The true nature of public debt

11 February, 2015 at 17:39 | Posted in Economics | 13 Comments

national debt5One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. But this does not hold for national debt which is owed by the nation to citizens of the same nation. There is no external creditor. We owe it to ourselves.

A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the repayments than they will be enriched by receiving them.

Abba Lerner The Burden of the National Debt (1948)

Added 18:30 GMT: But how about Ricardian equivalence then? Surely Lerner would have had a different view if only he had been familiar with that pivotal element of “modern” macroeconomics? I’ll be dipped!

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.

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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.

A couple of months ago, 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. Abba Lerner IS evoking Ricardian equivalence in his argument. I doubt you understood it. And if you did, you should argue against it.

    • Really? Usually Lerner’s position is interpreted as a kind of “asymmetry thesis” built on the view that INTERNAL public debt involves no burden to the “public,” but EXTERNAL public debt does indeed involve a burden. And usually when believers of Ricardian equivalence apply it to Lerner’s thesis, the conclusion is that there is no such asymmetry.
      So please elaborate and enlighten us, Pontus, on your new Cambridge interpretation of the Lerner-Ricardian equivalence connection!

      • Sure, Ricardian equivalence looks at debt from a closed economy’s perspective in which it is internal debt. Money we owe to ourselves.

  2. Lars,
    Mark Blyth had an excellent (and hilarious) short take on this kind of argument in the 2013 Google talk he gave on “Austerity: The History of a Dangerous Idea.” I thought that, by now, *someone* would have uploaded the thing to Youtube. Since no one has, I’ve done so here:

    As Hugh Trevor-Roper said about combating Toynbee’s theory of civilizations,

    “Scholarly criticism had failed. Those weak pellets had glanced impotently off that smooth impervious surface. Mere denunciation was useless, inaudible above the choral dithyrambs of praise. I decided that there was only one effective method. The balloon must be punctured and the gas let out. Perhaps if the worshipers could smell it, they would recognize its true character. And the puncture must be neat, scientific, where the skin was most stretched, most tender, with a sharp needle dipped in deflationary ridicule: the ridicule that kills, the ridicule which, in Shaftesbury’s phrase, is the test of truth.”

    • This is not related to Ricardian equivalence at all (as Ricardian equivalence takes the path of government spending as given).

      FYI: I disagree with Lerner because I know that Ricardian equivalence doesn’t hold. In particular, debt can only be reduced using distortionary taxes and those are burdensome, today or in the future. Even if we owe them to ourselves.

      • Distortionary taxes? Weird concept, pretty much an example of marketfundamentalism. Without these taxes, much of the infrastructure needed to produce market production would not exist, which means that cost prices (which do not take many kinds of taxes used to pay for this into account!) are ‘distorted’ too. Heck, my country (the Netherlands) would not even *exist* without dikes – and believe me that we learned it the hard way to finance dike building with taxes.

      • I am sorry, but you don’t seem to know what distortionary taxes mean. Just because the net benefit of doing something is positive doesn’t mean that gross costs are zero.

      • Since I was just linked to this old blogpost, might I point out that Lerner – who is not using “Ricardian” equivalence but accounting & logic to distinguish between internal and external debt, explored and agreed with the existence of pontus’s distortionary tax objection, but rightly dismissed its relevance in the silly ways it is usually used these days (& then). Which silliness I am not sure whether pontus is engaging in, so should be given the benefit of the doubt. Look at the chapter on the National Debt in Economics of Employment, which does not expound an incorrect “asymmetry thesis”. If people had read & understood that, there would have been a lot of papers not written. Seymour Harris’s book on The National Debt is good for background, and seems to have influenced Lerner imho.

  3. By the way, your explanation of Ricardian equivalence contains a few errors. For instance, current consumption is not positively related to the real interest rate, but negatively related.

    There are also more stylish ways of showing the same result. For instance, the private sectors budget constraint is

    B(1+i)+Y-T=C+B’

    where B denotes bonds holdings, Y income, T taxes, C consumption, and a prime denotes “tomorrow”. The government’s constraint is instead

    D’+T=D(1+i)+G

    where D denotes government debt, and G government spending. Consolidating these constraints and imposing market clearing B=D, we get

    Y=C+G

    Thus consumption does not, by accounting, depend on either debt or taxes, but only on government spending. So how can it depend on the timing of taxes? By introducing it back into the equation again. Keynes, for instance, put C=C(Y-T), and then it of course matters. Many other models would put Y=Y(T), by distortionary taxes, which again breaks the equivalence.

    Barro showed that if agents are forward looking then C is independent of the timing.

    • This is not very helpful Pontus. No matter how hard you try, you don’t get around the fact that Barro’s model actually assumes that people are public debt experts (as shown e. g. by Buiter (1988)) and if empirical studies show anything on this issue it is that people are NOT at all experts on public debts. Usually no more than 20-30% give what could be considered reasonable estimates.
      Stiglitz is right. Ricardian equivalence is sheer nonsense!

      • Fine, but then don’t quote Lerner in the next breath. Sheer nonsense doesn’t become wisdom just because it happens to serve your purposes. Be consistent!

  4. The true nature of economists’ confusion
    Comment on ‘The true nature of public debt’
    .
    Ricardo spoke about war financing in a monetary economy. Merijnknibbe talks about financing dikes. The Neoclassicals have not realized that utility is a nonentity and let the representative agent, another nonentity, optimize real consumption over time. Pontus declares that consumption does not, by accounting, depend on either debt or taxes. No accountant worth his salt would ever make such a claim.

    Lerner famously said ‘we’ pay interest on public debt to ‘ourselves’. But ‘we’ consist of savers and non-savers. And while income tax and interest payments are indeed equal there occurs a redistribution of income from non-savers to savers that never ends if debt is revolved. This crucial distinction and this real effect is semantically vaporized with ‘we’ and ‘ourselves’.

    The true nature of confusion and mystification is that economists subscribe to the ‘anything goes’ methodology and are more famous for never ending wish-wash than for logical consequence.

    For the formally correct refutation of Ricardian equivalence see the Section “The question of equivalence: three scenarios” in (2015).
    .
    Egmont Kakarot-Handtke
    .
    References
    Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: Aggregate
    Demand. SSRN Working Paper Series, 2564590: 1–22. URL http://papers.ssrn.
    com/sol3/papers.cfm?abstract_id=2564590

  5. There’s also the fact that “the public” is not a uniform entity. Interest on the debt is a transfer of wealth from taxpayers to the owners of the debt, and since each citizen does not maintain ownership of the national debt in proportion to his wealth or income, the debt represents a real burden upon taxpayers who own a less-than-proportionate quantity of the debt.


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