Friday, February 6, 2009

Mitt Romney Does Not Understand Ricardian Equivalence Either

I guess CNN felt compelled to allow Mitt Romney words to be aired because Romney was once a Presidential contender but the following is really stupid:

These are extraordinary times, and like a lot of Republicans I believe that a well-crafted stimulus plan is needed to put people back to work. But the Obama spending bill would stimulate the government, not the economy … We're on an economic tightrope. The package that passed the House is a huge increase in the amount of government borrowing. And we've borrowed so much already that if we add too much more debt, or spend foolishly, we could invite an even bigger crisis … First, there are two ways you can put money into the economy, by spending more or by taxing less. But if it's stimulus you want, taxing less works best. That's why permanent tax cuts should be the centerpiece of the economic stimulus.

Maybe Romney is thinking along the lines of the Friedman permanent income hypothesis when he calls for permanent tax cuts but he also noted we have a huge deficit. Paul Krugman understands how to put the Friedman permanent income hypothesis together with the long-run government budget constraint and apply it to increases in government spending as well as tax “cuts” which are actually only tax deferrals:

a temporary increase in government spending should have a larger impact on demand than a permanent increase, not a smaller impact. And that’s actually an important point: one way to explain why government spending is better than tax cuts as a stimulus is to say that temporary tax cuts aren’t effective at increasing demand, but temporary spending increases are. Here’s the logic (which follows directly from Milton Friedman’s permanent income hypothesis, by the way): suppose that the government introduces a new program that will cause it to spend $100 billion a year every year from now on. To pay for this, it will have to raise taxes by $100 billion a year, permanently — and if consumers take this into account, they might well cut their spending enough to offset the increase in government purchases. But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes — say, $5 billion a year. That’s a much smaller impact on consumers’ future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I’m not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.) So economic theory — Milton Friedman’s theory! — says that spending is a more effective form of stimulus than tax cuts.

The same logic falls under the heading of Ricardian Equivalence - a topic that Robert Barro understands. Yet- Mitt Romney gets this all completely backwards. I guess when he was running for President, he never quite grasped these basic topics even though Greg Mankiw was one of his economic advisors!


Nick Rowe said...


Assume I'm Mitt Romney (first daft assumption). I could argue that a permanent tax cut means either:

1. a future permanent cut in government spending with the same present value today.

2. a permanent increase in money creation (seigniorage) and the inflation tax.

Hmm. 2 would increase expected inflation, reduce real interest rates, and increase aggregate demand....but I don't think I'll go there (because I don't like inflation).

Let's try 1. Assume future government spending would have been totally unproductive wasteful expenditure. And assume it would have taken place at full-employment anyway, so would not have increased measured GDP. (This is sounding more like Mitt, I think, though being Canadian I can't say I really ever needed to know much about him). So my personal disposable wealth has now increased by the full amount of the present value of the tax cut. If I assume the PIH, and my discount rate is the same as the governments, I will consume (nearly) the full amount of the tax cut.

Reverting to me again, I don't believe those assumptions, but someone logically could.

Shag from Brookline said...

"A permanent tax cut" = an oxymoron

Like death a "permanent tax cut" is a sure thing?

As the Pennsyvania Dutch would say: "Romney is Mitt-out brains." But he would make a good model for the top of a wedding cake

ProGrowthLiberal said...

Nick - your #1 might explain what Reagan was thinking about in 1981. Tell folks you'll slash the role of the government in the future and give them a tax cut today. Consumption rises today but the cuts in G are backloaded. Could explain the fall in national savings in the 1980's but there is one problem. Reagan never delivered on those cuts in G. Nor did Bush41 or Bush43. Something tells me that the public has stopped believing in these libertarian promises!

Nick Rowe said...

PGL: agreed. If people didn't believe there would be a future cut in unproductive govt spending, it wouldn't work.

2slugbaits said...

I believe Mitt Romney is challenging Don Luskin for the title of Stupidest Man Alive. But a word of advice for the your back. Stephen Moore is gaining ground fast.

Bruce Webb said...

Well I think this debate is largely over with the Mittster on the losing side. The compromise bill coming out of the Senate side is going to infuriate Republican leadership. They are not going to get their tax cuts and much of the funding cut from the bill will probably be able to survive the regular appropriations process. That is Law Enforcement, Science and Homeland Security all took pretty big hits. As did aid to the states meaning that Republican governors will likely be weighing in.

But the dream of being able to use this bill to push the Supply Side dream of 100% focus on tax cuts is dead, dead, dead. If the House leadership is smart they should just accept this bill as is and then turn around and propose standalone legislation to achieve the rest of their agenda.

John N. Winn said...

The Republican position is actually one of ever-increasing spending on the military while leaving the "third rail" Medicare and Medicaid untouched and/or expanding them (as did Bush with Medicare Rx benefits) and permanently reducing taxes. Selling off America to foreign investors is the result. Borrow and Spend, especially when the borrowing is to be cheered as confidence in the American economy, they have found to be far preferable politically to Tax and Spend.