Monday, September 5, 2011

Ricardian Equivalence is a Myth

A post on ThinkMarkets by Jerry O’Driscoll caught my eye:
Jerry O’Driscoll, “A Divine Miracle,” ThinkMarkets, September 1, 2011.
In essence, O’Driscoll cites the New Classical Robert J. Barro’s idea that even deficit spending will not impart fiscal stimulus because of Ricardian equivalence (or, more technically, the Barro-Ricardo equivalence theorem).

The first thing that strikes me is that reading Barro’s original op-ed one can see the chasm that separates even the New Classicals from the Austrians. Despite his heavily free market ideology, Barro thinks that food stamps and other transfer payments are not “necessarily bad ideas in the world of regular economics.” He just thinks they have trade-offs. By contrast, the Austrians would condemn any transfer payments, even to the poor, as immoral and bad economics.

Barro’s belief that deficit spending causes zero fiscal stimulus is derived from the idea of Ricardian equivalence, one of those absurd ideas of New Classical macroeconomics, which Barro himself helped to create.

However, Ricardian equivalence is false. Why? The reason is that it assumes and requires rational expectations:
“Ricardian equivalence is the claim that whether a given path of government expenditure is financed through taxes or debt is unimportant: substituting debt for taxes appears to increase disposable income today. But since the debt must be repaid with interest, a rational taxpayer would save the entire windfall in order to afford the future tax bill, leaving his expenditure unchanged. Ricardian equivalence remains controversial because it depends on assumptions about the public’s foresight and grasp of the fiscal system closely related to the rational-expectations hypothesis and on debatable assumptions about the incidence of taxes and expenditure.”
Kevin D. Hoover, “New Classical Macroeconomics.”
But we face fundamental uncertainty about the future. Rational expectations is false, and the whole notion of Ricardian equivalence falls with it like a house of cards.

It is very strange seeing Austrians appealing to Barro’s Ricardian equivalence, when many Austrians also say that expectations are subjective. If any Austrian seriously subscribes to subjective expectations, then this Ricardian equivalence argument of Barro is ruled out as nonsense, because rational expectations cannot be true.

When Paul Davidson (1989; 1993) reviewed O’Driscoll and Rizzo’s The Economics of Time and Ignorance (1996 [1985]), he accused the Austrians of not taking their alleged fundamental ideas – non-neutral money, fundamental uncertainty, and subjective expectations – seriously. Has anything really changed? Not really.

LINKS

There are some good links here on the fallacy of Ricardian equivalence:
Bill Mitchell, “The Impossible Equation,” August 23, 2011.
Bill Mitchell shows here how Barro and other New Classicals made predictions about Reagan’s fiscal stimulus over 1982–1984, and were completely wrong.

Bill Mitchell, “Pushing the Fantasy Barrow,” February 25, 2010.
BIBLIOGRAPHY

Davidson, P. 1989. “The Economics of Ignorance or Ignorance of Economics?,” Critical Review 3.3/4: 467–487.

Davidson, P. 1993. “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3: 423–444.

O’Driscoll, G. P. and M. J. Rizzo, 1996 [1985]. The Economics of Time and Ignorance (2nd edn), Routledge, Oxford, UK.

7 comments:

  1. Even assuming rational expectations, couldn't Ricardian equivalence also be wrong because it can be rational to invest rather than save that money in order to give a higher rate of return?

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  2. Also, even assuming rational expectations, taxes do not necessarily have to be raised to pay back debt in the future.

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  3. Probably worth quoting Ricardo himself on Ricardian Equivalence:

    'But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. 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.'

    So Ricardo didn't believe Ricardian Equivalence and Say didn't believe Say's Law, yet we have people who believe both claiming they have the answers to our economic woes, and, worse still, being listened to.

    Sad.

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  4. Cahal, could you, or LK, explain what you mean when you say, "Say didn't believe Say's Law..."

    That would be interesting if true.

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  5. http://delong.typepad.com/sdj/2010/06/is-macroeconomics-hard.html

    DeLong wrote, "Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: "every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared..."

    The general glut, Say wrote in 1829, had been triggered by a panicked financial flight to quality which had led the Bank of England to shrink its liabilities:

    The Bank [of England], legally obliged to redeem its banknotes in specie... [t]o limit its losses... forced the return of its banknotes, and ceased to put new notes into circulation. It was then obliged to cease to discount commercial bills. Provincial banks were in consequence obliged to follow the same course, and commerce found itself deprived at a stroke of the advances on which it had counted, be it to create new businesses, or to give a lease of life to the old. As the bills that businessmen had discounted came to maturity, they were obliged to meet them, and finding no more advances from the bankers, each was forced to use up all the resources at his disposal. They sold goods for half what they had cost. Business assets could not be sold at any price. As every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared among merchants and among bankers, who having placed more bills in circulation than their personal wealth could cover, could no longer find guarantees to cover their issues beyond the undertakings of individuals, many of whom had themselves become bankrupt..."

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  6. Say changed his mind in the panic of 1829. Here he is in 1832:

    'Business assets could not be sold at any price. As every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared among merchants and among bankers, who having placed more bills in circulation than their personal wealth could cover, could no longer find guarantees to cover their issues beyond the undertakings of individuals, many of whom had themselves become bankrupt...'

    http://delong.typepad.com/sdj/2011/04/hoisted-from-the-archives-macroeconomics-is-not-hard.html

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  7. I read the comments over at the ThinkMarkets article, and I am a little confused; is Barro (and by extension O'Driscoll) saying that Keynesian policy recommendations (vis-a-vis government stimulus) boil down to "make tax-assessed transfer payments"?

    If that's accurate, then I've got to say: I am not a professional economist, and even I see a problem with that. Why don't they?

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