Arnold Kling  

Ricardian Equivalence and Stimulus Failure

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The graph at John Taylor's blog explains stimulus failure. (I wrote about the Cogan-Taylor work earlier, but it bears repeating.)

Everyone, including Keynesians, agrees that if Ricardian equivalence holds, then stimulus does not work. Ricardian equivalence means that the folks receiving the funds that the government borrows use the funds to save rather than to spend.

The Taylor-Cogan story is that in the case of the 2009 stimulus, a lot of the funds went to state and local governments, which promptly saved them (or, equivalently, reduced borrowing). The stimulus was not an increase in spending. Instead, it was a transfer between bank accounts. In other words, there was no stimulus. All the econometric modelers that applied their multipliers to estimate the effects of the stimulus are making bogus claims, because there was nothing to multiply.

If Taylor and Cogan are right (and I have not checked their work), then CBO, Blinder-Zandi, et al, ought to climb down from their claims that the stimulus saved umpty-ump jobs. That might be embarrassing for them, but it would show a willingness to be grounded in reality,

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CATEGORIES: Macroeconomics

COMMENTS (7 to date)
Joey Donuts writes:

Can someone explain why the data in Taylor's article (see link from Sam above) is so different from the data here.

B.B. writes:

Actually, no.

Is the misnamed Ricardian equivalence about expectations or about reality?

Krugman has made this point repeatedly, as have others. Suppose a block of households find that they are in debt, must make monthly debt payments, but find that their access to more credit has been denied. They cannot increase leverage, but they must deleverage. Such households are liquidity constrained.

They do save some because they are forced to. But after taxes and debt payments, they spend their net cash flow. It is the Keynesian consumption function. If they get a tax cut, they will spend it because the extra cash relaxes a credit constraint, even if they rationally expect their future taxes to go up.

So there is a role for aggregate demand policy using tax cuts.

Also lower interest rates would reduce the burden of deleverage for those with debt.

Joseph K writes:

Responding to B.B., I'm gathering your argument is that Keynesian stimulus can still work when people just use the additional money to increase their savings, because they'll spend it later (presumably once they increased their savings to a more comfortable level). If this is what you're saying, it doesn't seem to make sense to me. If you stimulate using taxes, then you've taken money from one sector, reduced their savings and spending (reducing their future spending) to give it to another sector. If you stimulate using debt then you're just increasing one sectors saving at the expense of another, increasing one's future spending and decreasing the other's. In the aggregate it just seems like zero net benefit.

Lord writes:

Believers in Ricardian Equivalence should also oppose the current tax proposal, but I don't hear any saying so. That might interfere with their prejudices. No, I don't believe states simply saved it; they would have cut spending much more without the funds. Politically money does have to be given to those not needing it to provide for those that do but that is politics. That says however it was not stimulus in a positive sense but in a negative sense; the economy would have been worse without it, but it did not improve it over its prior level.

Hyena writes:

Why would Ricardian equivalence suggest that, though?

If Ricardian equivalence does hold and debts are denominated in that country's own currency, then people would internalize the indebtedness less the expected value of future inflation to pay for those debts.

Given that it's the expected value of future inflation that drives Keynesianism of all kinds, that would seem to keep the two out of contradiction.

But why would we expect Ricardian equivalence anyhow? Doesn't it require there to be no discount rate? Even a rational one?

Miguel Madeira writes:

"Everyone, including Keynesians, agrees that if Ricardian equivalence holds, then stimulus does not work."

No, they don't

So let me try this one more time.

Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.

Is that explanation clear enough to get through? Is there anybody out there?

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