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Why is economic growth stalling? May be it is Ricardian equivalence!

Posted by on August 2, 2011 in Economic Theory, Financial Crisis, Recession | 0 comments

The British and American recoveries do seem to be stalling. The recovery profile is by no means as strong as is usually the case after recessions, even after pretty major financial crises like that of 2008/09.

One of the insights of complex systems is that the impact of any particular factor may differ dramatically according to circumstances. So think, say, of a network of firms or consumers and ask how optimism or pessimism might spread across the network. Each decision maker will for his or her view in part upon the views of others to whom he or she is connected i.e. pays attention. And each agent (decision maker) will have its own level of persuadability. In other words, how easy is it for other agents to get the agent to change its mind?

A well established result is that changes in the opinions of a small number of agents can have dramatically different outcomes in terms of how far they spread across the system as a whole. Most of the time, changes of mind by a few agents won’t get very far. But occasionally, they can infect, as it were, almost the whole network.

Ricardian equivalence is an esoteric concept which much of the time has little or no impact. But it might be doing now.

David Ricardo was a great English economist who wrote in the early 19th century. He made millions in the City and was also an MP. During the Napoleonic wars, government expenditure grew phenomenally. Ricardo asked: does it matter how this is paid for?

One way is to put taxes up now. The other is to run a deficit and issue government debt (bonds) to pay for it. Ricardo said it didn’t matter how it was done. The latter way implied a future stream of interest payments on the debt, and rational agents would anticipate that taxes would go up in future to meet these payments. So they would cut back their spending now to save for the increases in future taxes. Their spending would fall by just as much as if they were taxed now. The two methods are equivalent.

The current massive emphasis on government debts and deficits certainly alerts consumers to the idea that taxes might have to rise to pay for them. So they are cautious about spending. Companies, sitting on piles of cash, observe this caution and postpone investment decisions which they can easily afford to pay for.

So the economy stalls. In more normal times, Ricardian equivalence is a pretty odd idea. But it might be why the recovery is weak now. Paradoxically, cutting the deficit more sharply might lead to a much stronger rebound.

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