Thursday, December 29, 2011

Partisan Misrepresentation of Ricardian Equivalence is Nothing New

Paul Krugman catches Robert Lucas (not to be confused with Robert Barro - thanks for the comment David) misrepresenting Barro’s claim to fame:

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.


Let’s get back to this after this abbreviated explanation of Ricardian Equivalence from David Andofatto. OK David, we know that in a life cycle world where households understand the long-run government budget constraint that households view all tax cuts (even the 1981 and Bush43 tax cuts) as mere tax surcharges that have to be repaid. But this model goes well beyond this. If fiscal policy involved a permanent increase in government consumption, it also involves a permanent increase in taxes which would be a wash as Barro alleges. So if the Obama Administration passed a law where we built a bunch of bridges every summer only to tear them down every winter for the rest of time, then maybe Barro’s claim makes sense.

But this is not the correct policy experiment. The building of a bridge is a temporary blip in spending intending to invest in the public infrastructure where the benefits will be long-term. The financing requirements can be met either by a blip in taxes or very low taxes each year over the future. And in either case, the fall in private consumption in the first year will be small in proportion in the rise in government spending to build this bridge (which it does not intend to subsequently tear down).

One would think this logic was well known. The reason for this blog post, however, is to note that Republican hacks have grossly misrepresented Ricardian Equivalence before. Recall all the fuss over why the Bush43 tax cuts would be better aggregate demand stimulus if that were to be made permanent as opposed to temporary? While that might be good life cycle theory if we could ignore a lot of other economic propositions – such as the long-run government budget constraint (and of course Ricardian Equivalence). Yet some Republican hacks even went so far as to dismiss any concern about crowding-out (even as the FED was already raising interest rates) based on the proposition that tax cuts do not raise interest rates ala Ricardian Equivalence and that Paul Evans AER 1985 paper entitled “Do Large Deficits Produce High Interest Rates”. But wait a darn second – the Ricardian reason for all of this is the assertion that tax cuts don’t encourage more consumption. This incredible dishonest mishmash was most evident when Victor Canto claimed in what National Review November 2002 piece that the Bush tax cuts would be more powerful in encouraging consumption if made permanent, while in another National Review November 2002 piece he used Ricardian Equivalence to argue that the tax cuts would not raise interest rates. To be fair to Mr. Canto – the National Review expects such brazen dishonesty if it is in defense of its rightwing agenda.

I should say that the Evans AER 1985 paper always puzzled me because the Reagan tax cuts did raise aggregate demand by raising consumption during a period when government spending was not reduced. And while nominal interest rates may have declined, real interest rates rose. In other words, we got classical crowding-out from a mix of expansionary fiscal policy and the Volcker tight monetary policy. Now if you wanted to remain a true believer of Ricardian Equivalence, I guess you could have argued that households expected the Reagan revolution to eventually get around to reducing government spending. Domestic spending after all was trimmed a bit even as defense spending soared. But we did eventually get that good old Peace Dividend – in the 1990’s.

11 comments:

Rotwang said...

I continue to be confused by this discussion. I understand the point that under moronic assumptions, a permanent spending increase is offset by a permanent reduction in after-tax private consumption. And I understand that a spending increase in one period paired with a tax increase spread over the future has a net positive impact in the present. But if we use a tax increase for an equivalent spending blip, all we are talking about is ye olde balanced budget multiplier, right? Where does Ricardian equivalence come in?

John said...

Economic activity is only indirectly related to debt or taxes, neither of which impacts the real engine - demand.

Most discussions conflate wealth and income which are two entirely different realities. Both have to do with demand, but not in the manner that most people believe.

WEALTH is net worth, assets minus liabilities.
INCOME is a revenue stream, measured in 12 month increments, which may or may not affect net worth.

Those with negative or small net worth cannot be described as "wealthy" unless and until their financial position gets much better, regardless of their income level.

And there are a comfortable few for whom income is irrelevant, whether large, small or non-existent, thanks to a net worth (wealth accumulation) which is sometimes sufficient for all the needs of themselves and their heirs for generations yet to come.

National or "sovereign" (the new buzzword) debt has little to nothing to do with individual consumer debt. I doubt that anyone personalizes any part of the national debt except in political arguments. But personal debt obligations are completely intimate.

Demand is the result of an income stream sufficient to be designated partly to additional wealth accumulation (or debt reduction) plus a comfortable amount more that can be considered "discretionary." Concern about taxes and national debts (i.e. Ricardian dynamics) are way out of consciousness. What really counts is what's in the pockets of consumers.

Someone during the Great Depression noticed that no matter how down and out people got enough people could scrape up enough to enjoy a cup of coffee and a donut, so places like Krispy Kreme and Dunkin Donuts were born. Same was true of tiny hamburgers (White Castle, Krystal), movies for a quarter, etc. Even in the depth of hard times it is demand which drives the economy. Debt become irrelevant.

These arcane discussions of nose-bleed economics make me tired.

David Andolfatto said...

"If fiscal policy involved a permanent increase in government consumption, it also involves a permanent increase in taxes which would be a wash as Barro alleges."

I actually disagree with this statement (one that I often hear Krugman make). It is easy to show that there are cases where a permanent increase in G can induce higher levels of Y, even in a world where Ricardian equivalence holds.

Also, you might want to make a correction: Krugman was making reference to Lucas, not Barro.

Don Levit said...

John:
I agree with you that demand is the key for a productive economy.
Do you agree that the median household income has decreased over the last 30 years?
If so, then demand will be diffucult to satisfy, unless, of course, people get subsidies in Obamacare for already-overpriced insurance.
Don Levit

John said...

Exactly. I saw something a couple weeks ago comparing median incomes of various countries in the "developed" club illustrating that the US is poorer than either Japan or the UK.

When the national wealth is divided by the population the result is the average income. But when the population is ranked in terms of income the median income is that point at which half the population is over and the other half under that amount. (Bill Gates walked into a bar and everyone in the place became a millionaire -- on average)

I don't recall the numbers but the median incomes of Japan and the UK were dramatically better than the US -- median vs average incomes.

When I hear that canard about "wealth redistribution" stupidly tossed around by those trying to argue against progressive income taxes I want to hurl. We have had wealth redistribution, alright, as the result of the upper income earners harvesting super-big portions of any additional new wealth for years, with the trend accelerated by the so-called Bush tax cuts.

I can't understand why so few wealthy people can't grasp the simple reality that unless they allow more people to follow them with meaningful upward mobility the can never expect to have good demand for the goods or services responsible for their fortunes. Squeezing every dime out of customers is the best way to insure that those customers will soon not be able to afford to continue doing business with you.

I think the problem is that too many people know that making money from money is possible but overlook the fact that the "real" economy rests on making money from goods and services -- not interest, derivatives, hedges, and other forms of leverage.

I'm just an old guy blogging in retirement but this ain't rocket science.
~~~~~~~~~~~~~~~~~

Regarding universal healthcare there is a wad of confusion, starting with two serious misconceptions.

In the same way that income and wealth are not the same, so too are --
►Insurance vs healthcare
and
► Professional compensation vs. corporate profits.

Healthcare is about healing.
Insurance is about risk management.

Professional compensation is what medical professionals are paid for services.
Corporate profits are what shareholders receive after expenses, taxes and depreciation.

And all of the above is badly muddled by arguments about who pays how much and for what. That's another whole mess. Don't get me started.

Don Levit said...

John:
I think I may have found a twin!
Let's see what you (and others) think about this regarding health insurance and health care.
Obamacare will cover a lot of preventive care at 100%.
This is exactly what we don't want to happen from a risk management standpoint.
If Obamacare is enacted, people will need to willingly forego covered benefits, and pay for (what would be covered) preventive, out-of-pocket.
In addition, they will need to have some type of primary policy to cover the first $25,000-$50,000 of benefits for the family.
I have some ideas on how that would be done, and it would take 2-4 years, depending on contributions and claims actually made.
But, as the monthly contributions are made, and coverage builds on the primary plan, the deductible is raised on the traditional plan, saving premium dollars, every month.
Once $25,000 is built up, the premium drops by 60%.
Once $50,000 is built up, the premium drops 80%.
Don Levit

John said...

Thanks.
I have more thoughts about healthcare than will fit into a comments thread, having followed the whole mess from the time the pig was killed to when sausage came out in the form of PPACA.
To give you an idea go to Newshoggers where I have been blogging...

(http://www.newshoggers.com/blog/)

...and scroll down to a Google search feature in the sidebar (just under the Twitter widget) key in "HCR" (as in health care reform), select "Newshoggers" and the result will be many pages of posts related to healthcare reform.

(Perhaps we can have a better discussion via email. If you leave a comment at any of our posts I can discover your email without your having to post it publicly.)

run75441 said...

Don and John:

In order to get an appropriate answer to the ACA, you are going to have to be specific.

Up to a certain income and family size there are subsidies for healthcare. This should cover most of the population. Don, I am not sure where the $25,000 - $50,000 is coming from.

John, you are correct in thzt healtcare costs differ from healthcare insurance costs. Within the ACA there are controls which will regualte both and drive down thecosts of both.

Don Levit said...

run75441:
I cannot be specific at this point on where the $25,000-$50,000 comes from.
The reason is that I am in the process of applying for a business methods patent on my design.
The patent should be filed this week, so, hopefully, next week, I can provide more details.
In general, the plan works like a supersized HSA.
It will be primaruy coverage, so we need to work with health insurers that are willing to raise the deductible every month as this primary plan grows.
My experience with health insurers is that they don't like to do this.
In fact, in Texas, if you have an individual policy, you are not even considered "insured", so with your medical policy, which may be similar to the group policy, you are not even covered in the group "participation rate."
Don Levit

ProGrowthLiberal said...

Rotwang:

"But if we use a tax increase for an equivalent spending blip, all we are talking about is ye olde balanced budget multiplier, right?"

I think you are correct.

"Where does Ricardian equivalence come in?"

It likely doesn't as your argument holds even in a Ricardian world.

John said...

Tying up a loose end, Mr. Levit and I exchanged emails and we definitely aren't twins.