G20 Unity And The Indiscipline Equivalence Of Economic Policies

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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That it does not really matter for consumption whether the government finances its shortfall through debt issuance or higher taxes is known to the economics profession as the Ricardian equivalence between debt and taxes, named after David Ricardo who had postulated it by studying the issuance of war bonds.

The simple explanation for the indifference of consumption to debt issuance or a tax increase is that consumers save in government bonds by buying government debt now to prepare for the expected tax increase by the government to pay off that debt in the future. Had the government not issued debt but simply increased taxes, because the consumers’ disposable (or after tax) income would fall, the consumption that is predicated on the disposable income would also fall as if they had purchased government debt and saved instead of consuming.

To balance the imbalances in the U.S economy, the Obama administration is on the path of reversing the course in fiscal policy that has been in place since 2001. Budgets and taxes are being committed through reforms in health care, financial regulation and energy for the next decade to redistribute national income from the top (through higher taxes) to the middle (through lower taxes) and the bottom (through welfare state). At the same time, the higher taxes on the wealthy are being offset by muted regulatory reforms for political purposes as is clearly evident in health care and financial regulation.

Debt issuance has risen to an all time high since World War II and taxes have both risen on some and fallen on others, even as personal consumption remains low hampering economic recovery. The fiscal impetus from both debt and tax changes has not yet led to an increase in consumer demand sufficient to lower unemployment. Debt is expected to rise and tax changes are expected to taper off (once the Bush tax cuts are fully reversed) for the economy to gradually recover to full employment by 2016.

Given that the purchasers of government debt and payers of higher taxes are mostly the wealthy, it is likely that consumption has fallen along with investment across the income spectrum, not because of Ricardian equivalence but because of doubly lower disposable incomes at the top due to both higher government debt and higher taxes at the same time. Because government debt crowds out private investment, there is a multiplier effect on the downward pressure on consumption. Hence, the current persistently higher unemployment, the initial trigger for the recession being the shock of the bubble economies since the late ‘90s bursting by 2007.

This shock has largely been self-induced. It points to a lack of discipline in both monetary and fiscal policies. There is no way out besides monetary and fiscal discipline. When consumers expect stable prices and a fair, simple and consistent tax policy, with the tax rates geared to funding an effective and efficient government, consumption will also be optimistic and less volatile and so will growth.

Monetary policy must explicitly target price stability, tax policy must be simple, and government budgets must be efficient, effective, parsimonious and targeted mostly to the pure public goods (which includes the wars in Afghanistan and Iraq). This must be the framework to save the faltering unity of the Group of 20 countries.


About Chandrashekar (Chandra) Tamirisa

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