Reeves’ fearmongering has scared Brits into saving. The consequences will be more frightening than Reeves’ ‘black hole’, writes Paul Ormerod
A very bad piece of news for the Chancellor, Rachel Reeves, slipped out last week with relatively little comment.
The personal savings ratio – the proportion of incomes, net of borrowing, which individuals save – rose sharply. From 10.3 per cent in the third quarter of last year, it went up to 12 per cent in the final three months of the year.
Obviously, if people save more, they spend less.
In the final quarter of 2023, savings were only 8.1 per cent of personal income. Consumer spending is just over £1,700bn a year in the UK. So by the end of 2024, people were choosing to spend £70bn less at an annual rate than a year ago.
These are big chunks of money which are being taken out of action. No wonder the economy is teetering on the brink of recession if consumers are becoming much less inclined to spend.
It is a major headache for Rachel Reeves and her desire to see the economy grow. But it is also an interesting test of an important theory in macroeconomics, one which has key practical implications.
Beware of Ricardian Equivalence
The theory goes back just over 200 years. For 20 years from the mid-1790s, Britain had been engaged in a titanic struggle with Napoleon’s France.
To pay for the conflict, the government had borrowed on a massive scale. The cumulative financial deficit – the difference between income from taxes and what the government spends – in the twenty years from 1795 amounted to over £2 trillion in the prices of today.
David Ricardo, Member of Parliament, multi-millionaire and one of the greatest ever economists, tried to answer the question: how should the war be paid for?
Obviously, one way to pay off the cumulative deficits would be to raise taxes. The other was to issue government bonds.
Ricardo argued that whichever of the two were used in whatever combination, the impact on the economy would be the same.
When the government runs a deficit, spending power is injected into the economy. But an increase in taxes cancels this out. But what if the government simply finances the debt by issuing bonds?
Ricardo believed the private sector would act rationally. People would anticipate that in the future, taxes would have to go up anyway to pay off the debt. As a result, they would save more and spend less now to be able to pay these taxes.
This is a key idea in modern macroeconomics, known as “Ricardian equivalence”. The two methods of financing a deficit – taxes and issuing bonds – are equivalent in their impact on total spending in an economy.
Why Brits are saving
The modern version of the theory makes a number of qualifications to Ricardo’s original idea. But the basic principle survives: if a government runs a large deficit, the private sector will save more because people anticipate that taxes will have to rise at some point to pay off the public debt.
At every conceivable opportunity the Chancellor, and other members of the government prompted by her, has trotted out the phrase “£22bn black hole in the public finances”.
People have indeed taken note of the fact that the public finances are heavily in the red. They realise that taxes may well have to rise even more to pay off public debt. And they save in order to be able to pay the taxes.
The more that people believe that taxes will rise, the more they will save. And the more they save, the weaker is economic growth and the less are government receipts from taxation. So the deficit rises, which makes even more tax increases likely to fund it.
The Chancellor is creating her very own black hole, this time a genuine and frightening one.
Paul Ormerod is an honorary professor at the Alliance Business School at the University of Manchester and an economist at Volterra Partners LLP
