## Ricardian equivalence — nothing but total horseshit!

14 Mar, 2018 at 17:05 | Posted in Economics | 5 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.

Why?

In the standard mainstream consumption model — used in DSGE macroeconomic modelling — 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 mainstream 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 does not fit the facts we already knew.

Now Jonathan Parker has 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. Or, as Nobel laureate Joseph Stiglitz has it:

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

1. “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.”

Not surprisingly swedish politicians always have to earn budgetsurpluses for the future and at the same time urging other countries with large current account deficits(i.e USA) to do the same and thinking mercantalist like China is financing their(USA i.e) economy.

I feel like a fool when thinking about my semester in basic 101 macro-economics!

How many fools are there in our own parlament?

2. Dear Lars,
As in the case of the so-called Ricardian trade model, you omit to mention that the so-called Ricardian equivalence theorem has nothing to do with what David Ricardo actually wrote. In fact, he actually believed the exact opposite. See here:

It seems that you prefer to argue against neoclassical non-sense instead of having to deal with more serious arguments against deficit spending, like the ones offered by Ricardo.

3. Thanks Jorge, but I have actually cited Ricardo’s own view on the equivalence many times in books, articles and blogposts. Last year I had a post up here saying:

“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.”

On this I am totally on Ricardo’s side!