Friday, March 11, 2011

The Ricardian Equivalence Bubble

Suddenly it’s everywhere. Justin Yifu Lin (the chief economist at the World Bank), Tyler Cowen, Paul Krugman, Nick Rowe, our own PGL: hot debate about how Ricardian equivalence applies to the current economic situation. There’s just one minor problem: Ricardian equivalence is an absurd idea, with not a shred of evidence or logic to support it.

Behind the imposing moniker dreamed up by Robert Barro, RE simply says that government debt must eventually be paid down to zero. If the government borrows $1B this year, it must run a surplus of $1B some time in the future. If spending is constant, this means taxes have to go up.

I pointed out the vacuity of this idea in a previous post, so I won’t repeat myself. The question of the day is, why should anyone give RE more than a moment’s attention? In particular, why would smart economists with state-of-the-art training be debating the fine points of what RE would mean if it were true?

The only answer I can give is that the theory can be decked out with lots of math (overlapping generations ratex models of the behavioral response to knowledge of future taxes), enhancing the reputations of all involved. The fact that RE simply assumes a nonexistent and impossible state of affairs plays no role.

That, in a nutshell, is what’s wrong with economics.


jre said...

As you have suggested, there is "not a shred of evidence or logic" behind Ricardian equivalence. But those are two different things.

On the logic side, we have the self-justifying nature of RE: since it is all about expectations, any failure of the theory is easily patched up by going back in time. Since what happened did happen, obviously everyone expected it to happen, and so made it happen. This is what you find if you go to the OED and look up silly-assed, adj.

On the other hand, we have the evidence. RE predicts that a stimulus should not stimulate. Every time a stimulus is actually applied, amazingly enough, it does stimulate. This problem is most readily solved by recourse to the RE time machine already mentioned.

Sandwichman said...

Hear! Hear!

"why should anyone give RE more than a moment’s attention?" (or why should anyone give a ra about re?)

Sandwichman has a theory. Freudian screen memory. Economists are remembering RE to screen out the traumatic, rentiercidal memory of Keynes's complete view on full employment.

Don Levit said...

I think it is important that the government at least indicate an attempt to pay back some of its debt, and all of its debt, even better.
There may not be your economics logic behind it, but there are psychological advantages for running surpluses.
It encourages individuals to save surpluses for the future.
It also shows that the government is serious about paying back its liabilities, which is an encourager for individuals to do likewise.
Government may be different than a household or a business, but, really, they are all interconnected.
The supposed fact that this government can't go broke is no indicator of the people's prosperity.
80% of Americans live paycheck to paycheck.
Government should do the same - run a balanced budget, each and every year.
Don Levit

Sandwichman said...

"80% of Americans live paycheck to paycheck."

And does that include mortgage payments? If you distinguish between capital outlays and operating costs there's no good reason you EVER have to pay back your capital investment as long as your equity offsets your debt liability.

That isn't even economics. It's double entry book-keeping.

Don Levit said...

It is a positive that equity exceeds the debt.
But the family still has the obligation of paying off the principal, which, fortunately is more prevalent in the latter part of the loan.
Or, conversely, they sell the home, and extinguish the debt.
The point is to pay off the principal, not roll it over, as the federal government does.
In addition, some of the interest paid on debt held by the public is paid with debt, which is a foolish strategy over the long run.
Don Levit

Sandwichman said...

"But the family still has the obligation of paying off the principal..."

Wrong. As long as your equity exceeds your debt, you can roll over till you die at which point your estate can sell your assets and liquidate the debt.

The difference for the federal government is rather simple. It never dies.

Deficit financing of operating expenses is another question. But if you don't grasp the concept of equity, then it becomes difficult to explain the distinction.

kevin quinn said...

Peter: RE does not depend on the assumption that the government pays off all its debt. It assumes that the present value of government debt vanishes in the limit - or that the debt grows at a rate less than the interest rate. This in turn is condition for non-explosion of the debt/GNP ratio in an economy where the interest rate exceeds the growth rate.

Peter Dorman said...


1. Why should the PV of government debt vanish in the limit?

2. Yes, if the interest rate on public debt exceeds the growth rate of the economy in perpetuity, debt *growth* will have to be slowed to avoid debt/GDP explosion. But this is contingent on a state of affairs (interest > growth) that cannot exist in a viable economy, and even so it does not entail retirement of the debt, only a reduced rate of new debt issuance.

The useful service performed by Tyler Cowen is that he expressed RE without any finery and showed how absurd it is.

greg said...

Peter Dorman said: …But this is contingent on a state of affairs (interest > growth) that cannot exist in a viable economy,…

Do I have this right? Interest >growth. But: Total debt, US 2009= 296% GDP.
3 times GDP, say. Say average interest on debt is 3%. ( Assuming the US government gets the best deal, the average must be at least the minimum.

So, interest is (more than) 9% GDP. Growth of GDP? 2.8%. Plus 1.6% inflation gives 4.4%. Hmm. Are we talking a viable economy, here? Or what are we looking at?
Or am I missing something?

Stephan said...

Putting aside the ridiculous theoretical assumptions of Ricardian Equivalence there's no empirical evidence whatsoever for it's existence. But the search for the Ricardian aliens is still ongoing and it's proponents are optimistic to find them before a rival research team on the lookout for the Yeti accomplishes it's mission.

In August 1981 the US congress gave out large tax cuts to stimulate the US economy. RE groupies with their chieftain Robert Barro were allover the place with their predictions how hopeless such an endeavour is. What actually happened is the US personal saving rate fell from 7.5% in 1981 to average 5.7% in 1982-1984.

Since Robert Barro dreamed up Ricardian Equivalence he uses every opportunity to write an Op-Ed in the WSJ, … always giving the same dire predictions. I guess this happens to remind the Nobel Committee that he's still alive and well.

Peter Dorman said...

Greg: In the long run, economic growth must be equal to or greater than the risk-free interest rate. Government bonds are normally risk-free, and the conditions under which they aren't have to do with fiscal space, not RE.

trucker said...

In the fiat money world, governments do not need to borrow. It may be that the tax drain is too high, thus stifling the economy. But more likely, it is the savings (hoarding) drain that is at fault. When people that "have money" can "knit up" behind government secured assets and not pay appropriate taxes then we have an economic failure. As the economy shrinks, the hoarders become more and more powerful. It is only creation of more money working in league with the tax man that can fix this problem. The reality of inflation is the means by which the money hoarders are compelled to invest. Selling T-Bills to "finance" a stimulus is dumber than dirt. And refusing to tax the rich (refusing to reclaim economic rent) is even dumber.

The secret to obviating RE is to formally announce and support the fact that borrowing in unnecessary.

That people will "save" in anticipation of future taxation is not true if inflation will be eating the savings. The Bush tax cuts should have been allowed to expire and QE2 should have been at least double what it is.

JW Mason said...

Kevin is basically right, I think. But his point can be put a little more precisely.

If d > g - r then the debt/GDP ratio will explode, where d is the deficit as a share of GDP, g is the growth rate of GDP and r is the interest rate on government debt. Now obviously that means if r > g, any deficit is unsustainable. But RE can still apply where g > r, if current (expected) deficits are already equal to g - r. In that case, a higher deficit now still implies a lower deficit later, if the debt ratio is not to explode. So it is "rational" for agents in that situation to behave as Lin, Cowen, etc. say they do. There's no need to assume that debt will be paid down to zero.

That said, I agree 100% that RE is a silly notion that has no place in discussions among grown-ups. But that's for the reason jre gives, that expectations empirically don't behave anything like the models say they do. It's not wrong simply as a matter of logic.

JW Mason said...

Strictly speaking the condition for a stable debt/GDP ratio is d*(D/GDP) = g - r, where D is the level of debt. Current deficits are well above this level, so "rational" agents should believe that any increased borrowing now implies corresponding reduced borrowing (i.e. higher taxes) later. Again, this is wrong, but not as a matter of logic; it's just that people in the real world are not "rational" in the way the model requires.

Don Levit said...

I agree with JW Mason that people are not rational in relation to this model, or any of the other equations posted here.
Money is loaded with emotion, and people tend to act in herds, which usually means negative, not positive reactions.
When was the last time millions of people came together to do something good?
Greg's posting detailed total debt representing financial and non financial institutions, households, and governments.
I think his figure is more reliable, because these entities all interreact to help gauge the full faith and credit of the U.S. Government.
Peter, how do you think people would react if the offiocial position of the U.S. Government was not to even attempt to pay down its debt?
How would the average person react, if the official position was dependent on some formula?
Oh, don't worry, trust us, the formula says it's okay.
Oh, don't worry, we can never go broke, for we can create money out of thin air, just like God created the world when he spoke.
The average person would discount all these theories, or even worse, would say, give me more then, give me more. I'll help the GDP.
Don Levit

trucker said...

The digging and filling of holes is reduced to a "transfer payment". I am going to assume that the transfer is from "the tax payers" who, according to Heritage and other right wing tanks are by and large the top 20% of the American income recipients.

It seems to me that stimulus then is offering the rich people an alternative: "You can use that supposed superior economic brain of yours to figger' out how to employ people at a small profit or you can pay higher taxes to dig and refill holes".

This may or may not have anything to do with RE, but it does have to do with curing the injustice of hoardeing.