To spend, or not to spend?
There is really only one question on the agenda at the G8 and G20 meetings in Toronto and in policy circles throughout Europe and North America: to cut government spending and risk recession; or to keep on spending, risking a return to inflation, or more likely to stagflation ‚Äď inflation with stagnant economic activity?
You won‚Äôt be surprised to hear that economists are divided ‚Äď and, remembering the 364 of my colleagues who protested about government policy in 1981, you can be forgiven for disregarding our views altogether. Perhaps the best I can do here is to unpack one or two of the fundamental issues at stake in the current fiscal policy debate.
Suppose I spend 10,000 pounds on a new car. If I pay cash for it, I have 10,000 pounds less to spend on other things. So, aggregating total spending in the economy, the car industry benefits to the tune of 10,000 pounds, but my local restaurants, supermarkets, cinema, etc., lose the same amount of business ‚Äď net effect, zero.
Now, instead of paying cash, suppose I borrow the 10,000 pounds ‚Äď will the outcome for the economy be any different? Will I still cut back on my spending on other items, in recognition of the fact that I now have a debt of 10,000 pounds hanging over me? In an important sense, the situation is the same as if I had paid cash. I may still have the 10,000 poundsin my own bank account, but it is now mortgaged, earmarked for payment at some future date.
The privilege of being able to smooth my cashflow by postponing repayment is something I have to pay for in the form of interest, so that in accounting terms, I am committed to repayments whose present value is the same 10,000 pounds.¬† Whichever way you tell the story, it shouldn‚Äôt change the conclusion ‚Äď prudent, rational budgeting requires me to cut back on my spending on everything else by as much as if I had paid cash for the car.
Now, instead of me spending 10,000 pounds, suppose the government spends. Does it matter whether it pays cash on the nail or borrows? The answer ought plainly to be no. After all, its spending is on my behalf, and I ‚Äď as citizen and taxpayer ‚Äď am going to have to pay for it, either now, through an immediate tax increase, if that‚Äôs what the government decides to do, or at a later date, if the government decides instead to borrow.
In other words, government borrowing is simply deferring the tax hit, and if I am rational, I will take this into account here and now, setting aside enough to amortize the debt which is going to be collected from me in my tax bill in the coming years.
Hence, we arrive at the conclusion attributed to the great classical economist David Ricardo some two hundred years ago: in a rational world, government spending has the same effect whether it is financed by taxation or borrowing.
Like so many of the fundamental propositions of economics, the logic is indisputable – but alas the reality is very different. There are simply too many circuit breakers in the mechanism linking a government‚Äôs commitments to repay its (our) debts in, say, 25 years, and my own tax liability.
In the first place, tax is levied unequally, so nontaxpayers may well be totally indifferent. On the other hand, if I am currently working, but expect to be a non-taxpayer in 25 years from today, I may quite rationally prefer to see the government borrow, leaving my share of the repayment burden to future generations.
Should I care about the tax bill I leave to my grandchildren (assuming I have any)?
If so, I should save now, so as to increase my bequest to them by enough to repay the additional borrowing ‚Äď but how many people actually do this, especially given the distortionary effect of inheritance tax? Who knows? Perhaps the country will be vastly richer when today‚Äôs toddlers are in their prime, so the burden of repaying our current overspending will seem like chickenfeed to them.
Above all are two critical reservations. The first, more obvious post-Lehman Bros than ever, is that most people do not make rational decisions. After all, if borrowers had always been rational, they would never have wanted to borrow beyond their capacity to repay, and they would never have been given the opportunity, if banks had been rational in their turn.
The other reservation is that the Ricardo logic ignores the default option, whose rules and policing are well defined for private bankruptcies, but vague and unenforceable in the case of national governments.
The existence of this escape hatch creates a continual cat-and-mouse game between lenders and sovereign borrowers, as we have seen in recent years from the examples of Argentina and Greece.
The vast amounts of human and electronic brainpower devoted to unravelling these issues have yielded no clear answer to the tax-or-borrow question. For what it is worth, my own gut feeling is that spending has to be cut ‚Äď and cut drastically, not because it will somehow prevent a recession, but because the ensuing recession will be less catastrophic and long-lasting than if we carry on borrowing.
I say this because we need also to consider the dynamics, specifically the fact that in the modern welfare state, whether to be a tax payer or benefit recipient is a matter of individual choice for more and more people. Even before the crisis, I feared a future in which the younger generation would simply refuse to carry the cost of a demographically-inflated welfare state ‚Äď and we now have to add in the cost of the bank bailout.
Refusal is straightforward and insidious. It does not necessarily involve a tax rebellion or any kind of explicit political upheaval (though it might). You can simply drop out of the labour force ‚Äď emigrate to Australia or, more commonly and more damagingly, to the unemployment register. The danger is therefore an unstable situation where debt repayment raises tax rates to the point where more and more people find life on welfare preferable to work, creating an even greater fiscal burden, meaning higher taxes, and so on.
Whatever the decision, you may think that in a few years we‚Äôll know whether it was right or wrong ‚Äď well, don‚Äôt hold your breath.
Economists are still divided over whether Keynesian remedies worked (where they were applied) in the 1930s.
In fact, the lessons of that awful decade are much disputed ‚Äď and not just on the economic front. George Soros is warning us that deficit reduction measures could lead via mass unemployment to the (further) rise of 1930‚Äôs‚Äďstyle anti-democratic movements.
He may be right, but in my own (albeit amateur) understanding of Central European history, the lesson is the absolute opposite. It was the burden of paying post-World War Two reparations leading to hyper-inflation and the consequent destruction of the middle class which created the conditions for the rise of Fascism.
For reparations, read today‚Äôs bank bailout, and the danger is money printing, aka quantitative easing leading to inflation ‚Äď a glib interpretation, no doubt, but it should at least serve to illustrate the ambiguities in the current situation.
(By the way, it‚Äôs G8 ‚Äď but does the ‚ÄúG‚ÄĚ stand for Gigantism? At $1 billion a throw, summits are now so costly, they should perhaps be held only every four years, like the World Cup and Olympic Games.¬† In the meantime, video-conferencing should be sufficient.)