In the provocatively titled “‘Creeping Into The Unconventional’ And Why Everything You Thought You Knew Is Wrong“, I mentioned the Ricardian equivalence “problem”, whereby a loosening of the public purse strings is offset by private sector retrenchment.
On a strict (and probably unrealistic) interpretation, households and corporates assume that taxes will eventually be raised so that the government can pay for debt-financed spending. Rational actors will then increase their savings, which means the impact of fiscal stimulus will be blunted by private sector belt-tightening.
It’s conceivable that debt monetization by central banks can help short-circuit that dynamic. Basically, the argument is that if people know the central bank is buying the debt, they won’t necessarily expect to see their taxes increase later, and therefore won’t be inclined to immediately increase their savings. That means they’ll spend instead, which is what the economy needs during a downturn, especially an economy which relies on consumer spending.
As you’re probably aware, savings spiked in April thanks in no small part to transfer payments (or, as the BEA called them, “government social benefits to persons”).
Between payments to individuals from federal virus relief funds and the impulse to hoard cash, the US witnessed a surge in the savings rate the magnitude of which would have seemed unimaginable prior to the pandemic.
Consider this in context. “During Q1, nonfinancial private sector net savings increased by just over 12% of GDP, while general government net savings decreased by only 6.5% of GDP from the previous quarter”, Deutsche Bank’s Stuart Sparks writes, in a new piece.
Have a look at the juxtaposition in the figure.
(Deutsche Bank)
Clearly, that is not a tenable situation.
As Sparks notes, “additional government spending (and hence net borrowing) will flow into the economy in Q2 by virtue of current budget law [but] the savings behavior of the private sector is perhaps the more critical variable due to the threat of Ricardian equivalence”.
So, how to ameliorate the situation? Simple: The Fed needs to disincentivize savings.
Otherwise, the government will need to keep spending and spending and spending, which will prove fruitless if Ricardian equivalence holds, and could actually get worse as the public’s fears of higher taxes increase with the deficit, in a Sisyphean nightmare for fiscal policymakers.
“From this perspective… a clear function of QE is to reduce the financial incentive to save by lowering yields”, Deutsche goes on to say, adding that “to this end, we argue that in these circumstances the Fed would prefer to observe deeply negative real yields, and is likely to increase QE purchase levels in order to keep real yields low”.
What happens if they don’t? Well, again, savings could offset economic pump-priming. As Sparks writes, “persistent increase in private sector savings means that the public sector stimulus must be larger, more persistent, or both”.
In addition to being self-defeating (from a Ricardian equivalence perspective), there are ostensible limits “to the extent that the public sector can increase net borrowing, both political as deficits grow and debt levels increase as a percentage of GDP, and — in extremis – in terms of debt sustainability, particularly given uncertainty about potential growth levels in the post-pandemic world”, Sparks remarks.
He goes on to discuss the second incentive for the Fed in terms of persisting in strong QE flows. That second incentive is obviously just the portfolio balance channel, whereby the Fed sequesters risk-free assets away on the balance sheet and drives rates on those assets into the floor, pushing investors out the risk curve and down the quality ladder.
But the purpose of this deliberately short missive (or “short” by my standards anyway), is to say that with the Fed having made it (mostly) clear that negative rates are not in the cards stateside, they will have to maintain QE flows sufficient to engineer a de facto negative policy rate.
Otherwise, you (as consumer/citizen) might just keep on saving. And we can’t have that.
As Sparks puts it, “one of the most fundamental problems the Fed must manage is the tendency of economic agents to increase precautionary savings given uncertainty about their future employment and earnings prospects”.
I would suggest that one way out of this scenario is direct debt monetization, where “direct” not only means cutting out the middleman, but making it abundantly clear to the public that the Fed is overtly enabling government spending.
That way, folks might be more likely to spend now, either because they don’t fear being taxed at a higher rate later, or, on a less benign take, because they think prices will be rising in the future.
I can never understand why the notion of Ricardian equivalence is still bandied about. I mean, does the average American look up from their plate of summer ribs and say, “Honey, I bet taxes will rise in 5 years. Let’s cancel that trip and put some money aside to pay those later.”
At the corporate level, isn’t building up a long-term tax reserve pool totally antithetical to the current “pay it all out and more” religion in corporate boardrooms?
That leaves the poor US states which often DO try to build up “rainy day funds” when times are good, unlike now.
Well, we can forgive Mr Ricardo. He lived in a different world. But to roll it out in today’s world ?
Want spending? Allow 10% tax free withdrawals from 401k/IRAs. CARES already pushed back RMD’s by 2 years, why not all investors to tap tax-deferred saving accounts tax free? If they are worried about those dollars just going into the market, place restrictions on what the dollars can be used for. Cars, houses, whatever.
I love it! Forget Ricardo as he is totally antithetical to US thougtht. The real juice is taking money from the 401k and spending it now so we don’t have it when we need it, (Of course I did that – I only had enough to get to 68 anyway!) Americans are so up the creek it is unreal. Day trading – that is the answer.
If interest rates are driven down to make fixed income assets unappealing for savers, the result would be to drive more “savings” into riskier income-generating assets and capital growth assets.
This was already happening pre-Covid crash, as written about at length here. When $1MM only got investors 1.50% in Treasuries and not much more in IG corporates, they were pushed into high yield, dividend stocks, growth assets , etc. If $1MM only gets 0.00% in Treasuries, the same will happen on a larger scale. Investor don’t say “Gee, Treasury yield is zero, so I’ll buy a new refrigerator”.
I expect a more nuanced view may result in different conclusions. That is if these ‘savings’ are the result of stock sales or fear based hoarding then I do not think low rates will help flush out that much cash. It would however help bank bottom lines at the expense of less fortunate.
Low rates generally hurt banks by compressing net interest margins. Okay it’s the flat yield curve that hurt but when rates are low, not much room for sloping yield curves.
European banks have been suffering from this.
Exception for banks that don’t actually rely on lending, and instead rely on fees, commissions, trading, etc – the Goldmans and Morgan Stanleys etc.
It is complicated.
They get paid all the money and have all the PhDs. They can’t figure it out? Hire lobbyists and lobby for fiscal policies.
Incentives. Inflation. Fiscal policy.
Pray for inflation. It’s a tax, right? Maybe they’ll get their 2% this time and let it run hot.
Health care costs. it’s too difficult and expensive to have health insurance in the US. A cheap, $1,500 / month policy for a family for health care continuation is a lot of trips to Target. Few who have health care and get laid off are going to decide to not pay this for their families.
Fiscal policy. Where are the huge infrastructure bills that no one has passed in three years?
Give money to cities. They will spend all the money on hiring people who will spend all their money on supporting their families.
Maybe etch in stone that Roth IRA earnings will not be taxed ever. And, that highest tax rate on traditional IRA funds will only ever be be at the rate applicable when the earnings were set aside. There’s a fear that one cannot save too much as future expectations are for higher taxes. Freeze taxes on these and people currently saving into them can save less.
Putting electrical grid in separate from infrastructure above. Rebuild and expand as necessary grid as necessary. Fiscal policy.
The Fed’s only hope is inflation. Additional fiscal incentivize certain behaviours would be helpful.
So much of this is a self inflicted wound.
As the fed pushes rates lower and lower, I wonder if state and local governments with large pension obligations and other guarantees will need to raise taxes and if that could be a contributor to Mr. Ricardo.
Well it is true that if every person were given $500 visa debit cards where excess balance expired every 30 days. Then people would spend at least that money. However just giving out money without a continuation guarantee will just cause any other money to be salted away due to fear.
Bingo UBI means spending. One time checks means saving for emergencies.
If the Fed were to directly fund government spending, then there would be no excuse for not funding every program that one could possibly conceive of. (Yes, grammar police, I know that sentence contains a double negative and concludes with a dangling preposition. You can put away your truncheons now.) Since the Fed has no limit to the credits that it can conjure from its monetary vacuum, then how would you determine the prices paid for the goods produced, and/or the services provided in those programs? Answer: you would need those to be administered by the federal government, the Federal Reserve, or a separate “Pricing Bureau”. At this point, we would receive this directive: “Do not attempt to adjust your outlook. We are controlling transmission. We will control the supply. We will control the demand. You are participating in a predetermined adventure. Your economic reality has now reached “The Outer Limits”.”
The FED could ban all taxes on the well to do and leave it to the poor to pay taxes. This will create more taxpayers in time. Might get a full throated laugh out of Mitch with that one.
sounds like a centrally planned economy
There may be two consumers in the entire USA that actually think about future tax rates and those two do not let it affect their future spending. As others have suggested, if you want the consumer to spend then give the consumer money to spend. It is much more efficient to give the consumer $1 to spend than to have the Fed pour $1000 into the “economy” and let that tenth of one percent dollar trickle down to the consumer.
The US could probably solve their entire economic problem if they didn’t have a parasitic healthcare system that sucks 10% of the money out of the entire economy. For some reason there never is a moral hazard giving trillions to the financial world but there always is a moral hazard to give hundreds to an individual.
I agree with others who have commented that Ricardian equivalence is not behind the increase in savings. I did a back-of-the-envelope calculation that one-percenters earning $800k per year had the present value of their future taxes increase by $680k due to this year’s “stimulus.” But they are oblivious to it. The increase in savings is due to lockdowns. Personally the most I could figure out to spend money was to buy a soundbar for my 67″ TV. Also, the remedy proposed does not work. Negative rates would stimulate savings, since more savings would be needed to achieve a target sum at retirement. For those versed in economics, the income-effect would dominate the substitution-effect. Of course gold and stocks would rally further, which is also not a disincentive to savings.