Abba Lerner and the nonsense called ‘Ricardian equivalence’

9 August, 2018 at 10:43 | Posted in Economics | 9 Comments

According to Abba Lerner, the purpose of public debt is “to achieve a rate of interest which results in the most desirable level of investment.” He also maintained that an application of Functional Finance will have a tendency to balance the budget in the long run:

There is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full employment, the government must always be borrowing more money and increasing the national debt …

dec3bb27f72875e4fb4d4b62daebb2fd161b36392c1a0626f00cfd2ece207d84Full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase …

Since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself, the guarantee of permanent full employment will make private investment much more attractive, once investors have gotten over their suspicion of the new procedure. The greater private investment will diminish the need for deficit spending …

As the national debt increases it acts as a self-equilibrating force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow comes completely to an end. The greater the national debt the greater is the quantity of private wealth.

Abba Lerner

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 to 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 raised today.

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

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.

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.

There is, of course, no reason for us to believe in that fairy-tale. Ricardo himself (!) didn’t believe in Ricardian equivalence. In ‘Essay on the Funding System’ (1820) he wrote:

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.

That the theory does not fit the facts we already knew. Studies that have empirically tried to test the theory have over and over again confirmed how out of line with reality Ricardian equivalence is. This only 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.

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  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.
    .
    Ricardian equivalence is trivially true in purely nominal terms, and acknowledging as much can motivate some insight into the sleight of hand Barro means to practice.
    .
    Consider what the government does when it borrows: it sells a marketable bond. The market value of the bond at the date of issue is exactly equal to the net present value of the promise to pay interest and principle in the future. Please note that no heroic assumption of rational expectations is required to make the bond equal in value to the promised future payments of interest and principle. The bond is the promise and the equivalence in nominal terms is by definition of the promise.
    .
    Let us now consider the position of an imaginary, infinitely lived agent, who either pays taxes or buys bonds as her government bids her. She pays taxes or buys bonds with money. Whether she reduces her current rates of planned consumption out of current national production in order to pay taxes or buy bonds may be a behavioral question of the utmost importance to the policymakers who choose whether to ask the Agent to pay taxes or buy bonds. We could not possibly comment.
    .
    Regardless of what the Agent does regarding her planned consumption out of current production, buying a bond falls within the common sense meaning of “saving”. That this act of financial “saving” — saving money, in the common parlance — has no necessary relationship to rates of consumption of goods out of current production is simply a consequence of money being an economic phenomenon distinct from goods. But, the bond does have a necessary relation to the promise of future payments of money from the government: the present bond and the future promise are identical by definition of the bond: the bond is the promise, and they are quantitatively identical in nominal terms.
    .
    I apologize if I seem to belabor this equivalence, which must seem obvious, but its obviousness must be overlooked to make Barro’s argument for Ricardian equivalence.
    .
    My point is that our Agent, in buying the bond, has taken into her hot little hands paper exactly equal in nominal value to the money taxes that will be levied in the future to pay the promised interest and principal. No heroic powers of rational expectation in the Agent are necessary to establish such equivalence.
    .
    Whether the Agent buying the bond reduces the Agent’s consumption in the present depends, one supposes without knowing, on the Agent’s perception of her own present circumstances. But, the Agent’s anticipation of future taxes are fully covered by owning the bond.
    .
    “Que sera, sera”, our Agent may sing and with or without rational expectation super powers, she knows that she has in hand in the form of the bond the means to pay the taxes necessary to pay off the promise of the bond.
    .
    Again, I fear I am being tiresomely obvious in making this last point, but apparently Barro thought it necessary to obscure this implication so I soldier on. Given that the Agent has the means to extinguish the anticipated future taxes in the bond, spending by the government now financed by borrowing now can have absolutely no effect on future consumption through the channel of a future tax burden. That taxes have to be “higher” in the future to pay off the bond cannot mean that those future taxes will reduce future consumption. Why? Because those future taxes can be paid from the income stream of the bond — debt service and taxes exactly cancel each other out in nominal terms with no effect on future claims on consumption from future production.

    • “My point is that our Agent, in buying the bond, has taken into her hot little hands paper exactly equal in nominal value to the money taxes that will be levied in the future to pay the promised interest and principal.”

      All that will happen is some number on a treasury hard drive will be reduced, and a number on a central bank hard drive will be increased. Net result: 0.
      Whether a government bond, or reserve balances on current account at the central bank, both are financial liabilities of the state, which are by definition – debt. And which are the corollary for net savings of the private sector.

      • “Whether a government bond, or reserve balances on current account at the central bank …”

        Or currency outside bank vaults.

      • Contrast what you say with what Barro is quoted above as asserting: “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.”
        .
        Barro’s assertion ought to seem puzzling. What would the “government’s saving” look like in Barro’s imagining, do you suppose? What would the state “save”? What is to be the form of this “saving”?
        .
        The only clue in the passage quoted from Barro above is the parallel assertion: “no impact on the aggregate demand for goods”. The zero-sum conservation law implied is that one either spends on goods or one “saves” in the sense of refraining from consumption out of current production.
        .
        I suppose something like a loanable funds theory lurks behind Barro’s confusion.

  2. 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. Robert Barro

    Adding to Bruce Wilder’s refutation of Robert Barro , the typical purchasers of sovereign debt are not doing so out of potential consumption but out of their surplus while a monetarily sovereign government spends (or at least should spend) all its tax revenue and fiat borrowings. So aggregate demand IS likely to increase with deficit spending by the monetarily sovereign.

    Not that a monetarily sovereign government should borrow its own fiat anyway or at least not at non-negative yields and interest. Why? Because the debt of a monetarily sovereign government is inherently risk-free and should return no more than 0% MINUS administrative costs to avoid providing welfare proportional to account balance in said debt

  3. Full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. Abba Lerner

    This is called Overt Monetary Financing (OMF). An objection to OMF is that the Central Bank then has no corresponding assets with which to defend the currency.

    However, a Central Bank need own no assets at all to defend the currency IF it has the power to levy negative interest on fiat account balances there – but not on individual citizen accounts* below a certain deposit limit such as $250,000 in the case of the US.

    *Not that individual citizen accounts are yet allowed at Central Banks but they should be as part of fundamental reform.

    • Never a benefit to defend a floating currency anyway

  4. […] Ricardian equivalence is taught in every graduate school in the country. It is also sheer […]

  5. I teach college economics. I have seen colleagues in other departments, Ph. D. in physics or engineering, complain about how high their taxes were and asking for explanations. They didn’t understand their deductions for dental plan or even their parking fee.
    ANd some taxi driver is supposed to know how high is some budget deficit financing and plan his consumption expenditures 20 years from now based on that?
    This is how low our profession has sunk.


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