Sunday, January 10, 2016

New Debt Initates a Cash Flow Pattern

[Edited 1/12/2016. Replaced Figure One with improved graphics and text.]

Nick Edmonds has an interesting post on "Sticky Prices, Unexpected Inflation and Ricardian Equivalence". 
Ricardian Equivalence is a theorem that includes the concept that people must change their spending assumptions when new government spending occurs. It is claimed that the this change occurs coincident with the announcement of new spending. 
Here is a quote from the post:

"To look at this, I need to make some of the standard assumptions for Ricardian Equivalence to apply, so I'm going to assume homogenous households with infinite horizons and no issues like liquidity constraints. Under this assumption, the long-run government budget constraint is binding. This says that the present value of taxes cannot be less than the value of current debt plus the present value of government spending.

The usual way to interpret this is to suppose that any change in tax now must be offset by a change in tax at some future time. So, for example, if there is a one-off tax reduction today, then this will need to be financed by issuing debt. That additional debt, plus the interest, must be repaid at some point and this requires future taxes."

I doubt the Ricardian Equivalence theorem because I see new debt as initiating a cash flow pattern that looks like the outline in Figure One. This outline is similar to the outline projected by Edmonds but broken into components. I think the breakdown of components speaks directly to the Ricardian Equivalence Theorem.
Figure One: New debt results in a cash flow pattern

New debt (by any party) initiates a series of events.

When a party takes on new debt (not refunding old debt), it can be safely assumed that the purpose is to initiate new spending. This new spending is depicted in Figure One as a green area. This spending will show up on the GDP calculation as an increase in economic activity.

The party taking on the obligation of debt repayment will probably agree to a constant rate of debt repayment and interest payments. In Figure One, this constant payment stream is represented by the purple area. It will result in increased taxes paid to government to the extent that only after tax income can be used for debt and interest payments.

[For any one debt pattern, the amount of money represented by the purple area will be bigger than the amount of money represented by the green area by the amount of interest paid.]

The red area of Figure One is of particular interest: This area represents reuse of the money placed into motion by the creation and spending of the original debt. The size of this area is dependent upon the rate of money destruction. The easiest way to see this is to realize that, each year, some of the new money is likely to be used to repay older monetary debts, thus destroying money. Money is created when new debt is assumed; money is destroyed when debt is repaid.

We can argue that not all loans create new money as in "only bank loans can create new money", or perhaps "only government loans create money". [It is generally agreed that private loans do not create money. Private loans only accelerate the rotation of money through more hands.] It is not important for this discussion to agree on how money is created and destroyed; we only need to agree that it is possible to create and destroy money.

We close this discussion by looking at the future spending implications of Figure One.

If we are part of the red area (we are secondary beneficiaries of the new spending) we will consider this sudden influx of spending to be a temporary event unless we know this to be a consistent pattern of the borrower. We have little choice except to accept the jobs and income offered, and to pay the taxes extracted. We only know that the pattern we see will continue until it does not.

If we are part of the green or purple area, we are a decision maker. We had a choice of creating the debt or not. We have the choice of making the payments and interest by doing hard work, by imposing new taxes, by borrowing additional funding next year, or by simply not honoring the obligation. 

Ricardian Equivalence anticipates hard work or new taxes. Modern governments around the world more likely choose borrowing-additional-funding-next-year.