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.

Three Experiments in Keynesian Stimulus

The Greek adventure is the latest example of Keynesian stimulation in the news.
Unfortunately for Greece, the adventure is ending badly with stimulation replaced with at least a forced national budget that must be in balance. This will be an example of one economic balance morphing into a second economic balance. We can learn lessons from this event.

The Greek example can be contrasted with the experience of China and Japan. Both China and Japan have also had high rates of monetary stimulus. The difference is that Greece obtained stimulus by borrowing from outside the national boundaries. China and Japan borrowed from within their national boundaries.

As this post is being written, Greece has been sent home with a demand to pass legislation acceptable to the remaining euro community. This with enough money to allow Greek banks to reopen soon. The goal for a Greek budget seems to be balance -- balance expenses with income. It will take a large change in the Greek economy to accomplish this goal.

One lesson here should be that Keynesian stimulation obtained by borrowing from extra-national sources exposes the borrower to a sudden stimulation stop due to denial by lenders. Loss of control is never a good option for a national government.

On the other hand, China and Japan have both borrowed internally to obtain their Keynesian stimulus. Both have run up their internal debt to multiples of their GDP. At the same time, both have acquired ownership of large amounts of debt from other nations. Both have more than $1 trillion in value of American debt.

This acquisition of foreign debt can be traced to internal debt being used to build products intended for foreign sale. Then the foreign nation must be willing to buy the products with borrowed money. The foreign borrowing does not need to be directly linked to the products. In America, the borrowing was for houses and American national debt; subsequently the money borrowed for houses and national debt was spent on China and Japan products. The final result was large amounts of American debt held by China and Japan.

There are more differences. The difference between internal and external borrowing of stimulus seems to have led to different internal economic distribution. In Japan, the stimulus led to very low unemployment and later, persistent GDP malaise. The malaise has coincided with a population decline as the population opted to have a birthrate less than death rate (but this may not be a direct result of stimulation).

The Chinese example seems similar but the record of stimulus in China is shorter and is being carried out in a one party political environment. China uniquely enacted a one-child policy that slowed it's population growth.

The Greek experience with stimulus has been different. Some groups (such as pensioners) seem to have done very well. Others, such as young workers, have done very poorly with unemployment rates near 25 per cent. Greek productivity seems to have greatly declined and imports have increasingly exceeded exports.

One lesson from Greece seems to be that groups favored by government do very well compared to groups not favored. This effect also seems to be present in China and Japan but is less visible.

We should also notice that the Greek borrowing was mostly done from within the euro zone. We can therefore examine if the Greek borrowing can be considered as a subset of borrowing within the larger euro zone, with the larger euro zone also having Keynesian stimulation but at a different rate with different distribution effect.

These observations are all anecdotal,  offered without charts and data support. Careful examination of the data is expected to support these observations and may dig out additional correlations or contrast.

Keynesian stimulation remains in the experimental stage. Year-after-year borrowing has only been widely undertaken by governments-world-wide since about 1973 when the gold standard was abandoned by the United States. The long-long term effects are yet to be recorded.

Greek Loan Repayment

The following is a comment made in response to a Ralph Musgrave post. An example of a young-couple-who-liked-to-borrow is used to question whether we really want to have Greece repay the loans it has received.

"Our community could have a young couple that liked to borrow money from the community bank for the simple reason that they liked to spend more than they could earn.

If this couple was very likable, they might be able to borrow more than they earned every year for many years.

In fact, they could do this until the bank said "NO MORE LOANS!".

A "NO MORE LOANS" decision would be a paradigm change. It would be a change in the annual way of running the local economy.

How might the economy change if, after many years of lending to the (formerly) young couple, the lending stopped? Those businesses that received the annual loan proceeds (the couple always spent the loan money) would see fewer sales and need fewer workers. This because less money each year would be spent.

Now if the bank also required the (formerly) young couple to repay the loan, there would be an additional effect that we might call a second paradigm change. The couple would need to work harder to earn money. Working harder would entail producing products already made by other workers which would increase sales competition. The  economic effect of loan repayment is the opposite of initial loan creation.

I think we can consider that Greece has been this (formerly) young couple. Now the loans are being denied. Do we really want them to repay the loans?"

The story of the (formerly) young couple illustrates that TWO paradigm changes occur when a series of annual loans evolves into a series of annual loan repayments. Paradigm changes are difficult events for entire economies.