Thursday, March 10, 2011

Critique of Public Investment Based on Another Misapplication of Ricardian Equivalence

Antonio Fatás rightfully blasts the following from Justin Yifu Lin:

But how can the Ricardian trap be avoided, i.e. an outcome where the government stimulus fails to boost aggregate demand because economic agents expect future tax increases to pay for larger deficits and thereby increase savings? To avoid the Ricardian trap, it is important to go beyond conventional Keynesian stimulus of “digging a hole and paving a hole” by investing in projects which increase future productivity."

Antonio notes:

No one can disagree with the statement that if the government can choose between different spending projects, they should select the one with the highest return (in terms of productivity and income). But we need to understand that the advise for the government to invest in productive investment applies at all times (good and bad). What is different when there is spare capacity is that "pure demand" policies can bring the economy closer to potential in a shorter period of time. By doing so they will be increasing the overall output and income of the country. And this additional income is the source of potential increases in private spending and tax revenues. This is the intuition behind the Keynesian recipe for times of high unemployment, which is consistent with the concerns of Justin Yifu Lin.

Let me add one other important element to this critique of this supposed critique of Keynesian policies from the Chief Economist of the World Bank. Ricardian Equivalence might hold that a permanent increase in government purchases would lead to an increase in permanent taxes, which would cause private consumption to fall by an equal amount. But even if a temporary increase in government investment were squandered say on building new pyramids or another damn baseball park for a team like the Yankees (with all due apologies to my neighbors who may be Yankee fans), standard lifecycle models of consumptions (e.g., Ricardian Equivalence) do not predict a fully offsetting reduction in consumption.


Ken Houghton said...

Many of your neighbors are Yankee fans--but I would wager they don't thrill to paying an extra $1 for a bagel in midtown because that money subsidizes Their Favorite Team.

(That's speaking as a Devils fan who is still paying for the old arena, let alone the new one, and wishes New York would take back the Giants and Jets, instead of leaving us with the bill for [again] their old and new stadia.)

Nick Rowe said...

I think you are wrong on this one:

James said...

Nick hit the nail on the head with this one. His post on this topic is a must read.

Sandwichman said...

Am I the one really confused here? This seems to be a debate about the relationship between events at a discrete time "t" and events at a discrete time "t+1". Meanwhile, social production spins merrily along on its axis of a continuum.

How do we know that digging and filling holes or burying bottles filled with banknotes is less productive than, say, building a rail line from Birmingham to Manchester? Is the standard of value being used one of subjective utility or of capital accumulation?

The word "employment", which appeared several times in Paul Krugman's post doesn't appear at all in Nick's. So, is this debate about employment and policies to increase it or is it about abstract "bangs" that may be bigger or smaller? If the issue is really about employment, aren't there more urgent and realistic questions that need to be addressed than Ricardian Equivalence?

Unknown said...

Ricardian Equivalence and Keynesian stuff are both dependent upon a model in which money has intrinsic value; where money is static and "scarce". When will the economics profession get off of this merry go round???? Keynesian money theory is at least consistent within that sort of frame. Ricardian Equivalence is pure pig shit because it does no account for slack demand and underutilized real resources that then become more fully utilized after the fact. If money is injected by virtue of fiscal policy AT THE BOTTOM of the economy during periods of low interest rates (slack demand) and then paid back when the money is more scarce (everyone wants to invest) then the Keynes theory works even in an intrinsic money system. The fact that we do not have the handcuffs of intrinsic money totally destroys any validity of "Ricardian Equivalence" and aids the Keynesian concept. The money need not be prepaid if it is created money. There is no interest expense. Such a thing (QE2) is moderately inflationary and absolves old debt to boot. Please address the issue. and stop tap dancing around.