Piper always has to be paid


http://www.financialpost.com/story.html?id=2918021

Saturday, April 17, 2010

Piper always has to be paid

Consumers know they will have to pay taxes

Peter Hodson,  Financial Post

On Wednesday, March retail sales in the United States showed a 1.6% gain, the biggest in four months. Prior months were revived upwards as well. Meanwhile, the United States continues to issue hundreds of billions of dollars of new debt every week as it finances its US$1-trillion-plus deficit.

Does this make sense? Does it make sense for consumers to keep spending money while their government goes deeper and deeper in debt?

Well, according to noted economist David Ricardo, it makes no sense at all.

The Ricardian Equivalence, derived from a paper entitled Essay on the Funding System (1820) is an economic theory that attempts to reconcile the fact that governments can finance deficits by either raising taxes, or issuing debt. The Ricardian Equivalence states that, under many scenarios, the economic result will be the same in either case.

Most Keynesian economists, of course, scoff at this theorem. Standard Keynes theory suggests that borrowing money now and spending the borrowed funds has a far greater economic impact than taxing consumers now and then spending the tax proceeds.

Governments, during this financial crisis at least, seem to certainly agree with the “spend borrowed money now” theory.

Ricardo, though, noted that consumers internalize the government’s situation and act in a similar manner whether government spending is financed by borrowing or tax increases.

In other words, consumers realize that all that money the government is borrowing has to be paid back eventually, and the only way to do it is to raise future taxes, so it doesn’t matter to them whether the government taxes now or taxes later.

If later, consumers simply adjust their spending habits to get ready for the ‘future’ tax burden that will eventually come.

As an example, consider your own situation. If you had $20,000, and the government needed to finance, say, a bank bailout or something like that. Would you prefer a tax of $50 a year for 20 years, or a single one-time tax of $1,000?

There are many considerations involved, like interest rates and your trust or distrust of government, but Ricardo would argue that, if rational, you wouldn’t care which of the two choices you had to make — either way, the piper has to be paid.

Robert J. Barro, in 1974 in a paper titled “Are Government Bonds New Wealth?” added to the Ricardo theory. He stated that if families act as infinitely lived dynasties the Ricardian Equivalence makes more sense. In other words, you and I both know that all this government borrowing needs to be repaid.

So when governments increase borrowing you simply save more during your lifetime or bequest more to your children so that those future taxes can be repaid by your heirs.

Barro and Ricardo would certainly argue today that the increase in the savings rate we have seen post crisis (although it is dropping slightly again after a sharp rise) is because families are saving for the ‘future’ tax burden that all this government spending will create. If you are not an economist at all you might just say times are tough so we better start saving.

Most modern day economists would today dismiss Barro and Ricardo’s theories. However, they do highlight something that governments need to take heed of: Individual actions, en masse, can totally derail a government’s plan of action. It is these ‘unintended consequences’ that are really the scary part of any government action whatsoever.

peter@sprott.com———

-Peter Hodson is chairman and a senior portfolio manager at Sprott Asset Management.

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