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.