Ricardian Equivalence and why Britain’s really in a recession
The intriguing factor governing low household spending isn’t mortgages or energy prices, argues Paul Ormerod, but saving…
News that we have entered a technical recession will come as no surprise to anyone who has even a passing acquaintance with the British economy. But what is less well understood is how personal spending – or rather the lack of it – is contributing to low growth.
Household incomes have been squeezed by rises in energy prices and mortgage rates. But that’s not the whole story. Wage increases and falling inflation have offset some of these pressures, with real incomes per head now 3.5 per cent higher than in the second half of 2022. And mortgage-holders make up only a small fraction of households.
The intriguing factor governing household spending is not income – but saving.
The Office for Budget Responsibility (OBR) estimates that during lockdown, households accumulated a massive £180bn of so-called “excess savings”. Most economists at the time assumed that once the restrictions were lifted, people would spend and run these down.
But on the contrary, households are saving more than they did before the pandemic, not less.
In the third quarter of 2023, the proportion of household income saved was 10.1 per cent. This compares to just six per cent in the year immediately before the onset of the Covid pandemic. In cash terms at an annual rate, the difference between the two is just over £50bn.
Two hundred years ago the great British economist David Ricardo – who has the same superstar standing among economists as his near contemporary Adam Smith – argued that this behaviour is entirely to be expected.
Writing at the time of the Napoleonic Wars, by far the biggest military effort in British history up to that time, Ricardo argued that this huge injection of government spending would not boost the economy overall. Rational investors and consumers understood that any stimulus financed by debt would eventually have to be paid back. Therefore they would save more in expectation of higher taxes in the future, offsetting the increase in demand created by additional government spending.
This theory, known as Ricardian Equivalence, is controversial among economists, but it is consistent with the evidence. As long as public debt remains stubbornly high, the public are choosing not to spend, regardless of what the Chancellor says about cutting taxes.
The solution is obvious – to restore household confidence, Jeremy Hunt must reduce public debt.