 | | Pedro Antunes
Director
National and Provincial Forecast |
Are households too smart for the economy’s good? According to a poll conducted by Opinion Search, nearly all Canadians believe that public deficits will, sooner or later, result in a larger tax bill. These results bring up an age-old question among economists: Does fiscal stimulus get muted by a negative effect on household spending? According to what is called “Ricardian Equivalence” (based on an idea first proposed by 19th century economist David Ricardo) if governments lift spending by increasing their debt, consumers will see this as a future tax, and reduce their current expenditures. The “equivalence” pertains to a mathematical formulation that suggests that households have “perfect” foresight, such that if governments increase spending by taking on debt or increasing taxes, the effect on the economy is the same—households will perceive the debt load as a future tax and reduce their spending by an equivalent amount as if taxes had been immediately raised.
Fascinating that households could be so calculating! But the truth is that Ricardo himself didn’t believe in equivalence. The math was just a tool to demonstrate that when governments take on debt, consumers are likely to save more—but how much more they save can have important implications for fiscal policy and for our current medium-term forecast. The impact of fiscal stimulus as a recession fighting tool might be muted if household spending declines as spending on infrastructure ramps up. More importantly, what will happen to household spending in light of the huge fiscal deficits that much of the developed world is now facing?
As Ricardo might have predicted, consumers are saving more. We recently polled 1,000 Canadian households asking whether federal and provincial government deficits would result in their paying higher taxes in the future—and a resounding 86 per cent said yes. In tax-averse British Columbia, over 91 per cent believe that higher taxes are on their way. Is Ricardian equivalence then partly responsible for higher savings? In 2009, Canadian households chose to augment their savings by an additional $13 billion, boosting the aggregate household savings rate to nearly 5 per cent last year. If the potential for higher future taxes is responsible for the recent increase in savings, the repercussions for the near term economic outlook are disheartening.
In 2009, municipal, provincial and federal governments in Canada will produce a combined deficit of over $84 billion (on a national income accounts basis) and not much improvement is expected for 2010. While $84 billion in deficits may seem huge, we’ve been there before. As a share of gross domestic product (GDP) this combined deficit will reach 5.5 per cent in 2009, in line with levels last seen in the mid-1990s and well below what occurred in the early 80s. And in comparison to other developed economies, you could almost say that we’re in pretty good shape. Take the U.S. for example; their federal deficit is estimated to have reached 8.7 per cent of GDP in 2009 and is expected to climb to 9.5 per cent of GDP this year. Moreover, given the President’s plans to increase spending on health and other social programs, the deficit as a share of GDP is not expected to recede from these high levels over the next few years. If the buildup in debt is also partly responsible for the lift in household savings in the United States, U.S. consumers will likely continue their frugal behavior.
The difficulties don’t end there. The 2008-09 recession has left many other governments scrambling. While stimulus was needed to bring confidence and growth back to the global economy, the repercussions for government accounts, especially in developed countries, have been harsh and will be long-lived. Japan, the U.K. and many European countries are swimming in debt and struggling with deficits. Over the next few years, much of the developed world will continue to face rising debt, even as they seek to bring balance back to government accounts. The combination of rising debt and rising interest rates (as monetary stimulus is also removed) is likely to keep household savings rates high and growth in consumer spending soft. This, combined with fiscal restraint, will soften the Global economic recovery for years to come.
It’s clear from our poll that Canadian households are aware and concerned about government deficits, more importantly though, they are convinced that the buildup in debt will result in future tax hikes. Still, Canadian consumers might not be badly affected given our (believe it or not) relatively good fiscal stance. However, if households are as savvy in the U.S. and other developed economies facing high deficits, the impact of the current recession on household spending will linger and the typical post-recession rebound in consumer spending will be muted.