Ricardian equivalence — total horseshit

18 Jun, 2014 at 08:32 | Posted in Economics | 13 Comments

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

6a00e54ecbb69a88330148c6a1f2cd970c

Why?

In the standard neoclassical consumption model — used in DSGE macroeconomic modeling — people are basically portrayed as treating time as a dichotomous phenomenon  today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

ct + cf/(1+r) = ft + yt + yf/(1+r),

where ct is consumption today, cf is consumption in the future, ft is holdings of financial assets today, yt is labour incomes today, yf is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(ct) + au(cf),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u'(ct) = a(1+r)u'(cf).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u'(c) = 1/c, the Euler equation can be rewritten as

1/ct = a(1+r)(1/cf),

or

cf/ct = a(1+r).

This importantly implies that according to the neoclassical consumption model changes in the (real) interest rate and consumption move in the same direction. And — it also follows that consumption is invariant to the timing of taxes, since wealth — ft + yt + yf/(1+r) — has to be interpreted as present discounted value net of taxes. And so, according to the assumption of Ricardian equivalence, the timing of taxes does not affect consumption, simply because the maximization problem as specified in the model is unchanged.

That the theory doesn’t fit the facts we already knew.

And yesterday, on Voxeu, Jonathan A. Parker summarized a series of studies empirically testing the theory, reconfirming how out of line with reality is Ricardian equivalence.

This only, again, underlines that there is, of course, no reason for us to believe in that fairy-tale. Ricardo himself — mirabile dictu — didn’t believe in Ricardian equivalence. In Essay on the Funding System (1820) he wrote:

But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.

And as one Nobel laureate had it:

Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.

Joseph E. Stiglitz, twitter

13 Comments

  1. Vox has two economist on why DSGE models inherently crash.

    Hendry, D. F., and Mizon, G. E. (2014), “Unpredictability in economic analysis, econometric modelling and forecasting”, Journal of Econometrics, 182, 186–195.

  2. Thanx 🙂
    I’ll check it out.

  3. In Ricardo biography, recently published in web, he prepares the loan to british government to finance napoleonic wars especifically in days before Waterloo battle, also Ricardo loan to East Indies company in a era when India GDP was major than England GDP. Are there an interests issue?

  4. Here is the complete Stiglitz’ quote:

    “Some economists have suggested that if the government runs a deficit, households will be spurred to save, knowing that at some time in the future they will have to pay the debt back through higher taxes. In this view the increased government spending is fully offset by reduced household spending. Ricardian equivalence, as it’s known to economists, is taught in every graduate school in the country. It is also sheer nonsense. When President Bush cut taxes in the early years of the decade, savings rates actually fell.”

    – Joseph Stiglitz http://amzn.to/1iEtEpT (p. 71)

    • Thanx 🙂

    • Well it’s true by accounting that if the government sells bonds worth $X (paying interest r), someone has to buy bonds $X (paying interest r). This cannot be avoided.

      The Keynesian narrative then hinges on the idea that consumption is entirely driven by disposable income. Thus (planned) private sector spending exceeds their income, which through demand raises income (and therefore consumption and saving) until the private sector has exactly increased their savings by $X.

      That savings rates actually fell is much more interesting evidence.

  5. So when the government taxes me to pay for a road to a piece of property that I wish to develop, I will cut future spending equivalent to the tax, because government spending never causes economic growth?

    Imagine how much government taxation to build out the Internet and GPS system has depressed consumption!

    • Absolutely not. That’s a gross miscomprehension of Ricardian equivalence.

    • Governments spend then tax, and how much they tax (and eventually collect) does not have to balance the yearly books either. Hence, as Randy Wray describes, and others too, tax is part of the real historical world, is a matter of policy and does not exactly pull our DSGE puppet strings. http://neweconomicperspectives.org/2014/05/need-taxes-mmt-perspective.html

  6. Great. Point me to an explanation in standard macro of how e.g. govt. spending on GPS can increase consumption rates way over costs.

    • I think you will have to do that work on your own. But Krugman (1998) is a good starting point.


Sorry, the comment form is closed at this time.

Blog at WordPress.com.
Entries and comments feeds.