What was Robert Barro smoking when he came up with ‘Ricardian equivalence’?

23 August, 2016 at 15:12 | Posted in Economics | 1 Comment

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.

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 a couple of months ago, 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

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1 Comment »

1. I’m not sure why you have such an issue with Ricardian equivalence. First, is government debt a burden for future generations (or for you in the future)? As Abba Lerner reasoned, the answer ought to be no — future generations are also the owners of the assets which constitutes the debt, and will hence not suffer from any such tax/debt cancellation. Well reasoned from Lerner according to me.
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Ricardian equivalence asks the opposite question: Is government debt a blessing for future generations (or for you in the future). As Robert Barro (and David Ricardo) reasoned, the answer is again no — and the reason is exactly the same as the reason Lerner used to illustrate that public debt not a burden. So it’s hard for me to understand how you can believe that Lerner provided a deep and useful insight, and at the same time ridicule Barro. It’s the same argument!
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Now, it may perfectly be the case that agents act as if public debt is a burden or a blessing (and hence would violate either Barro’s or Lerner’s proposition), but from a strict accounting perspective it is not.
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Lastly, my own hunch is that the issue you, and other post keynesians, have with Ricardian equivalence boils down to the effectiveness of fiscal policy. Sure, if Ricardian equivalence holds (or worse, if debt is indeed a burden!) the Keynesian reasoning falls apart. BUT, there are other good reasons for why the effect of fiscal policy may be large anyway. Here is, for instance, a paper I have written myself on the topic:

http://restud.oxfordjournals.org/content/83/3/1189