The visible hand in economics

“Twin deficits” and Ricardian equivalence

Posted on: October 22, 2008

A while ago (after the Pre-EFU) Brian Fallow discussed the upcoming “twin deficits” New Zealand is likely to face.

Fundamentally, the private sector in New Zealand has been borrowing a lot from overseas while the public sector has been saving. His fear is that, once the public sector starts borrowing again our debt levels will rise and we’ll be in big trouble.

However, there is a nifty little thing called Ricardian Equivalence which we can call on to state why this may not be such a problem. In the case of Ricardian Equivalence, when households see the government borrowing, they know that the government will have to increase taxes in the future (as they assume that government spending will itself grow at some rate). As a result, private people save a bit more in order to cover there future tax liability. In this case, it is the national level of debt that is the concern – not the idea of “twin deficits”.

Even if you don’t believe in Ricardian Equivalence (it is something that is often questioned) think of it this way: As national debt rises the interest rate we get charge increases (as risk of default increases) which inturn leads to an improvement in the private savings position – in this sense private debt will adjust, at least partially, to an increase in public debt.

Of course – this does not defend the fact that both Labour and National are looking at running an unsustainable budget. This type of politicing could lead to further ramifications – by reducing our perceived credit worthiness. However, it is not the existence of “twin deficits” that threatens our credit worthiness in this case – it is the poor decisions by either public (as a result of agency problems) or private (as a result of information problems) agents.

I don’t think either party is that “irresponsible” and as a result, I think it is obvious that Labour and National will both have to either cut spending, increase taxes, or both – I think we know which party prefers which option, and as a result lets hope that people vote on that basis 😉

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