Jean Claude Trichet’s Jackson Hole speech is here. This bit caught my eye:
The economy, it is sometimes argued, is at present too fragile and thus consolidation efforts should be postponed or even new fiscal stimulus measures added. As I pointed out recently, I am sceptical about this line of argument. Indeed, the strict Ricardian view may provide a more reasonable central estimate of the likely effects of consolidation. For a given expenditure, a shift from borrowing to taxation should have no real demand effects as it simply replaces future tax burden with current one.
The written version of the speech cites two papers by Robert Barro as supporting evidence for this position.
I think it’s worth noting that the Ricardian equivalence idea put forward by Barro—that consumers see deficits and taxes as basically the same thing—has been tested many many times. And the general consensus on this, as I understand it, is that there is very little evidence to support the idea.
Moreover, though the idea works in one very simplified model set up, there are lots of reasons why the proposition does not hold in reality (liquidity constraints, people having finite lives, people not having rational expectations, uncertainty about the path of government spending—see this extract from David Romer’s textbook.) Very few economists emerge from graduate schools believing in the Ricardian equivalence idea.
There are, of course, lots of arguments in favour of European governments setting out their long-term plans for the restoration of fiscal stability. However, it is a pity to see economic theories that are known to have little support regularly rolled out as arguments for fiscal austerity.
Trichet follows up on his Ricardian equivalence comments by arguing that expansionary fiscal contractions “are not just a theoretical curiosity” with the footnotes citing the old Giavazzi and Pagno paper with its two examples: Denmark in the mid-1980s and, of course, Ireland in the late 1980s. I’ve already said my bit about this, so I won’t repeat it. Suffice to say, this is pretty weak evidence that Trichet is serving up.
58 replies on “Trichet on Ricardian Equivalence”
I am on the same page as you WRT Ricardian equivalence. Elegant in theory and reaffirmed in more recent times using micro foundations, clear empirical evidence isn’t available.
It’s tempting to role out that old quote from Keynes about policymakers being slave to scribblers and madmen. But I’ll resist it.
But don’t you find it depressing, stepping back from all of this, that we are simply rehashing all of the arguments from the 1930s as if there has been no progress in macro at all? We argue about whether fiscal policy will be contractionary or expansionary? And, more recently, there is demented debate in the blogosphere, sparked by a Fed Governor, about whether or not rasing interest rates now would be a good idea?
David McWilliams had an article on RE last week in the sunday business post: http://www.thepost.ie/commentandanalysis/if-it-looks-like-a-duck—-51191.html
This is what you get when a central bank is completly divorced from national treasuries.
Nations take the pain and the banks collect the interest.
The superiority of bank balance sheets over the money supply is now manifest.
As an non economist, can I pose a simple question. Should the government endeavour to expand the deficit or endeavour to contract the deficit at the current time?
Our government has little choice but to endeavour to contract the deficit given the reluctance of the bond market to allow us to keep borrowing at the current rate.
Others, however, have far more leeway to choose the timing of their adjustment.
Would market distortions as a result of excessive government spending not amount to the same thing Ricardian equivalence is trying to explain? Just curious about your opinion on this as this is an argument often used by laissez faire economists
I like Trichets conclusion about the apolitical economy – again he gives the classic central banker illusion of unique communion with God.
Maybe they should introduce more elaborate rituals when a new chairman is elected – white smoke coming out of Frankfurt may be appropriate but perhaps may convey echoes of another papacy which would be unfortunate.
Before people paint-up their caricatures with allusions to the 1930s, it should be recognised that the ECB was the first major central bank to react aggressively to the credit crunch 3 years ago this month with unprecedented emergency measures.
It also supported fiscal stimulus measures and banking rescues in the EMU.
Trichet isn’t calling for immediate Draconian measures in response to high debt but reform programs to reduce the high public debt which will be an bigger problem when some countries will face the burden of ageing.
For example in France, Sarkozy is proposing to raise the pension age from 60 to 62; Socialist party leader, Martine Aubry/Miss Thirty-Five-Hour-Week, opposes it.
Economists can argue about Ricardian equivalence and so on, but for a French male who retires at 59, may have entered the workforce at 24 and lives 24 years in retirement – – 48 years as a ward of the state, is it any wonder that the pensions system is bust?
France has to address its budget problems but Trichet knows as a former French treasury official that if longer term reform is not started now, it will just be put on the long finger once even a tepid recovery takes hold.
I don’t believe he wants a front-loading of big cuts now.
Karl Whelan said: “Our government has little choice but to endeavour to contract the deficit given the reluctance of the bond market to allow us to keep borrowing at the current rate.”
Even if we hadn’t to please the bond vigilantes, where there is a an annual deficit at about 56% of tax revenues, there would be again a case for beginning reform. That doesn’t mean just gutting the budget — it’s easier to slash costs thn implement long-term reforms.
Again as in France, if reform does not begin now, the vested interests will be back in control.
There are some reforms such as full transparency on public contracts, would cost very little.
Thanks for the reply. So whether RE exists or not is largely irrelevant if you are up against a budget constraint. Mark’s question is perhaps more interesting.
I think that you are a bit harsh in your assessment of Trichet’s comments. It might be difficult to pick up in the quarterly national income accounts but over a ten-year or so horizon, short-term painful cuts in excessive government budget deficits can pay for themselves several times over in terms of aggregate ten-year impact on GNP. It also is extremely state-dependent so that for example the long-run fiscal multiplier for Ireland at the moment is probably substantially negative, do you agree? Or do you think that for example in Ireland at the moment the long-run impact on GNP from a decrease in government expenditures would be negative? It seem counterintuitive to make such a claim.
So in essence, Trichet is correct if the time-horizon is long enough and the state of the economic and fiscal environment (e.g., Ireland 2010) is the correct type.
When the UK cut its fiscal debt in the 80s it exploded its monetory debt – this credit money did not create wealth but simply converted the BTUs of the North Sea into consumption.
It multiplied these policey failures by running down utilities to create a short burst in profit and consumption.
Again I repeat, the central banks cannot create any wealth they can only transfer it from one area to another.
The era of credit creation to propel consumption is over as the resourse capital extraction has to be increasing to make it work.
Capital has to be used to create wealth again – I remind you that the monetarist regimes of the UK produced only one nuclear reactor during those years and one channel tunnel – the rest was just fluff.
“Or do you think that for example in Ireland at the moment the long-run impact on GNP from a decrease in government expenditures would be negative?”
Given that we are taking the money saved by cutting spending and simply chucking it down the toilet that is our banking system, then I would say yes. We will end up with low spending now and higher taxation in the future to pay for our banks.
In the general case, Trichet can only be right in very benign economic circumstances. If households and businesses have their backs to the walls, the promise of low future taxation will not matter a damn.
The ECBs artificial 3% deficit rule is at the core of the disaster in the EU.
German and French savers were forced into speculative monetory instruments that blew up the primitive economies of Iberia and Ireland.
Concentrating on fiscal spending is a absurdity in this situation.
Monetary debt needs to be destroyed and fiscal debt expanded.
Why should France give up its ability to run high fiscal deficits ?
The French executive is one of the most effective bureaucracies in the world – its strategic investments have been proven to be the most wise and far sighted of all goverments.
Concentrating on increasing the reteirment age is a absurdity in a age of high unemployment – we are not a slave / beast of burden economy – we reley on high density energy to maintain our wealth ,not a slave class – their function is merely to serve the needs of the wealthy not to increase wealth.
@ Gregory Connor
Have you any evidence to back that up?
Surely it all depends on what the government spends the money on (or cuts). At the moment we can borrow at about 5%. The govt should spend money on any project that will give this return or greater. Due to the large amount of money spent on dole payments the cost to the government of employing someone on such a project is greatly reduced.
Due to the huge amount of slack in the economy and credit constraints for the private sector the fiscal multiplier is most likely greater than normal.
No, Trichet is not ‘essentially correct’. He is arguing for a generalised fiscal tightening starting now (not at some vague time in the future) in all deficit countries. And he is using Ricardian equivalence to back his policy prescription. He is not using the Irish example to generalise.
And how can we possibly know what the 10 year fiscal multiplier is? You need a model. And your Ricardian one sets up one answer. And Ricardian equivalence, across the literature, only holds in very unusual circumstances. Those circumstances may or may not obtain in Ireland at the moment – a negative fiscal multiplier may obtain, but possibly for reasons that Ricardo could never have imagined.
This is about formulating macro policy – Ricardian theorising will make for very bad policy with very bad outcomes.
This is an example of why economics is in disrepute. We have academics arguing over an obtuse theory for which there seems to be very little imperical evidence. In any event the debate is as irrelevant as cut and thrust over angels on pin-heads beloved of jesuits.
All you need know is that public sector debt levels and deficits across the European union and the G7 are increasinly not being funded by private markets. This determines the stance of fiscal policy does it not?
If Trichet came out and said “we must tighten fiscal policy because there is nobody who will buy this crap….other than me” would he not be telling the truth?
CJH could have been correct when he said that you should give an economist a room at the end of a long corridor and send a porter periodically for his work.
Geoffrey Howe could have been correct as well with his witty aphorism but that is a another story.
@tull: the Germans are having no trouble at all selling bonds. It is important to keep the distinction between countries like Ireland and countries like Germany in mind.
As regards disputes among economists: Karl is right. Not many people I know take Ricardian equivalence seriously since the empirical evidence refutes it. That is why it is so disheartening to see the ECB head coming out with this nonsense.
But Michael Hennigan is also right to point out that the ECB has been quite pro-active during the crisis thus far: its bark has definitely been worse than its bite.
@ Greg and others
My scepticism of Trichet’s comments isn’t particularly related to the current Irish environment. He’s not talking about us, he’s talking about Germany, the UK and elsewhere and implicitly wagging his finger at the Obama administration for disagreeing with him.
Ireland, of course, does come into this discussion partly, because Trichet is citing a study that has a pretty inaccurate representation of a particular episode in Irish economic history.
As for current circumstances, yes they call for further fiscal austerity. However, for a number of reasons, I’m not holding my breath waiting for the E that this FC is supposed to trigger.
OK – lets keep it simple stupid
Banks will not be able to to produce credit this side of armageddon.
And people want to reduce the fiscal deficit!!!!!!!
All money is debt stupid.
If you reduce the money it will automatically produce a contraction – this is economically speaking equilivent to Newtons laws of motion – it cannot be refuted unless you can come up with a elegant theory that can be tested accurately.
The question that needs to be answered is will the money try to stimulate more consumption in a capital free fire zone (fail) or will this money go to capital/wealth creation.
Economics is the only “science” that seems to want to increase the complexity of a model to explain reality.
Its a sad reflection on the politicized state of this “science” that amateurs with a engineering and scientific background such as Steve Keen and Dilleinger accurately predicted the crisis.
The psychobabble such as Ricardian nonsense should be drop kicked through the goal posts of life.
How flawed economists who pontificate into infinity about this situation when even fools like my self as seen this train coming down the track is beyond my comprehension.
Again, there is almost certainly no opportunity for Ireland to go for any stimulating plan – since we’re too close to a major edge effect, i.e. a loss of lender confidence.
On the general point, it would be interesting to see literature on the validity of RE in “hard money” vs “soft money” situations. Historically I think it’s reasonable to say that it’s been rare for a population to have to actually pay back a deficit. Inflation or devaluation usually runs into the game eventually and “solves” the problem by screwing some people, or everyone.
Similarly, while it’s easy enough to suggest that history shows people don’t modify their spending in a way that matches Ricardian equivalence, central banks have long experience that people’s inflation expectations are hugely important and that they can be modified by experience and by PR.
Is it possible that the population’s Ricardian expectations have been changing over time – as the Euro and low inflation beds in – and that people may now be expecting to really have to pay back the deficits? Would that make low multipliers more likely? Just asking..
My central question on all of this is “will the Germans win?” If the German approach to money wins then the deficit will have to be paid back and extra spending now will be very painful in the future, and visibly painful.
I say if the Germans want to go all Teutonic on us then our only option is to stuff some worthless mortgage paper in their face.
It is now becoming a civic duty not to honour our mortgage paper both individually and collectively.
After all these bastards can produce all the money they want for their buddies but will have to use more forceful means to make sure Celtic cretins honour their debts.
Bring it on.
For someone who dislikes economists so much, you seem to spend a lot of time on a site populated by them. Why not give yourself a break and move over to some other site for a while? (FictionalTDs.ie?)
Surely you’ve better things to do with your time than waste it typing out tired old Haugheyisms?
Bond investors should be very careful here. The odds favour 2 outcomes:
a) a default by the periphery which means that the Core Europeans do not get all their money back -negative nominal returns b) a bail out of the periphery via higher inflation which means negative real returns for Core European investors.
First JTO and now Tull, who is next? Who is next to feel the wrath of Karl?
Wasn’t Wrath of Karl a Star Trek movie?
“Have you any evidence to back that up?”
It would require re-estimating the Bradley-Whelan 1998 magnum opus allowing for a much longer lags, with the lag structure not simple reduced form but rather tied to inward investment and productivity improvements over the post-1987 ten years. That is challenge – I will put it on my to-do list, unless someone beats me to it. I conjecture that the sufficiently long-run effect of the 1987 fiscal tightening was aggregate-GNP positive for Ireland, without providing convincing direct empirical evidence. Ten years seems about right to me to get the correct sign and reasonable magnitude in that specific case. Sorry for the technical comment.
@ KC: Keith, I mentioned this before – ‘they just ain’t paying any heed to you. Either they do not understand what you are saying, or they do, will ignore you, and hope you will get frustrated and go away. The math is against them. The finite set of global resources is against them. The immutable laws of Physics and chemistry are against them. However, when you have constructed an heroic and very successful failure – sure you must keep with the programme!
I have formed the opinion that there exists an inverse relationship between the level of a persons theoretical intellect and their ability to get a meaningful grasp of reality – the late Richard Feynman is excepted!
We (the developed economies) are all deficited out. So we must produce something to sell to make a negative deficit. Just what is it intended we produce, at such a low cost, that is in such high demand, that commands a nice high price and produces that elusive negative deficit? Actually, who are the buyers for this wonderful product? Deficited out by the looks of it!
Our developed economies are in the process (very SloMo) of regression to a previous lower level of activity – say about the mid-1990s.
I’m sure you know this as well as you know Ricardian equivalence but it was Wrath Of Kahn.
“It is now becoming a civic duty not to honour our mortgage paper both individually and collectively.”
It’s nice to have a clear understanding of someone’s values.
Thats a slightly cryptic response for this simple soul – are you casting dispersions on my character ?
Speak plainly – I have little time for cat fights.
Dogfights are much more fun.
I think M. Trichet is talking about Germany and German expectations. Anecdotal evidence suggests Germans save more in anticipation of inflation or reduced future state benefits (later retirement age). Given that one of the imbalances that exists in the eurozone is the lack of consumption within Germany and that the Mittelstand is concerned about the size of the deficit, this would seem to be a case of Ricardian equivalence in point. No?
As Reinhart and Rogoff point out, domestic default, often in the form of abandoned future obligations, is both less visible and more prevalent than external default of sovereign debt. In that case, expectations of future payouts at current levels lead to a rise in saving at a time of economic hardship.
The discussion of the reintroduction of college fees and the raising of the state retirement age has this anonymous poster saving more on two fronts.
How many microeconomic factors make a macro one dancing on the head of a pin?
Ah a Trekkie! A man after my own heart. It should be noted Karl, that The Wrath of Khan* starred another Ricardo, a Mr. Montalban as Khan.
* simpleton – please please do not mis-spell it as Kahn, it breaks my heart just like that other notorious mis-spelling Ghandi.
I’ll claim a typo rather than a mis-spelling. Either way, if that’s all it takes to break your heart can I suggest therapy?
I read through the Brad De Long extract that KW linked to above. I picked out some sentences, which caught my eye.
We had a situation in Ireland (driven by policies such as de-centralisation), where our government was borrowing through the citizenry, rather than on behalf of the citizenry. There is a strong argument to suggest the Irish government of the last decade paid a huge interest on such vicarious borrowings. I refer you to an RTE podcast available through iTunes, about taxation and local government, an interview from 2008. It is podcast no. 9 on the list at the link below. We had something called stamp duty which was very high indeed and was a tax on transactions with property. The central government managed to divert most of that for its own use. Which is in marked contrast to a property taxation which would flow to a local government.
As a result, the household has little incentive to increase its saving. Instead it can indulge its high discount rate and increase its consumption, knowing that its tax liabilities will be high only if its income is high.
This does resemble Ireland quite a bit. It is not as if, many households engaged in some way in construction activities during the Celtic Tiger in Ireland, didn’t realise their party would end abruptly at some stage. This is where the comments of people such as Chris Horn do come in useful, to enlarge the debate about Ireland’s capacity for wealth creation. That is, we do not create enough. Various political factions talk about re-distribution of wealth. But what wealth do they mean? I worked side-by-side with people valued in hundreds of billions of euro during the Celtic Tiger. None of whom, have a pot to pee in now. BOH.
God I hope we can go back to the early 1990s and not the 1890s.
I need a computer, some decent food and modern beer to have a good look at this train wreck.
Drinking archaic porter will do nothing for my insides.
@simpleton: BTDD 🙂
I had thought these ideas on Ricardian equivalence were widely recognised as nonsense, its supporters confined to to the more excitable members of the blogosphere. It is extremely worrying they find support from someone in Trichet’s position, but then all his recent comments have become increasingly eccentric in support of fiscal tightening.
The ‘theory’ assumes that income flows are fixed, and that by increasing today’s consumption tomorrow’s will necesarily be reduced. But no economic agent operates in that way with regard to either consumption or, more importantly, investment, since the latter increases future incomes.
This economy provides a practical demonstraton of that. Under the Barro/Trichet view increased government spendng and tax cuts during the boom ought to have set private sector alam bellis ringing. They would ‘know’ this was unsustainable and reduce inveastment and consumption in response They did the opposite.
Romer says this is imperfect knowlege. Perhaps. But then none of us has a crystal ball. Maybe the inducement to increase consumption arises from the fact that the pro-cyclical fiscal policy encouraged that increase? Just as the pro-cyclical policy now is encouraging contraction.
Investment (GFCF) has fallen for 12 consecutive quarters, for a peak-to-trough decline of nearly €32bn, greater than the fall in either aggregate GNP or GDP.
It may be that M. Trichet recognises that any salvation for the PIGS will require some measure of haircuts for the bond investments in the PIGS financed by savings in the core EZ countries. Once this begins to take shape it is likely the bond market will drive up the cost of funds in the EZ; and to make the haircuts palatable there may be a requirement for some fiscal compensation of the savers affected.
The fiscal position of the core EZ countries will need to be rock-solid to weather this storm. Perhaps M. Trichet is scraping the economics barrel to find additional reasons to shore up the fiscal position in the core EZ economies.
Let me weigh in on my favourite bug bear – crowding out.
Let us suppose that RE in the classical form does not hold because consumer/taxpayers are too myopic. This seems to be the main sort of objection that Prof Whelan and others have to the elegant logic of RE.
So then govts borrow in recession. Consumers, blithely unaware of the fact that they will have to pay this money back (I really know people like this!) keep spending heavy. What happens?
What happens is investment is directed away from the private sector and into the public sector. This happens because interest rates rise for entrepreneurs, while companies securing public contracts are in effect beneficiaries of state-backed (hence cheaper!) funding. In effect, the Big Gun that is the State (ultimately the State is a bunch of police guys with big guns) points itself at the money and says “go into the public sector, or I’ll shoot you”.
Now, if there is no RE, as Prof Whelan and others suggest, because of myopia etc., then the net effect of this intervention will depend on whether the public sector is more or less efficient at investing than the private sector. I’m not sure the answer to this is always what the economists instincts demand, but it should be clear we are an awful long way from digging holes and filling them in again.
If, on the other hand, there is RE, not only does the govt have to invest so very wisely as to secure a greater return that the private investment they just crowded out, but they also have to provide a return to compensate the economy for the overall mismatch in the allocation of income to consumption versus investment which the RE implies.
It seems to me the odds are stacked against the government on this one.
Michael Burke says:
The problem is, we know that [central] government expenditure in Ireland increased after the increase of expenditure by the private sector. Not the other way around. Summed up by the famous Charlie McCreevy phrase, when I have it, I spend it.
Because the more stimulus via tax incentives etc, that central government could provide to the private sector, the more taxation the same government effectively gleaned from consumption of property by ordinary citizens. As I mention above, there is a big debate at the centre of this, to do with local versus central government. I don’t think that debate has fully resolved itself yet. Not by a long stretch. In the podcast I linked to above, councillor Eric Byrne relates that one traffic management decision in Dublin city requires no less than 44 separate bodies to be consulted.
I am not a big fan myself, of each local authority having its own planning, housing, water department etc. I believe more centralisation of these services will make a lot more sense. But on the other hand, we have to ask what could local government perform more efficiently? Of course, lets not forget Mr. Trichet either, and that layer of governance above and beyond the ‘central’ nation government. And then, on top of that, the friction between the ‘parlimentary executive’ and the house of parliment in Ireland, which has caused such problems this year. Not to forget either, the fact our minister for health (and associated dept. of health, the permanent branch of government), have out-sourced so much to the HSE. It is all rather confusing, and overall there appears to be a lot of dilution of responsibility, and a whole lot of government to support through collection of various taxes. As I said, the government at the various levels requires the citizenry to spend, in order that government can spend also. It seems to be in the interests of governments to create excessive bubbles to fill their coffers as fast as possible. Hence the need for regional booms, influx of foreign capital, population and so forth.
I think that Diarmaid Ferriter’s excellent documentary series, The Limits of Liberty, developed on the points of the earlier radio programs. The entire radio series I linked above, was called What if, and is available from RTE via iTunes. BOH.
I have yet to see a good empirical paper on Ricardian equivalence. A near impossible nut to crack I fear. You need a long time frame, but as you go longer, too many other factors intervene.
As for Trichet’s speech, how many have read it? Expectations play a
big role in the ECB’s thinking. It is not a simple call to slash spending and raise taxes. Ireland however is a special case, with the largest eurozone deficit for several years. And it is at real risk at some stage of losing sovereignty of its economic affairs if policies
do not start supporting long term stability. How do you want to
integrate that into a prospective fiscal multiplier, or demultiplier?
We do know that an unexpected increase in the budget deficit boosts the current account deficit (from standard intertemporal models eg Rogoff, Sachs). Is that desirable for Ireland. More of the same medicine?
Assume than that Ricardian Equivalence does not hold. External debt than rises. And that happens even if households are credit constrained (Kumhof + Laxton, and Philip Lane has worked on this too). And there is plenty of evidence indicating tighter budgets vs trading partners can lead to real depreciation.
A much longer term view would posit that the recurring sovereign
crises are the result of diabolical demographics (eg Foot at Toronto
and Dyson at LSE). I’d argue that the paltry growth we are seeing
today is partly the result of governments unable to come to terms with ageing, and allowing deficits sky rocket. How do you want to integrate that into Ricardian equivalence?
Anyway it is quite disturbing that, in Ireland of all places, there
should be so many voices accepting that the government stay the current course with irony of ironies, the connivance of the ECB and the EC (talk about looking a gift horse in the mouth!).
“…it is quite disturbing..etc”.
I expect you meant “not accepting”. Or am I missing something?
Ciaran O’Hagan says:
The big problem is we are still trying to decide in Ireland what sovereignty of our economic affairs, might actually mean. Because, there is no evidence to suggest we have achieved the right balance and distribution of duties between the European central, national central and national local government layers. In a very real way, our sovereignty definition has to be expanded in the coming years to embrace more ground on the upper (European) end, and on the local regional level. With less ground in the middle, for the central national sovereign executive. Those are quite deep debates and extend far beyond economics alone.
Lets bear in mind also, that many of our critical social systems in Ireland were merely central government grafted on top of systems of the Catholic church. You don’t have to go very far back in Irish history to find a time, when the Church held a lot of sway at all levels, from the European down to the very local. I think we are still working through that process, in addition to everything else. The Health Service Executive, where central government outsourced duties bound to the dept of health, of the central national government – is a prime example of a difficult resolution with the past, and Church influence.
What is that phrase that Garret Fitzgerald often uses? Pre-modern society. BOH.
“Again as in France, if reform does not begin now, the vested interests will be back in control.”
Have they ever lost control – even during the response to the crisis?
see Simon Johnson’s article linked by Philip Lane here
“There are some reforms such as full transparency on public contracts, would cost very little.”
Of course, were it not for Eddie Molloy’s Severe Implementation Deficit Disorder, which may be related to the above
Eddie Molloy misses one key point is that as one experienced public servant put it “When you talk to the politicians they blame the civil servants and when you talk to the civil servants, they blame the politicians”
I wrote a block in July 2009, which I entitled 1979, in which I tried to examine some of the issues, regarding Ireland and its distribution of responsibilities for economic sovereignty. It seems kind of appropriate to this discussion. BOH.
Occam’s Razor and Barro’s Paper
Barro’s paper “Are Government Bonds Net Wealth?” (available for free outside the pay wall, courtesy of the Harvard economics department, at http://dash.harvard.edu/handle/1/3451399) gives an elegant and convincing defence of Ricardian equivalence – it is the paper which ignited the modern debate. Arrayed against the clarity and elegance of Barro’s theoretical insight is a barrage of contrary empirical evidence from over-fitted quarterly macro models. Sometimes the clear, big-picture insight is important when thinking about long-run relationships.
Economic theory is well stocked with clear and elegant proofs of propositions that turn out to be wrong. Forget the overfitted quarterly models, many of the crucial underlying assumptions of the proof clearly don’t hold.
For starters, why would someone react to the emergence of a large fiscal deficit by assuming that the path of government spending will remain unchanged, so that the PDV of taxes remains the same?
An increase in taxes is what it is, an increased deficit on the other hand may trigger increased taxes in the future or it might trigger lower government spending. Certainly there’s no sensible reason for someone to assume that a €1 billion deficit will have the exact same effect on their present discounted sum of tax payments as a €1 billion tax increase.
KW says: Economic theory is well stocked with clear and elegant proofs of propositions that turn out to be wrong. I wrote about 12 months ago on my designcomment blog. BOH.
@ Gregory Connor
But surely it depends on what the government is spending its money on. Suppose there is a public good that only a government would invest in. Would it not make sense for a govt to borrow the money at 5% if it gave a return of 6%? As a rational person I would think to myself that this government spending will lead to lower taxes in the future. The bonds may not be real wealth, but the infrastructure is.
Alternatively, suppose the government has two choices 1) a programme of spending in mind, and is going to finance it not through borrowing but through taxes each period regardless of where we are in the business cycle or 2) The government can take a smoothing approach and borrow to invest during down turns when there is plenty of spare capacity in the economy. I know taxes will increase during the next upturn, but I still know the smoothing approach will lead to lower taxes over the business cycle.
Are there any papers that deal with Ricardian equivalence with some form of business cycle model?
Interesting article here http://www.bloomberg.com/news/2010-08-30/austerity-hawks-lose-their-celtic-poster-child-commentary-by-matthew-lynn.html
Barro treats the case (your paragraph 1) where the government has high-return investment opportunties. In terms of implicit forecasts (your paragraph 2), Barro uses Radner’s equilibrium of plans, prices and price expectations which is standard in these model. In a Radner dynamic equilibrium, noone knows which random state will occur in the future but each actor creates a rational plan based on knowing the impact of prices etc. of everyone else’s rational plans. It is essentially a dynamic variant of a Nash equilibrium with the extra assumption of a competitive market. As Karl Whelan notes above there are problems with the specication of a Radner type dynamic equilibrium and it can lead to model flaws. So for example we might use in the model the wrong assumed plan for the future government state-contingent tax and spend policy. Radner-type equilibrium can be a problem but there is no alternative, they just need to be specified appropriately and with sufficient care.
One small qualification.
When we speak about central government in Ireland running a deficit, it is hard to find the evidence with the various departments investing in specific projects. However, when we look at the various semi-states or quangos established by local government, it is there were visibility of borrowing appears. For instance, the new Terminal project by the Dublin Airport Authority, or the Irish Glass Bottle site, where the DDDA was concerned.
Our government borrowing appears to be divided by industry sector, rather than by geographic region. Maybe this makes the investment easier to manage and track. I assume it does. But it also muddies the waters, from the taxpayer point of view. As very little tax-take ends up being spent by the local authority, and more of it diverted in ‘sectors’ by the semi-states and quangos. The semi-states were a 1950s creation by Lemass. The quangos seem to be a 1990s phenomenon, from the Ahern-McCreevy era. BOH.
Correction: However, when we look at the various semi-states or quangos established by central government, it is there were visibility of borrowing appears.
I think you have proved my point for me.
Private consumption continued to increase after public spending rose.
@ Michael Burke,
I don’t argue with your point Michael. However, it is important to insert that qualification. We are unsure if, at certain times the government spending increased first, or the private consumption. My guess, at various times one or the other took the lead. The private consumption became an engine for public spending, or visa versa. I just wanted to insert that qualification. We shouldn’t make automatic assumptions about sequence, when it comes to these matters.
It is worth stating the obvious maybe – that a stamp duty tax on a residential property in Ireland during the Celtic Tiger could easily amount to €30k. If we were really efficient in Ireland, that sum might be enough to pay for a property tax, a water charge and a bin charge for 30 years. I know I am stretching a point a bit there, but the local authority would receive a recurring payment, and the taxpayer might see a return for their money.
I just want to tack on something else if I may. We have the comment recently at the Irish Economy blog, that departments within central government in Ireland, other than finance, didn’t worry unduly about economics or finance. Their attitude was, that was the dept. of finance’s job only. On top of that, we had the added complication in Ireland, that our banks were given a monopoly and a huge degree of freedom to dictate the economic policies for the entire private sector. This is the issue I scratched at in my blog entry, 1979, a year ago. But I don’t fully know how to develop the argument any further. I just said I would mention it again. It is a bit like dept. of health outsourcing duties to HSE.
In Ireland, we have a large permanent government, which outsources economic responsibility to a dept of finance. Which in turn outsourced a large amount of responsibiliy since the 1970s, to private bank institutions. Clearly, a deep study of that arrangement is overdue. BOH.
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