A banana republic is a country where government obligations swamp total wealth. In a typical banana republic, wealthy individuals race to move their savings overseas to safe havens. Those who fail to do so will suffer from taxation, inflation, and currency devaluation.
There is a term in economics called “Ricardian equivalence.” The idea is that people incorporate government obligations into their personal balance sheets. Imagine that you were the only citizen of your jurisdiction. The government borrows $1000 and gives it to you. Has your net wealth gone up? Obviously not, since when it comes time for the government to repay the debt, the only citizen who can do it is you. If you believe in Ricardian equivalence, then there is no such thing as fiscal stimulus.
In practice, when government borrows and spends, the people who receive the money know who they are better than the people who are going to have to pay it back. That is why fiscal stimulus works…supposedly.
I see the U.S.government incurring many more obligations over the next few years.
–the recession will lower tax revenues and increase spending on things like unemployment benefits. These were known as “built-in stabilizers” back when I was first learning macro.
–the Troubled Asset Relief Program was originally billed as a way for taxpayers to invest in undervalued mortgage assets in a reverse auction and make a profit. So far, not one cent has been spent on buying undervalued mortgage assets in a reverse auction. It seems likely that the program will be, or already has been, transformed into a pure spending program. Personally, I was never a fan of buying mortgage securities. But if we’re not going to do that, the honest thing to do would be to repeal the bill that passed in September and pass a new bill.
–The stock market crash has hit state and local government pension funds as well as those of us trying to save for retirement. The assumption has to be that there will be a full Federal bailout of the state and local pension funds, which ultimately has to be paid for by taking money away from those of us trying to save for retirement.
My point is that sooner or later the U.S. government is going to have to get serious about stripping the assets of those of us who have tried to live within our means. Sooner or later, the profligate are going to take from the prudent, the grasshopper is going to confiscate the property of the ants.
If you’ve got wealth, you need to find a haven for it. You don’t want to keep it in a banana republic for too long.
READER COMMENTS
Isaac K.
Nov 5 2008 at 8:30am
Any suggestions as to where, Dr. Kling?
PJens
Nov 5 2008 at 10:22am
One problem with hiding wealth is that it is difficult to keep it hidden. When the wealth is once again revealed, it could lead to suspicion. I don’t think hiding wealth is such a good idea. Moving it to different investments, or purchasing infastructure might be a better idea. Might be a good time to buy a new fancy laptop for instance, or get a new car while the demand is low.
I forsee the expansion of the underground economy, more people working for and paying in cash. Bartering and exchange volunteering – such as…I’ll change the oil in your car if you help my kid with econ homework will also rise.
The largest threat to the economy I see is the increased risk of investing. Why will investors put their money into a venture if the threat of increased taxation and regulation looms so certain? I think many investors will just take their money and go home. Investors can and will find another way to spend their time, like start and run non-profits.
Huxley
Nov 5 2008 at 10:33am
As long as the government doesn’t institute a wealth tax, I figure I am ok since it is not that hard to manage your realized investment income to a low taxable level while retaining wealth. I remember Nelson Rockefeller saying that he usually didn’t pay income tax since his financial advisors were able to realize enough unrealized losses to offset the investment income. I expect the inheritance tax to go up in the future.
Methinks
Nov 5 2008 at 10:50am
Huxley, unfortunately there’s no guarantee that the government won’t institute a wealth tax. The effects on the economy will be devastating and I’m pretty sure (as a non-lawyer can be) that it would constitute double taxation and will be unconstitutional, but I don’t think the political class cares about the economy or the constitution. That’s another characteristic of a Banana Republic.
reason
Nov 5 2008 at 10:51am
Can I have one of your tin-foil hats too?
reason
Nov 5 2008 at 10:55am
Oh come on, surely one of the typical features of banana republics is also extreme disparities of wealth and income and inadequate tax revenues. I know the GOP has tried very hard to make that happen, but it was only 8 years ago that the Federal Government budget was roughly in balance and people were worried about the disappearance of the Government Bond market.
8
Nov 5 2008 at 11:37am
It appears the EU and US want to crack down on Switzerland, Cayman Islands, Vanuuatu and other tax havens. Can they truly be isolated from the global financial system?
JKB
Nov 5 2008 at 11:49am
I remember back in the first few years of the Clinton Administration some obscure undersecretary in Treasury gave a speech promoting the taxation of savings, not interest but principle. Fortunately, she promptly disappeared possibly to some room in the the Treasury building basement.
But the scent of money hasn’t been lost. California activists are trying to get a wealth and exit tax on the ballot.
Dick king
Nov 5 2008 at 1:24pm
Reason, you don’t want a tinfoil hat. They want you to wear one.
-dk
Brad Hutchings
Nov 5 2008 at 2:01pm
Some prudence on the doom and gloom is called for for the time being. There are a few things we don’t know yet. We don’t know if Obama will be a partisan in the Pelosi/Reed mold. We don’t know if he’ll cut and run in Iraq or take stock of the situation and act responsibly in the region. We don’t know if the Senate Republicans will coalesce and obstruct Obama’s agenda, demand offsetting spending cuts, or capitulate.
Obama’s background, record, and associations point to an out of control bed wetting liberal. His quick rise from obscure state senator to President-elect, and his mastery of creating a campaign organization and assembling an impressive cadre of advisors suggests more of a pragmatist who wants to govern and will eventually want to be reelected.
If you think that “new” and “young” voters put Obama over the top, you have to realize that they are non-partisans. They don’t like war and the don’t like division. They would feel really good if Obama asked McCain to be SECDEF or SECSTATE. They would like to see more cooperation and less bickering. If we get the partisan Obama, these voters are the ones who will vote him out of office in 4 years and probably become permanent Republicans.
Arnold, I notice you didn’t even mention his name in your post, but between now and when the questions are answered, everything will be evaluated, fairly or not, in the context of “Obama”.
aaron
Nov 5 2008 at 2:19pm
There is still such thing as fiscal stimulus. It’s called induced demand. It happens when new roads are built.
Derek Christiansen
Nov 5 2008 at 2:26pm
To “reason”…
Oh come on, surely one of the typical features of banana republics is also extreme disparities of wealth and income and inadequate tax revenues. I know the GOP has tried very hard to make that happen, but it was only 8 years ago that the Federal Government budget was roughly in balance and people were worried about the disappearance of the Government Bond market.
The budget was not in balance…they were busily spending the surplus of Social Security revenues
which were to be set aside for the future.
Remember ManBearPig’s “lockbox”?….get your facts straight…spending tomorrow’s mortgage payment today doesn’t make today “balanced”
Steve Sailer
Nov 5 2008 at 2:33pm
Dear Arnold:
Well said.
Jeff
Nov 5 2008 at 2:50pm
Most federal government debt, and all state and local government debt is not indexed to inflation. So the easiest way for the government to steal wealth is to create unanticipated inflation. The great thing about this tax is that no elected official has to explicitly approve it, a few winks and nods to the Fed will do.
B.H.
Nov 5 2008 at 2:56pm
On Ricardian equivalence, the debt burden is left to children or the unborn. They don’t know about the burden and don’t change their behavior.
About liquidity. Suppose during a credit crunch, the government can still borrow cheaply, but I am not longer to borrow (within my limits) because of credit rationing. The government borrows cheaply, lends to me (tax rebate), I spend optimally, then I repay the loan later (higher taxes). The core theory is that the government has a comparative advantage in liquidity. Works for developed countries but not banana republics.
BTW, the ant has been subsidizing the grasshopper for a century. It won’t stop in our lifetimes. It only requires that grasshoppers outnumber the ants at the polls. The grasshoppers are promised hope and change and vote for the politicians who will tax the ants.
Methinks
Nov 5 2008 at 3:35pm
Brad,
His quick rise from obscure state senator to President-elect, and his mastery of creating a campaign organization and assembling an impressive cadre of advisors suggests more of a pragmatist who wants to govern and will eventually want to be reelected.
Campaigning is merely marketing and being good at marketing doesn’t make one good at governing. Plus, the media ran so much of that campaign for him. It doesn’t surprise me that academics stepped out of their ivory tower to advise him. Academics (love that and his advisers are no more impressive than Greg Mankiw. I’m sure he wants to govern but I’m also pretty sure he wants to govern like Mitterrand rather than like Thatcher. With a Republican congress, I wouldn’t be as apprehensive but with a liberal Democrat congress, I’m less optimistic. I hope you’re right and I’m wrong.
Tom DeMeo
Nov 5 2008 at 4:33pm
If government obligations swamp total wealth, it will be caused by government overreaching to stabilize the markets, not by whining masses using political power to take from the rich.
We need to worry far more about how markets can continue to adjust to ever-increasing speed and complexity. This grasshopper/ant stuff hasn’t gotten any worse, and certainly isn’t the cause of our current crisis.
Brad Hutchings
Nov 5 2008 at 5:47pm
Methinks,
You make a very strong point that is consistent with mine that we just don’t know which Obama will show up to work. But there are issues that won’t go away. Think energy. If gas shoots back up over $4 next summer because the Dems have done nothing about supply, they will simply lose the House in 2010 because it will happen again summer of 2010 and Republicans will make it an issue of trying the same failed policy three years in a row.
I don’t worry a bit about card check or reviving the Fairness Doctrine. These were two very effectively deployed trolls by the Dems. Loud Republican constituencies were “pwned”, as the kids say, devoting a bunch of their time and outrage to non-issues.
Look to what the fruit and nuts crowd here in California did on renewable energy and alternative fuels yesterday. Voted down by 60-40 margins. The bullet train to Sacramento got just 52%. There is no way the country will stand for Obama’s silly green jobs plan. Enough people are annoyed with the curly light bulbs to not want to go full speed ahead on policy with pre-beta technology.
He’s got his hands full with current issues. If Pelosi can’t get a stimulus done before the end of the year, they’ll make that the first issue and he’ll be too bogged down and gridlocked before summer to do any more change.
Lord
Nov 5 2008 at 7:02pm
A banana republic, living beyond one’s means, is what the country has been doing for a long time. Living within them is stepping back from it. You thought your taxes were cut? No, they were just postponed.
Methinks
Nov 5 2008 at 8:43pm
Brad,
Good points. Thank you. I think I’ve become a bit unmoored lately as a result of my front row seat to socialization of the entire financial industry. I would never have imagined such a thing occurring as late as June of this year. Given the endless bailouts, I’ve begun to believe that almost anything is possible. I’m still nervous that if things get unpleasant enough people will vote for and demand outrageous entitlements. On the other hand, after getting over the shock, people may adjust their expectations and calm down as the recession deepens. Increased uncertainty leads one to factor in scenarios previously brushed off as bizarre.
Republican constituencies were “pwned”
Is that what the kids are saying? How do you pronounce that? God, I feel old.
Dr. T
Nov 5 2008 at 9:14pm
PJens said: “Might be a good time to buy a new fancy laptop for instance, or get a new car while the demand is low.”
I believe Dr. Kling was referring to people who have hundreds of thousands of dollars in liquid assets. Unless one buys a Ferrari race car, buying a new car won’t do much for asset preservation. Also, many of us have large amounts in retirement plans. To preserve those monies from future government predation, we may need to take the early withdrawal penalty and shift the money elsewhere.
I do agree with PJens about the difficulty of hiding wealth. If you believe that the U.S. will become far more confiscatory, then you will need to move with your money to a nation that won’t steal your wealth.
Mike
Nov 6 2008 at 1:17am
“Don’t cry for me Argentina”
Greg
Nov 6 2008 at 10:29am
It’s pronounced “poned” or “powned.” It comes from online gamers mistyping things like, “I owned you.”
No need to thank me for promoting inter-generational understanding.
Andrew
Nov 6 2008 at 11:25am
If you believe in Ricardian equivalence, then there is no such thing as fiscal stimulus.
Sure. And in the long run, we’re all dead. Fiscal stimulus is a short term measure to even out the business cycle. It does not follow that this does not exist from Ricardian equivalence.
But you already knew that, and were being disingenuous.
Andrew
Nov 6 2008 at 11:44am
The budget was not in balance…they were busily spending the surplus of Social Security revenues
which were to be set aside for the future.
Check your data. Discounting the unified budget and considering only the on-budget receipts and outlays 1999 and 2000 were surplus years (of only four since the Depression).
Lauren
Nov 6 2008 at 3:57pm
Hi, Andrew.
Arnold is completely correct that Ricardian equivalence rules out fiscal stimulus having any effect on the economy. Though the statement of the concept is attributed to Ricardo, it was understood long before he described it.
Here is Ricardian equivalence in a slightly more elaborate form than Arnold’s succinct explanation.
Suppose the government hands you–an average person in the economy–$100. The government has two ways to get that money. It can tax you $100 today. In that case, obviously you are not going to treat the money as a windfall and spend more–it just goes into one pocket and out the other.
Alternatively, the government can borrow the money–for example, a bank lends to the government by buying T-bills at, say, the going interest rate of 5%. If the government does that, it has to tax you $105 next year to repay the loan and interest.
In the latter case, since the money is going to come out of your pocket next year, you can do the sensible thing and put the money in your bank–that is, save rather than spend it–earning your 5% interest (or, if you don’t like that story, you can just buy a T-bill yourself for 5%). At the end of the year you simply hand over the $105 to the government to pay your taxes.
Either way, the way the government pays for it is a wash for you. You are kind of foolish to actually spend any more because one way or another, you have to pay the taxes. There is no actual stimulus to private spending because people know they have to pay the taxes. Even if Ricardian equivalence doesn’t hold exactly, the effect is not likely to be large. There can even be a perverse effect of people fearfully overestimating how much they’ll have to pay in future taxes–in which case they’d spend less and save more!
This doesn’t mean that the amount of government spending has no effect. The bailout was a big increase in government spending with big effects! It just means that for a given amount of spending, whether the government borrows and taxes later, or assesses the taxes today doesn’t matter for average spending in the economy. In fact, nothing real is affected–interest rates, employment, etc. don’t change. A so-called “countercyclical” fiscal stimulus–including any fiscal stimulus that is supposed to counteract business cycles without increasing total government spending–has no effect on the economy. At best it may have only a minuscule effect in the desired direction; and at worst, it may have a perverse effect that exacerbates the business cycle.
You can read more about Ricardian equivalence here: Does it Matter How You Pay for a State Dinner and Government Debt and Deficits.
PaulD
Nov 7 2008 at 8:59am
I doubt that the government will impose a direct tax on wealth. However, the government can use inflation to reduce the costs of its debt and this will in many ways have the same effect as a tax on wealth.
TheBigHenry
Nov 7 2008 at 10:40am
@ Greg writes:
It may be pronounced “powned” but its meaning is akin to “pawned”, as in “stripped of collateral, which will be forfeited, for a puny stimulus payment, which will not be repaid.
Larry
Nov 7 2008 at 1:24pm
I share Arnold’s concerns. Current fiscal and entitlement trends are unsustainable. Moreover, there’s no evidence that Americans are willing to scale back their unrealistic expectations or to impose higher taxes on themselves to pay for the services they demand. There are, as we know, many ways a confiscatory state can capture income and wealth from its citizens. I had always believed that the USG would “solve” this problem through inflation, but the prospect of a “wealth tax” is real. Of course, the size of the investor class has grown, and that could make inflation a less attractive option for the political class. Further, the political class is, by and large, wealthier than the average American, which may temper its confiscatory urges. Push will come to shove when international investors stop buying USG debt. My guess is that Obama will face just such a crisis during his first term.
patski
Nov 7 2008 at 10:36pm
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