The Ranting Kraut

19.3.2006 – 27.9.2010

Brown, Cameron and Ricardian Equivalence

Posted by rantingkraut on December 12, 2008

Are Brown’s German critics and Cameron misguided in criticising the current borrowing binge? Edmund Conway seems to think so. He recently wrote in the telegraph that this is the right time for a fiscal expansion and that the problem of Ricardian equivalence [1] can be counteracted by carefully planned spending cuts in the near future.
This sounds reasonable in general and the present crisis creates exactly the kind of situation where a fiscal stimulus would normally be advocated. I will not start speculating on how effective the current VAT reduction is likely to be compared to other options, nor will I dwell on the fact that Germany is hardly in a position to lecture anyone on sound economic management. Instead, I will speculate a bit on how likely it is that Ricardian equivalence may remain a problem for reasons that pre-date the current crisis.

It seems plausible, to assume that Ricardian equivalence will be more of a problem, the higher the public debt, and the less discretion the government will have about the magnitude and timing of re-payments in the near future. If the next ten years promise to be a period in which the government will be under pressure to reduce its debt substantially and in a short space of time it makes sense for tax payers to increase precautionary savings before the anticipated higher tax rates materialise.

The magnitude of the debt problem of course will only partly depend on the current crisis –which is beyond Brown’s control– and partly on a legacy of high public debt –which is entirely Brown’s fault. It is well known but not sufficiently noted, in the current discussion, that the long period of high and uninterrupted economic growth which preceded the current downturn ended with a considerable and avoidable build-up of public debt. During the first labour government, net public debt, as a percentage of GDP, fell until around 2001 (source [2]). Thereafter, and still during a period of sustained high growth, debt grew from under 30% of GDP to over 35% before the onset of the current crisis. This should have been a period where public finances could have been restored. Even from a traditional Keynesian perspective, it should have been a time when the government would have nurtured its fiscal health so that it can intervene in the event of a crisis.

So if the effectiveness of tax cuts is now constrained, we should not forget why: the heritage of New Labour’s profligacy during economic good times may well have rendered fiscal policy ineffective during a downturn. At the next election, one should wonder if a government with that kind of experience is the right one to manage the UK economy. Brown may not be responsible for the global credit crunch, but he can be blamed for Britain’s financial position at the beginning of the crisis.

[1] Definitions of Ricardian equivalence feature frequently in the current discussion. It is a process whereby consumers save more in response to higher deficit spending because they anticipate that additions to public debt in the present will lead to higher taxes in the future.

[2] See here for some of the definitions used in the linked source.

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