At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 09.27.05

The Lucy Effect and Ricardian Equivalence

While a good deal of lip service has been paid to the federal deficit in recent years although little has come from the discussion. With the disasters in the Gulf Coast, the war of terror, and the ongoing battle in Iraq, the government has seen its policies for creating an economy that would be resilient enough to handle emergencies and grow at the same time tested over and over again. Unfortunately, these challenges to these fiscal decisions of spending through borrowing and borrowing to give tax cuts aren't quite giving us the answers we need.

There is a prevailing school of thought, one the President and his chief advisors subscribe to that suggests that any growth in the economy equates in growth in GDP and that will offset any federal deficit of any size. To also believe in this concept is to blindly accept the fact that tax cuts given to today will not be paid by future generations but by growth in the economy. So what the administration is attempting to do is create an economy that pays for deep debt and the exorbitant cost of the service that goes along with it while the economy grows with enough significance to increase wages that will increase revenues that will eventually pay down the debt.

In the world that most Americans live in, you can see why this just doesn't make any sense.

Most taxpayers are concerned with the here and now. Whenever future generations are brought into the discussion, the biggest concern is not whether they will be able to pay for the sins created by this administration but whether the burden of this generation will be afforded the same courtesies and considerations we now give current retirees.

Ask anyone who is eyeballing retirement and the goal now is not to become a burden on our kids. That is a significant change. To avoid such an outcome is not unique and, in fact lies at heart of why public entitlement programs were developed. The realization that current generations cannot support previous generations in a significant way and move forward at the same time has become the primary concern of those in the later years of work. Mnay are beginning to come to grips with the fact that they simply have not saved enough.

We know that there is no way that our children will be free of the burden of paying for what we are doing right now. Problem is, the debt we are carrying today offers us no significant increase in life style. In other words, we will always equate debt with some improvement in how we are living even if it does not. Possibly the easiest and most obvious analogy is that of buying a home.

Homeowners refer to themselves as homeowners even if the house is 80% owned by the lender. That small percentage of ownership hardly constitutes the term "I own". As one writer, whose name escapes me suggested, just miss a couple of payments to find out who the true owner is.

But that doesn't seem to matter to the average American who has consistently seen the future and rearranged it to accommodate the present. A good deal of the refinancing that has taken place has been done to finance the present with no regard or intention to pay off the debt completely.

The current homeowner has increased their current mortgage to pay for the present and as a result will demand a higher premium of their home when they eventually sell. The belief that the marketplace will be able to absorb the costs for the same home, a structure that now has spending excesses added to its worth, may make it unrealistic for future generations to purchase. After all, the house should be bought, not the spending habits of the previous owners. If that becomes relevant, look out!

So it goes with taxes. The creation of the federal deficit, a basket of spending sprees and tax cuts, has been done with a passing regard to the Ricardian Equivalence. The reality of this economic principle is that it operates in a wholly different realm of thinking than the one populated by current thinkers.

Ricardian Equivalence comes into play as the discussion turns to who will pay for this administration's belief government spending and tax cuts will increase private savings, money they hope will be further invested. They seem to be convinced that the average citizen is forward thinking enough to understand that eventually the bill will come due long after, they hope, they are free of its obligation to pay. Economic policy is also assuming that it will happen if the private sector adds savings at the same rate the public sector avoids it.

Jeremy Sandford, the Park Place Economist once wrote that the "effect of debt that seems most unfair and most frustrating is that debt financing amounts to little more than borrowing from future generation(s)". The Ricardian Equivalence, he writes is "based on the tenet that taking on debt today will require higher taxes in the future".

Our children will look back on this decision and wonder why we needed to rearrange the income to savings ratio on a national level and encourage folks to do something similar on a personal level at the same time. If the President can continue to refer to the only great instant in his presidency over and over again, we should be able to point fingers at his suggestion (at the time) that to keep the economy going, we need to keep spending. How that post 9/11 thinking was interpreted by the American people, how that was interpreted by the Federal Reserve, and how we got to this point is more than just a Ricardian Equivalence, it is a Lucy Effect.

Over the last several years, as the economy seemed to be growing, so has the deficit. Keep in mind, I am finding it difficult to equate corporate cost cutting as business growth, the increased prevalence of the Alternative Minimum Tax as beneficial, and an employment rate that is just about 50,000 jobs a month over break-even as a good thing. To the average Joe on the street, this doesn't make sense.

The offset of GDP should be enough to have handled any emergency nature or terror could throw our way if the public was not so indebted and perhaps had a surplus. But instead of prudence and fiscal responsibility, we are using the GDP to show that growth can happen even if we are not circumspect about the outcome.

So if homeownership were analogous to what is happening on a federal level, our children should be embracing the world in front of them. Current generations have regarded the roof over their heads as the next best thing to an investment. Energy costs and property taxes will begin to feel like interest increases in the cost of that debt service and because of those increases, pressure points will develop in the daily budget of the average American.

As much as I disagree with Alan Greenspan's assessment of debt in the home, his influence on lenders to keep the economy moving by allowing borrowers to finance their homes on the cheap has led directly to his greatest fear: that risk has lost its meaning.

Left with little savings to fall back on, the average consumer/homeowner/taxpayer will need to reassess not only their worth but also their future earning power. If this group pulls back because of the Ricardian Equivalence and doesn't continue to use the Lucy Effect to blindly move ahead as if nothing else matters, the economy will slowly collapse in on itself.

That pullback will happen in spite of the President's foolhardy attempt to make the tax cuts permanent, to look for spending cuts in places where the average American is least able to recover, and to do it with blind ambivalence to how investments work less capital in the long run means less investments and that points to higher interest rates will leave use with only nodding concern for future generations. It will not, however, make it easier for any of us, including our children, to pay.

The previous week's articles.

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