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.

The Concept of “Animal Spirits” is a Red Herring

Keynes discussed the factors influencing long-run expectations in Chapter 12 of the General Theory (the chapter is entitled “The State of Long-Term Expectation”). As is well known, Keynes thought that business expectations are subjective, not objective in the sense that objective probabilities can be given about possible future events affecting investment.

Keynes used the expression “animal spirits” but three times in the whole General Theory, and all towards the end of Chapter 12, yet the concept seems to cause a considerable amount of confusion.

The relevant passage where the expression occurs is here:

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death. (Keynes 2008 [1936]: 144).

The term “animal spirits” was borrowed by Keynes from Descartes (Gerrard 1994: 15), and it is obvious that Keynes did not seriously use it in the original sense of Descartes, to mean “the fiery particles of the blood distilled by the heat of the heart” (as quoted in Gerrard 1994: 15). Critics of Keynes complain that they don’t understand what he means by it. But unless such people are incapable of reading English, the definition is perfectly clear: Keynes uses “animal spirits” in the sense of “a spontaneous [human] urge to action rather than inaction.”

Now Austrians like Jerry O’Driscoll also complain about the use of the term, and also that Keynes’s “psychology was of the crudest” kind. The answer to all these complaints about the use of the phrase is rather obvious to me: all talk, and use, of the phrase and concept of “animal spirits” can be dropped entirely from Post Keynesian treatments of subjective expectations without any problem at all. Modern Post Keynesian subjective expectations theory has, anyway, developed itself by using ideas from contemporary psychology, and, even if Keynes’s psychology was crude, this is also irrelevant to the modern theory.

The concept of “animal spirits” as used by Keynes is not even necessary to the modern subjective expectations theory. So much of the discussion of Keynesian subjective expectations by Austrians descends into waving the concept of “animal spirits” around and complaining about it, when this is nothing but the red herring fallacy, the logical fallacy in which some irrelevant topic is invoked in order to divert attention from the original issue. What is more ridiculous is that most Austrians also adhere to the view that expectations are subjective.

Whether or not humans have a “spontaneous urge to action rather than inaction” is a matter for modern psychology, evolutionary psychology, neuroscience and cognitive science.

All that Keynes needed to say is that human beings can, and do, act in the face of uncertainty, whether that is real or perceived uncertainty. This statement that would be a synthetic proposition, whose truth can only be known a posteriori (i.e., by empirical evidence). Because of uncertainty about the future, expectations in the investment decision are not a matter of mathematical calculation.

In A Treatise on Probability (1921), Keynes had already dealt with the issue of probability, and had argued that under uncertainty the likelihood of future events came in different forms:

(1) that there are no probabilities at all (fundamental uncertainty),
(2) that there may be some partial ordering of probable events but no cardinal numbers can be placed on them,
(3) that there may be numbers but they cannot be discovered for some reason, and
(4) that there may be numbers but they are difficult to discover (Barkley Rosser 2001: 559).

By 1937, Keynes had come to stress the importance of uncertainty in the sense of (1) above in economic decision making:

“By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealthowners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever” (Keynes 1937: 213–214).

Expectations are subjective, and the investment decision is not rational (the word “rational” is here used in the sense of the neoclassical rational expectations hypothesis). Business people making investments are also influenced by what other business people are doing, and there can be general waves of optimism or pessimism. Keynes’ ideas on uncertainty and the consequences for expectations were taken up by G. L. S. Shackle (1952, 1955, 1969) and Post Keynesians (Dow and Hillard 1995; King 2002: 181-188; Dunn 2008: 69-116), and developed into the modern subjective expectations theory.

In essence, in conditions where a human makes a decision in the face of genuine uncertainty, he or she can (1) recognise that uncertainty or (2) fall into the trap of thinking they do not face uncertainty, perhaps by believing that they can provide objective probabilities for future outcomes. Either way most people have a propensity to act.

So what happens in the case of investment? People making investment decisions cannot know the future or give objective probabilities for many possible events affecting their decisions: uncertainty simply cannot be quantified in an objective, precise mathematical way. Their subjective expectations in the short or long run about the profitability and success of their investment influence the decision, and they are also influenced by what other people around them think.

Even a cursory reading of the specialist literature in modern cognitive and evolutionary psychology suggests to me that the Post Keynesians would have little difficulty in using modern theories to support their view of subjective expectations in the investment decision.

“Human beings make a vast numbers of decisions throughout their lives. Some of these have rather trivial consequences ... others have more far reaching repercussions ... In the 1970s Amos Tversky and Nobel Laureate Daniel Kahneman published some startling work suggesting that people are rather poor at making decisions in situations that involve some degree of uncertainty. In particular, Tversky and Kahneman proposed that much of our reasoning under uncertainty involves the use of heuristics. Heuristics are short-cut solutions to a problem, which are usually fast and easy to apply but which do not guarantee a correct solution” (Workman and Reader 2004: 230).

The “heuristic and biases” method of Tversky and Kahneman (1974; and Kahneman et al. 1982) described above appears to be a very useful approach which confirms and complements the Post Keynesian theory of business decision-making under uncertainty (Fontana 2009: 39–41). Keynes can be seen as having examined the heuristics and biases by which people in business make decisions about investment, with their use of instincts, conventions and habits of mind. But heuristics do not necessarily “guarantee a correct solution.” A decision not to invest might be wrong, just as a decision to invest can be in error. The cognitive bias in decision-making called the bandwagon effect is relevant to how investors and business people are caught up in the general state of expectations, how waves of optimism can cause more and more businesses to make investment decisions, or how financial markets are subject to rapid changes from bear to bull positions and vice versa.


BIBLIOGRAPHY

Barkley Rosser, J. 2001. “Alternative Keynesian and Post Keynesian Perspectives on Uncertainty and Expectations,” Journal of Post Keynesian Economics 23.4: 545–566

Davidson, P. 1991. “Is Probability Theory Relevant for Uncertainty? A Post Keynesian Perspective,” Journal of Economic Perspectives 5.1: 129–143.

Dow, S. and J. Hillard (eds), 1995. Keynes, Knowledge and Uncertainty, E. Elgar Publishing Limited, Aldershot.

Dunn, S. P. 2008. The ‘Uncertain’ Foundations of Post Keynesian Economics, Routledge, London.

Fontana, G. 2009. Money, Uncertainty and Time, Routledge, London and New York.

Gerrard, B. 1994. “Animal Spirits,” in P. Arestis and M. Sawyer (eds), The Elgar Companion to Radical Political Economy, Elgar, Aldershot. 15–19.

Harcourt, G. C. and P. A. Riach (eds), 1997. A “Second Edition” of The General Theory (Vol. 1), Routledge, London.

Holt, R. P. F. and S. Pressman (eds). 2001. A New Guide to Post-Keynesian Economics, Routledge, London and New York.

Kahneman, D., Slovic, P. and A. Tversky (eds), 1982. Judgment Under Uncertainty: Heuristics and Biases Cambridge University Press, Cambridge.

Keynes, J. M. 1921 A Treatise on Probability (1st edn), Macmillan, London.

Keynes, J. M. 2008 [1936]. The General Theory of Employment, Interest, and Money, Atlantic Publishers, New Delhi.

Keynes, J. M. 1937. “The General Theory of Employment,” Quarterly Journal of Economics 51: 209–223.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Koppl, R. 1991. “Retrospectives: Animal Spirits,” Journal of Economic Perspectives 5.3: 203–210.

O’Driscoll, Jerry, 2009. “Animal Spirits,” November 13
http://thinkmarkets.wordpress.com/2009/11/13/animal-spirits/

Runde, J. and S. Mizuhara (ed.), 2003. The Philosophy of Keynes’s Economics: Probability, Uncertainty and Convention, Routledge, London.

Shackle, G. L. S. 1952. Expectation in Economics (2nd edn), Cambridge University Press, Cambridge.

Shackle, G. L. S. 1955. Uncertainty in Economics: And Other Reflections, Cambridge University Press, Cambridge.

Shackle, G. L. S. 1958. Time in Economics (Professor Dr. F. de Vries lectures, 1957), North-Holland Pub. Co., Amsterdam.

Shackle, G. L. S. 1969 Decision, Order and Time in Human Affairs (2nd edn), Cambridge University Press, London.

Shackle, G. L. S. 1976. Time and Choice (Keynes lecture in Economics, 1976), British Academy, London.

Shackle, G. L. S. 1988. Business, Time and Thought: Selected Papers of G.L.S. Shackle (ed. S. F. Frowen), Macmillan, Basingstoke.

Shackle, G. L. S. 1990. Time, Expectations and Uncertainty in Economics: Selected Essays of G. L. S. Shackle (ed. J. L. Ford), Elgar, Aldershot.

Tversky, A. and D. Kahneman, 1974. “Judgment under Uncertainty: Heuristics and Biases,” Science (American Association for the Advancement of Science) 185 (4157): 1124–1131.

Workman, L. and W. Reader. 2004. Evolutionary Psychology: An Introduction, Cambridge University Press, Cambridge, UK and New York.

Post Keynesian Concept of Uncertainty goes Mainstream?

There is an interesting article in the Economist attacking the efficient market hypothesis, citing work by Roman Frydman and Michael Goldberg in Beyond Mechanical Markets: Asset Price Swings, Risk and the Role of the State (Princeton University Press, 2011), which relies, to some extent, on the concept of uncertainty in economic systems and the inability to calculate objective probabilities for important factors in the investment decision:

“A New Attempt to Explain Market Inefficiency,” Economist, February 24th, 2011.

This follows some good work by the New Keynesians G. A. Akerlof and R. J. Shiller in Animal Spirits: How Human Psychology drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009) that clearly approaches the Post Keynesian concept of subjective expectations.

All this is good news: the mainstream is catching up with Post Keynesians!

Addendum: The Concept of Uncertainty in Other Schools

Uncertainty in the sense of not being able to assign objective probabilities to economic outcomes and events in the future is an idea fundamental to Post Keynesian economics.

Daniel Kuehn in a post called “More on Keynesian Uncertainty” (March 1, 2011) makes some comments on my post, and wonders why I connect “Keynesian uncertainty to Post-Keynesians specifically.”

It is perfectly true that the concept is held by other economists. The neoclassical Chicago school economist Frank Knight drew the distinction between risk and uncertainty. But have the neoclassicals ever adopted his ideas? They have not. The New Classicals and monetarists adopt the ergodic axiom and rational expectations, which are not compatible with the Keynesian/Knightian concept of uncertainty which is not measureable.

Radical uncertainty – uncertainty in the Knightian sense – was also stressed by Keynes and made a fundamental part of his macroeconomic theory in the The General Theory of Employment, Interest, and Money (1936).

G. L. S. Shackle (1903–1992) also adopted the idea from Keynes, and Shackle was generally classified as a hybrid Austrian/Post Keynesian (or someone who drew “Keynesian conclusions from Austrian premises”).

The Austrian radical subjectivists in the tradition of Ludwig Lachmann also use the idea of uncertainty in economic systems, and correctly draw from this the conclusion that expectations are subjective. But it is quite clear that Lachmann was influenced to a considerable extent by Keynes and Shackle in this, as well as Mises, and that Lachmann criticised Mises for failing to extend subjectivism to the realm of expectations (Gloria-Palermo 1999: 128).

Lachmann and the Austrian radical subjectivists supported the subjectivist nature of value, expectations, and knowledge, and Lachmann denied that free market systems tend to equilibrium or have coordinating processes, which follows logically from understanding the role of money, time and uncertainty in economic processes.

But then Lachmann’s position is rejected by other Austrians like Kirzner as “nihilism,” so there are clear limits to the extent to which Austrian economics really takes these ideas seriously.

BIBLIOGRAPHY

Gloria-Palermo, S. 1999. The Evolution of Austrian Economics: From Menger to Lachmann, Routledge, London and New York.