BoothPhilip Professor Philip Booth is the Editorial Director of the Institute of Economic Affairs

Professor Robert Barro gave the 20th Annual Hayek Memorial Lecture for the Institute of Economic Affairs earlier this week. He predicted that the next crisis would be a crisis of governments.

Robert Barro is perhaps best known in the UK for “rediscovering” Ricardian equivalence. The idea is that if government spending is financed by borrowing rather than by tax increases, it does not stimulate the economy because people anticipate higher future taxes and reduce their consumption accordingly. Strong assumptions are needed for this theory to hold in practice, but, even without those strong assumptions, a so-called fiscal stimulus is unlikely to stimulate anything other than vested interests that benefit from more public spending. Any government borrowing has to be financed and the financing of government deficits has effects on exchange rates and interest rates and leads to reduced private sector spending. The empirical evidence is pretty strong on this point, especially for countries that have floating exchange rates.

Indeed, Barro observed that the fiscal stimulus in the US had brought no real benefit. He accepted the reasons for bailing out the banks, given the systemic risks that they posed. However, the other elements of the stimulus package were always likely to have a small impact on very short-run economic growth and then have a negative impact after a couple of years. Then, for decades after, taxpayers will be paying higher debt interest as a result of the increased borrowing.

Some of the stimulus measures were highly destructive. The “cash for clunkers” programme – mirrored in the UK – involved destroying perfectly good vehicles in order to bring forward car purchases. This programme took Keynes’ example of how to use fiscal policy to reduce unemployment (by digging holes and filling them in) almost literally. There have been other damaging public spending measures. The length of time for which claimants can receive unemployment benefits in the US has been quadrupled. The result is that unemployment seems to be settling at Western European levels and, more disturbingly, the duration of unemployment has lengthened. This might have very serious long-term economic consequences.

Most Western countries, explained Barro, have very large levels of debt. The fiscal stimulus programme is increasing those debt levels further. When we add the implicit liabilities from state and public sector plans pensions, it is clear that the pending crisis is a crisis of state debt. In building up this debt in the US – especially in the form of future commitments under government health programmes – Obama and Bush (junior) have behaved very similarly. Barro argued that Obama and Bush are twins just as Reagan and Clinton were twins.

Currently, politicians and regulators are focusing so much of their energies on ensuring that the last crisis will not happen again. Huge efforts are being made to re-regulate the banking system and, in the US in particular, to reform mortgage markets. Though it is right for the government to get out of the business of underwriting mortgages argued Barro, the private sector is not going to make the same mistakes again. The next crisis will not come from the banking sector and the housing market. Instead, without radical reform, we will have a crisis of public sector indebtedness – or a “crisis of governments”. This does not just manifest itself in the obvious places such as Greece but also in the US. Some US states such as Illinois and California are in dire straits. Radical fiscal reform is necessary if the crisis is to be avoided.

Would Barro approve of UK government policy? He did not discuss this explicitly. However, the coalition has not accepted the myth of fiscal stimulus and, despite continuing high borrowing to finance inflated public spending, the government is not borrowing more in order to “stimulate” the economy. Barro would approve of that line. No doubt, Barro would want more action to be taken with regard to inflated levels of public spending and he would not be impressed by our convoluted tax system with all its exemptions and special provisions running to 11,000 pages.

In short, Barro would like to see a return to classical public finance: non-distorting and simple taxes; a balanced budget; and government spending justified only by micro-economic arguments that particular projects brought real value because they could not be undertaken in the private sector. The coalition seems to be fighting a losing battle against the vested interests in many aspects of its policy, but I am sure that Barro would give it a few marks out of ten for trying.

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