Trichet on Ricardian Equivalence

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.)┬á 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.