Why Ricardian Equivalence Is Nonsense
By Marshall Auerback and Edward Harrison.
Ed has asked me to deal specifically with the issue of Ricardian equivalence, the theorem used by anti-government proponents to argue that fiscal deficits are counterproductive and that cutting deficits in the middle of a recession will actually be good for the economy. It suggests that when a government tries to stimulate demand by increasing debt-financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt. The mainstream presumption, then, is that agents won’t spend extra income from a tax cut as they ‘know’ there will need to be a tax hike later to keep the budget balanced. The mainstream would also be concerned that the higher government deficit would somehow ‘crowd out’ private borrowing.
It is largely based on several wrongheaded concepts, not the least of which is the idea that the government reduces national saving by running a budget deficit. The basis of this claim is that such government spending causes interest rates to rise, and investment to fall. In other words, too much government borrowing "crowds out" private investment. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.
This argument reflects a complete misunderstanding of government spending. Increases in the federal deficit tend to decrease, rather than increase, interest rates. In reality, fiscal policy actions are those which alter the non-government sector’s holdings of net financial assets.
This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves – in the U.S. the federal funds rate – is driven to zero (yes, zero!). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the Fed Funds rate falls within the Fed’s target band. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn’t just true of the Fed.
RE posits a government borrowing constraint, based on the notion that there is a finite pool of savings to draw on and "finance" economic activity. It is predicated on the notion that governments have a constraint similar to a household budget constraint. Like a household, the rising debt cannot be sustained indefinitely and so spending must be curbed and brought in line with the financial reality. Of course, a closer look reveals how fallacious is the household analogy.
People say: “No household can continually spend more than its income, and neither can the federal government”. But there are big differences between a household and the federal government. You don’t have the ability to print money in your living room, do you? Well, the government does. So how it finances its own debt and spending is different from the way you do.
A government is the issuer of the currency. The household, on the other hand, is the user. Households are restricted by the need to somehow get money into their bank accounts, or their checks will bounce. The federal government, by contrast, doesn’t “have” or “not have” dollars. Extreme versions of the analogy – so-called Ricardian Equivalence – posit the notion that the households anticipate the future tax burdens and increase saving now which negates any stimulus effect coming from the budget deficits. It assumes (like most neo-classical models) perfect markets and that any household can borrow or save as much as they require at all times at a fixed rate which is the same for all households/individuals at any particular date. So totally equal access to finance for all.
Clearly this assumption does not hold across all individuals and time periods. As Bill Mitchell notes:
"Households have liquidity constraints and cannot borrow or invest whatever and whenever they desire. People who play around with these models show that if there are liquidity constraints then people are likely to spend more when there are tax cuts even if they know taxes will be higher in the future (assumed).
Second, the future time path of government spending is known and fixed. Households/individuals know this with perfect foresight. This assumption is clearly without any real-world correspondence. We do not have perfect foresight and we do not know what the government in 10 years time is going to spend to the last dollar (even if we knew what political flavour that government might be)."
Edward here. I think Marshall has been strangely subdued in tone. I will take the more aggressive tone here. Ricardian equivalence is bogus economics. it is the kind of nonsensical ivory tower rational expectations drivel which led us to the abyss. It’s the kind of rubbish on which the mathematical models which blew up the financial world are based. Total garbage. I hope I wasn’t too subtle with this last paragraph.
If so, let me summarize here: Ricardian equivalence = baloney.
For you non-economists, here’s how Wikipedia sums Ricardian equivalence:
The Ricardian equivalence proposition (also known as the Barro-Ricardo equivalence theorem) is an economic theory that suggests consumers internalise the government’s budget constraint and thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy being the same.
What this definition implicitly assumes is rational expectations which is the underpinning for all neoclassical modelling and other equally flawed theories like the efficient market hypothesis and the life-cycle model of savings. In this ivory tower view, you and I are rational ‘agents’ who look to maximize our savings over our lifetimes. We understand that any increase in government deficits via tax cuts or stimulus will be met with future tax increases or spending cuts down the line. In this world, in anticipation of these future events, we all collectively save every penny of the money from stimulus or tax cuts producing no net gain to the economy in the short run.
Does this sound like you? Remember the Bush 2008 stimulus bill? Did your cousin get his stimulus check and rationally calculate that taxes would go higher in future and immediately save all of the money? Or did he save some, pay off some debt and buy an iPod? I think you know the answer.
Star Trek’s Mr. Spock may operate under rational expectations but real-world people are not perfectly rational. Moreover, in an uncertain world without perfect information about future events people are simply not going to deviate that much from their set spending patterns. If I spend $32,000 of every $33,000 I earn, it is absurd to assume that I will save every penny of an extra $1,000 I receive via a tax cut. While the voodoo economics behind recent Republican claims that stimulus is bad but tax cuts are good is bogus, it does not follow that tax cuts will be saved.
Let’s take this one step further as Paul Krugman did just a couple of days ago. In talking about Fed policy activism, he writes:
So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.
Well I don’t believe in full Ricardian equivalence any more than Krugman.
So let’s look at this helicopter drop idea. Let’s say the Federal Reserve decided to credit every taxpayer’s checking account with $1,000 that it printed out of thin air. What would happen? Would the increase in base money feed through the economy via consumption or would people save (via saving or net debt reduction)? I reckon people would save some, pay down their debt and spend some too. After all, isn’t that what they did when they got their stimulus checks in 2008? And this was deficit-inducing tax cuts not free money printed out of thin air. Ricardian equivalence would have us believe none of this money would have been spent.
My point? I haven’t really decided on that yet. A helicopter drop is not going to happen, if only for political reasons. And fiscal stimulus is dead – for good reason in my view. That leaves tax cuts – with the Republicans are angling for an extension of Bush’s cuts for the rich. Except they use the now debunked claim that tax cuts pay for themselves to promote them – as if this wouldn’t run up the deficit too.
All of this reinforces Adair Turner’s idea that economists and policy makers abuse economic ideology for political purposes. At Project Syndicate, he writes:
I suspect that a greater danger lies… with the practical men and women employed in the policymaking functions of central banks, regulatory agencies, governments, and financial institutions’ risk-management departments tending to gravitate to simplified versions of the dominant beliefs of economists who are, in fact, very much alive.
Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system.
Thus, only 18 months before the crisis erupted, the April 2006 GFSR approvingly recorded “a growing recognition that the dispersion of credit risks to a broader and more diverse group of investors… has helped make the banking and wider financial system more resilient. The improved resilience may be seen in fewer bank failures and more consistent credit provision.” Market completion, in other words, was the key to a safer system.
So risk managers in banks applied the techniques of probability analysis to “value at risk” calculations, without asking whether samples of recent events really carried strong inferences for the probable distribution of future events. And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.
Economics is not a science. People can put together as many mathematical models as they want in order to convince themselves that they can control the economic forces which have buffeted societies since time immemorial. But reality will not change. Let’s not confuse the model with reality. These are simplified abstractions that can be useful tools if applied properly and taken in context. There is some truth to mild versions of the efficient market hypothesis and Ricardian equivalence. But, as we have witnessed over the past 3 years, people confuse the models with reality. These abstractions are dangerous as practitioners use extreme forms of them and the elegant simplicity of modelling them to take on risk.
My guess is that we have moved from the period where misapplication of economic theories and modelling brought down the financial sector to where misapplication of economic theories will lead to very poor political calculations. In a global economy moving quickly to stall speed, this is not a good thing.