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As Washington gets ready to engage in another game of "chicken" triggered by the deadlines often described as the "fiscal cliff," we begin to hear more and more tales of businesses and individuals cutting back on spending and investment in anticipation of higher taxes and an economic slowdown. Even though the government is running a huge deficit, which Keynesian theory would suggest to be highly stimulative of economic activity, the anticipation of tax increases and government spending cuts is apparently reducing private sector demand.

There is a classical economic theory that loosely fits this phenomenon. It is called Ricardian Equivalence or the Barro-Ricardo Equivalence Theorem. Essentially, the theorem suggests that, when there is an increase in government spending, the market is essentially indifferent to whether that increase is funding by government borrowing or by tax increases. While tax increases reduce private sector resources more directly, private sector demand will also decline if borrowing is utilized because the businesses and households in the private sector will realize that the borrowing will eventually have to be repaid and that there will be inevitable tax increases in the future. This will lead the private actors to spend less and save more in anticipation of lean times ahead.

The underlying assumptions and mathematics behind the theorem can get quite complex but it certainly sounds somewhat like what we are experiencing today. Before we jump to the conclusion that we have proven the theorem, it is useful to drill down on a few assumptions and, perhaps, better understand how deficits might be more effectively employed to stimulate the economy.

1. Borrowing versus Monetization of Deficits - When Ricardo was writing, currencies had a metallic backing and so governments really had to repay the money they borrowed. As I have pointed out, that is not really true in a purely fiat money system like the one prevalent in today's major economies. While large scale monetization of the government debt could produce unacceptable levels of inflation, this inflation problem is the only real limit upon such monetization. So, in a real sense, we do not have to pay the debt back with higher taxes. Unfortunately, this seems to be a "dirty little secret" that political leaders are afraid to reveal and so they resolutely express concern about "the national debt" and this concern leads the private sector to anticipate higher taxes and thus cut back on spending. As a result, the recession is prolonged and the debt winds up being a lot higher than it had to be. As always, honesty is the best policy. Someone has to tell the American people the truth about our money, the debt, and the way the Federal Reserve operates.

2. Anticipation of Recession versus Anticipation of Taxes - I think that a good deal of the reluctance to spend in the private sector is associated with anticipation of a recession (and thus becomes a self-fulfilling prophecy) caused by the fiscal cliff rather than simply the anticipation of higher taxes. This implies agreement with the underlying Keynesian insight that deficit spending does tend to stimulate demand and that a sudden reduction in the deficit will likely produce a recession. A bi-partisan commitment to maintain fiscal stimulus until GDP growth reaches a certain level would separate these two fears and might reinvigorate private sector demand. The timing of the "fiscal cliff" should not be a date on the calendar but rather a date determined by growth in nominal GDP - for example, 6 months after nominal GDP has grown at an average annual rate of 7 percent for at least 3 quarters. The private sector would then know that higher taxes would not appear unless and until a robust recovery was under way.

3. The Nature of the Anticipated Taxes - There has been very little debate about the nature of the taxes that will ultimately be imposed to reduce the deficit. Most people in the private sector assume that the current tax system will be expanded with rate increases. I have long advocated the use of a Value Added Tax (VAT) instead - both to encourage production and to improve our position in international markets. If the private sector anticipated the imposition of a VAT, we might see a rush of consumer spending on big ticket items like appliances and automobiles to "beat the tax" and the anticipation of the tax might actually stimulate the economy.

The insights of the advocates of Ricardian equivalence are useful, not because they prove that deficit spending is futile, but because they suggest ways to make deficit spending more effective in increasing aggregate demand. And effective deficit spending is important because it is only growth which will ultimately make our fiscal problems manageable. If deficit spending is employed in an ineffective manner which tends to discourage private sector demand, it will ultimately require larger than necessary deficits to restart the economy. In a real sense, "a deficit is a terrible thing to waste" - deficit spending must take into account the insights associated with Ricardian equivalence to induce GDP growth expeditiously.

Source: Bracing For The Fiscal Cliff: The Vindication Of Ricardian Equivalence?