Europe’s Ricardian Equivalence vs America’s Keynesianism

We thought this to be the most interesting chart of the recently released World Economic Outlook from the IMF.  Japan’s 2011 public sector funding requirement is a stunning 60 percent of GDP, which includes the rollover of maturing debt equivalent of 50 percent of GDP.  Note that Japan is the only country depicted on the right scale of the chart. The footnote states,  2 All left scale except Japan; Japan right scale.

The concern over public debt is a major issue dividing European and U.S. policymakers and the November election will be seen as a referendum on large budget deficits.

The Europeans are taking a Ricardian Equivalence approach, believing fiscal austerity and deficit reduction will have a far more positive economic impact than further stimulus.   In his Jackson Hole speech, ECB President, Jean-Claude Trichet confirmed this,

The concern is, however, that in the short run the deficit reductions – although unavoidable in the long run – have negative effects on aggregate demand. The economy, it is sometimes argued, is at present too fragile and thus consolidation efforts should be postponed or even new fiscal stimulus measures added.

As I pointed out recently , I am sceptical about this line of argument. Indeed, the strict Ricardian view may provide a more reasonable central estimate of the likely effects of consolidation. For a given expenditure, a shift from borrowing to taxation should have no real demand effects as it simply replaces future tax burden with current one.

There is the additional argument positing that credible fiscal deficit reductions through expenditure cuts lead the private sector to expect a lower future tax burden, especially when the nature of the cuts make future tax reductions more likely. This can generate higher consumption expenditures and more investment.

In Sunday’s  interview (click here for video) on This Week With Christitiane Amanpour, French finance minister, Christine Lagarde, spoke of the negative economic impact of further stimulus measures,

Amanpour:  …There seems to be tension between the United States and Europe over  what is the most sensible way to deal with current lack of growth.  The U.S. wants Europe to continue pushing money into the system.  Europe is talking about a lot of austerity.

Largarde:   …If we do not reduce the public deficit, it is not going to be conducive to growth.  Why is that?  Because people worry about the public deficit.  If they worry about it, they begin to save.  If they save too much, they don’t consume.   If they don’t consume, unemployment goes up and production goes down.  –  37 seconds

If the U.S. continues with fiscal stimulus and Europeans with fiscal austerity, this is about as close to a real time economic lab experiment that will ever take place — Keynesian versus Classical Economics.  Much is at stake.

It is a rare case, and we can’t recall,  when European policymakers and American conservatives were on the same side of such an important economic issue.

Our take away is the Fed senses the political winds and the “spending fatigue” of the body politic and is hoping to stimulate aggregate demand — though less direct and effective than fiscal policy — through QE2.   We will have more to say on this subject later in the week.  Stay tuned.

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7 Responses to Europe’s Ricardian Equivalence vs America’s Keynesianism

  1. Pingback: The Yoke is Hard and the Debt Burden is Heavy | Global Macro Monitor

  2. Pingback: Greenspan: High US Deficits Could Spark Bond Crisis | Global Macro Monitor

  3. Helen says:

    Hi, please can you tell me where you found this diagram?

  4. Pingback: Euro Swan Dive Splashes Santa | Credit Writedowns

  5. Pingback: Current Global Growth vs. Precrisis Average | Forex news

  6. Pingback: Time To Bury The Ricardian Equivalence | Robert Nielsen

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