Debt to GDP ratio – Where are we now?

Robert Barro in an interview with the Federal Reserve Bank of Minneapolis provides an explanation on the concept of Ricardian Equivalence. The feds question :

…suggest that deficit spending isn’t inherently harmful since rational people, expecting to pay higher taxes in the future to pay off government debt, will save more, so private savings will balance out the public deficit.

Does that imply that concerns about “irresponsible” levels of debt are unfounded? And is it puzzling to you that the Ricardian equivalence hypothesis isn’t a mainstream belief in macroeconomics?

Robert Barro’s response to this question is as follows:

“Let me say first that I think the Ricardian equivalence idea is basically right as a first-order proposition. However, people get confused as to exactly what it says. Before I say what that is, I should mention that, although the proposition is not mainstream in the sense of being fully accepted by most economists, the idea has had tremendous influence on the way economists think about this issue.

Analysis often begins with Ricardian equivalence as a first-order proposition and then goes on to investigate why there are deviations from precise equivalence. Thus, like the Modigliani-Miller theorem on corporate finance, Ricardian equivalence has become a common starting point for the way people think about budget deficits. This situation is vastly different from what it was before the mid 1970s.

To illustrate the potential pitfalls in what Ricardian equivalence says and does not say, one can consider the famous quote attributed to Vice President Cheney to the effect that President Reagan proved that budget deficits don’t matter. The Cheney quote is often interpreted to mean that the level of government expenditure does not matter, and that surely is not what Ricardian equivalence says. The Ricardian proposition is about the consequences of paying for a given amount of public expenditure in different ways. Specifically, does it matter—or does it matter a lot—whether the government pays for its spending with current taxes or with current borrowing, which entails higher future taxes?

So, a central part of the proposition is that the amount of public expenditure—today and tomorrow—is being held constant. It’s never part of Ricardian equivalence that the level of government expenditure doesn’t matter. As [University of Chicago economist] Milton Friedman put it, the costs or benefits of government outlays depend on the amount and nature of what the government spends—there is no free lunch about paying for that spending. So whether you pay for it now or later is secondary.

As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow, which is basically what a fiscal deficit is. The difference between taxes today and taxes tomorrow is analogous to the difference between paying for spending with an income tax or a sales tax. The method of public finance is an important question, but it is less important than the question of how big the government is and what activities it should carry out. Taxing now versus taxing later is an issue about optimal taxation, that is, a public-finance topic.

This view moves the analysis away from pure Ricardian equivalence to the optimal tax perspective, which brings in the principle of tax smoothing. The idea is that, unless something special is going on in different periods, optimal public finance dictates having tax rates, for example, on consumption or wage income, that are similar from one year to another. You do not want erratic movements in tax rates, because these patterns are highly distorting. From that standpoint, it is not desirable to have a very low tax rate today, financed by a fiscal deficit, followed by much higher tax rates in the future. This tax-smoothing result deviates from Ricardian equivalence, but in a 
second-order way, in the same sense that the choice between an income tax and a sales tax is second order but nevertheless significant.

Anyway, since we’ve talked so much about Ricardian equivalence, you might be interested in an anecdote. In 1973, I had worked out the basic invariance idea. If the government imposed some kind of intergenerational transfer—through fiscal deficits or enlarged Social Security—individuals who were connected through voluntary transfers to members of the next generation would neutralize the government’s actions. All that was required was an interior solution for voluntary transfers from parents to children or in the reverse direction.

Well, before I wrote anything, I sat down for a lunch with Fischer Black (famous, of course, for the Black-Scholes options-pricing formula). I took about 20 minutes to go through the whole analysis I had worked out. Fischer said nothing, but listened intently. When I finished, he uttered only one sentence: “Sounds right to me.”

IMF provides data on government debt and thought of analyzing the trends in government debt specifically the time frame pre-crisis (2007) and post-crisis (2009). The animated bar chart highlights the percentage of debt rising in troubled economies such as Greece, Italy, Portugal, USA and Belgium post 2007. These economies saw a substantial rise in debt to GDP ratio post 2007 i.e. debt was over 100% GDP.

The following interactive visual provides a view of the current debt levels in individual European economies. Many of the economies that had an increased debt level around 2007 have been successful in reducing their debt in recent periods.

Countries such as Denmark, Germany, Ireland, Romania, Sweden, and Hungary had higher debt levels but have managed to reduce the debt to gdp ratio post crisis.

On the other end of spectrum are economies such as Finland, France, Greece, United Kingdom, USA, Italy, Spain and Solvenia have a higher debt to GDP ratio post crisis. These economies have not been able to bring the debt levels down.

Going back to the Ricardian Equivalence and Robert Barro response we need to understand the interplay of tax, debt levels in global economies and how they would eventually impact private savings. Economies that have exhibited heightened debt levels post 2007 will have to eventually take appropriate measures to pay back their debt.

notes:

  1. Animated Bar plot : The animated bar plot was created using the flourish an online tool for data visualization.
  2. Multiple Grid line chart: The chart was created using the flourish an online tool for data visualization.
  3. Data : The Government debt data was sourced from IMF . When you download the data in excel format you will only see the data of one country at a time. The data for all countries is present in the same file but is hidden. To unhide click on Home -> format -> visibility -> hide unhide and visibility to make all the worksheets visible. All the raw data is in the sheet titled “rawdata” and is also in a long format so that comes in handy for using in flourish
  4. Generating interactive visuals in flourish are easy one you get a hand on it. Start with a template , click on data and upload your dat in the same format. Some visuals require you to upload data as a long format and some as a wide format.
  5. To add the visual to your blog like i did you need to first publish your visual and then obtain a link to embed the visual to your blog.

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