Ricardian equivalence — hopelessly unrealistic

14 October, 2016 at 13:36 | Posted in Economics | Leave a comment

According to the Ricardian equivalence hypothesis the public sector basically finances its expenditures through taxes or by issuing bonds, and bonds must sooner or later be repaid by raising taxes in the future.

If the public sector runs extra spending through deficits, taxpayers will according to the hypothesis anticipate that they will have pay higher taxes in future — and therefore increase their savings and reduce their current consumption to be able to do so, the consequence being that aggregate demand would not be different to what would happen if taxes were rised today.

Robert Barro attempted to give the proposition a firm theoretical foundation in the 1970s.

So let us get the facts straight from the horse’s mouth.

Describing the Ricardian Equivalence in 1989 Barro writes (emphasis added):

Suppose now that households’ demands for goods depend on the expected present value of taxes—that is, each household subtracts its share of this present value from the expected present value of income to determine a net wealth position. Then fiscal policy would affect aggregate consumer demand only if it altered the expected present value of taxes. But the preceding argument was that the present value of taxes would not change as long as the present value of spending did not change. Therefore, the substitution of a budget deficit for current taxes (or any other rearrangement of the timing of taxes) has no impact on the aggregate demand for goods. In this sense, budget deficits and taxation have equivalent effects on the economy — hence the term, “Ricardian equivalence theorem.” To put the equivalence result another way, a decrease in the government’s saving (that is, a current budget deficit) leads to an offsetting increase in desired private saving, and hence to no change in desired national saving.

Since desired national saving does not change, the real interest rate does not have to rise in a closed economy to maintain balance between desired national saving and investment demand. Hence, there is no effect on investment, and no burden of the public debt …

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.

To most people this probably sounds like nothing but witless gibberish, and Willem Buiter is, indeed, in no gracious mood when commenting on it a couple years ago:

Barro (1974) has shown that, given perfect foresight, debt neutrality will obtain when three conditions are met: (a) private agents can lend and borrow on the same terms as the government, (b) private agents are able and willing to undo any government scheme to redistribute spending power between generations, and (c) all taxes and transfer payments are lump sum, by which we mean that their basis of assessment is independent of private agents’ decisions about production, labour supply, consumption, or asset accumulation. Under these extreme assumptions, any change in government financing (government saving or dissaving) is offset one-for-one by a corresponding change in private saving itself financed by the accompanying tax changes.

aatical-economics-are-mere-concoctions-as-imprecise-as-the-john-maynard-keynes-243582All three assumptions are of course hopelessly unrealistic. Condition (a) fails because credit rationing, liquidity constraints, large spreads between lending and borrowing rates of interest, and private borrowing rates well in excess of those enjoyed by the government are an established fact in most industrial countries. These empirical findings are underpinned by the new and burgeoning theoretical literature on asymmetric information and the implications of moral hazard and adverse selection for private financial marketsl1; and by game-theoretic insights of how active competition in financial markets can yield credit rationing as the equilibrium outcome.

Condition (b) fails because it requires either that agents must live for ever or else effectively do so through the account they take of their children and parents in making gifts and bequests. In reality, private decision horizons are finite and frequently quite short …

Condition (c) fails because in practice taxes and subsidies are rarely lump sum …

I conclude that the possible neutrality of public debt and deficits is little more than a theoretical curiosum.

Willem Buiter

It is difficult not to agree in that verdict.

And how about the empirics? Let’s have a look:

In a series of recent papers … I and co-authors measure the impact of the receipt of an economic stimulus payment in the US in 2008 on a household’s spending by comparing the spending patterns of households that receive their payments at different times. The randomisation implies that the spending of a household when it receives a payment relative to the spending of a household that does not receive a payment at the same time reveals the additional spending caused by the receipt of the stimulus payment.

So how do consumers respond to cash flow from stimulus in recessions?

First, we find that the arrival of a payment causes a large spike in spending the week that the payment arrives: 10% of spending on household goods in response to payments averaging $900 in the US in 2008 (Broda and Parker 2014).

Second, this effect decays over time, but remains present, so that cumulative effects are economically quite large – in the order of 2 to 4% of spending on household goods over the three months following arrival.

On broader measures of spending, Parker et al. (2013) find that households spend 25% of payments during the three months in which they arrive on a broad measure of nondurable goods, and roughly three-quarters of the payment in total.3 Interestingly, the difference between the two measures largely reflects spending on new cars.

Finally, the majority of spending is done by household with insufficient liquid assets to cover two months of expenditures (about 40% of households). These households spend at a rate six times that of households with sufficient liquid wealth.

Jonathan Parker

As one Nobel Prize 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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