor a “Balanced” Approach that Mixes Spending Cuts with Revenue Increases

The Survey results reveal that:

… about half of survey respondents indicated they would prefer fiscal policy to be more restrictive over the next two years, while a large majority said it expects fiscal policy to be more restrictive …

More than half (56.1%) favor reducing the deficit only or mostly through spending cuts rather than only or mostly through tax increases (6.8%). The remaining 37.1% favor equal parts spending cuts and tax increases …

Nearly 40 percent of survey respondents believe that containing health care costs in Medicare and Medicaid is likely to be the most successful aspect of a deficit-reduction plan.

You will see that the Survey Instrument Questions did not ask where any of them thought the main policy problem was that unemployment was too high.

One question asked: “Of the following, which do you think is the biggest risk facing the U.S. economy over the next three years?” – and the options were inflation or deflation etc.

This is a profession that demonstrates its irrelevance every day.

Conclusion

There was a comment made by a CEO of the second-largest Italian bank at the weekend reported on Bloomberg. It was about Italy but is generally applicable:

The government is “doing everything to create stagnation — all this austerity, all the cuts and little investment for the future …

At least that is one economist who has the right idea …

I have run out of time today and have to catch an airplane. Back tomorrow sometime.

That is enough for today!