Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Wednesday, December 28, 2011

Ricardian equivalence, for the last time

Ah, controversy. What a great way to end the year!

I want to comment on Mark Thoma's post today about the Ricardian Equivalence Theorem (RET). Linking up to the interview with Barro was a good idea, Mark. Everyone agrees that the theorem has nothing to say about the effectiveness of G, and Barro explains all of this splendidly. Moreover, everyone agrees that since the conditions needed to render the proposition valid are violated in reality, the proposition cannot possibly be expected to make a perfectly accurate prediction of how altering the timing of taxes (holding G fixed) is likely to impact the economy. I guess that this is about where our mutual agreement ends.

What is there left to argue about? It's the holidays--I'm sure we'll find something. Let's start with Mark's opening paragraph:
I haven't said much about the recent flare up over Ricardian equivalence. Why? The answer's simple, the empirical evidence does not support it. Why argue about something when we already know it fails to adequately explain the data? Making the Ricardian equivalence assumption might be okay as a first approximation for some questions--though I'd argue that it mostly isn't--but in any case the theory does not adequately capture economic behavior.
I'm not exactly sure which flare up he is talking about, but I suspect that I may be involved in it somewhere, owing to this post here: Does Krugman Understand the Ricardian Equivalence Theorem?

I want to clear up a few things regarding that post. First, I was not trying to defend Lucas' views on fiscal stimulus. Lucas's view on the matter (insofar as one can gather it from what was clearly an informal and off-the-cuff speech) appears to be that a money-financed increase in G is stimulative, while a tax-financed increase in G is not. Now, there may be several ways to criticize the "rationale" of his argument. But whatever criticism you pick, it most certainly cannot be centered on Lucas' alleged appeal to the Ricardian equivalence theorem. For crying out loud--the man is claiming that the method of financing matters for a given G. This can only be true if the Ricardian proposition fails to hold in reality.

Now, what of Mark's claim that the empirical evidence does not support the RET? Well, as I said above, given that we live in a world of distortionary taxation, borrowing constraints, finite planning horizons, etc., etc., it would indeed be remarkable if the predictions of RET held up exactly in the data.

But surely that is setting the bar a little too high (not one of us has a theory that can perfectly predict such outcomes). Rather, the question is whether or not the assumptions constitute sufficiently good approximations for the purpose at hand (i.e., for a given policy experiment). Indeed, in the interview posted by Mark, Barro states his view on the matter quite plainly:
As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow...
So, to Barro it seems that the empirical evidence broadly supports the proposition, at least, to a first-order approximation. If so, that is bad news for me, because I like to work with models where the proposition fails. It would, however, be good news for those promoting an increase in G in the face of large deficits (the size of the deficit should not factor into the debate, if the proposition holds true).

In any case, I'm not sure whether Mark's claim about the empirical evidence not supporting RET is entirely valid. I am reminded of a paper I once saw Emanuela Cardia present: Replicating Ricardian Equivalence Tests With Simulated Series. Here is the abstract:
This paper  replicates standard consumption function  tests of Ricardian equivalence  using series  generated from  a  model which nests Ricardian equivalence within a  non-Ricardian alternative (due  to finite  horizons and/or  distortionary taxation). I show that the estimates of the effects of taxation on consumption are not robust and that standard tests may have weaknesses which can lead to conflicting results, whether Ricardian equivalence holds or not. The simulations also show that no clear conclusions about Ricardian equivalence can be drawn from observing a low correlation between the current account and government budget deficits.
In short, I think that the empirical evidence may be somewhat more mixed than what Mark suggests.

At the end of the day, I think that the key lesson of the RET is not (for example) that "deficit financed tax cuts do not matter." Rather, the lesson should be that "such a policy is likely to be much less stimulative than you would expect if you were to base your thinking on a model that did not incorporate Ricardian forces."

Now who wants to argue with that?

19 comments:

  1. I do not hold a PhD in economics. However, I can tell you that the government's fiscal position at present has no bearing on my decision to take a vacation this summer. In other words, I'm not basing my vacation decision on how the government is going to finance its current massive budget deficit. So would you then say that this at least provides some anecdotal evidence that the RET is valid -- since I don't care how our budget deficit is going to be financed? What if I told you that I also don't care if the government borrows $1 trillion more for infrastructure spending? I'm still going on that vacation. Is this also proof that the RET holds? Are all RET supporters then also supporters of massive fiscal stimulus, since deficit financing methods have no bearing on consumer behavior? Obviously not. And I think this is what Krugman is getting at. All RET supporters are vehemently against fiscal stimulus. It's sort of disingenuous of you to leave this out and describe the RET as a matter of only deficit financing methods. The fact is, the effectiveness of fiscal spending is a crucial part of the research and discussion around the RET. Sorry, but I think Krugman has got you beat.

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  2. David Andolfatto:
    "For crying out loud--the man is claiming that the method of financing matters for a given G."

    I do not see that.
    Lucas:
    "If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policyWe don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part."

    Apperantly he (all the sudden) thinks monetary policy can have a effect - or does he call fiscal policy with printed money "monetary policy"? If the later is the case, I guess you are right, but i thought "monetary policy" usually refered to the effect you aim to get through interest rate effects.

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  3. I think one of the more persuasive pieces of evidence is provided by David S. Johnson & Jonathan A. Parker & Nicholas S. Souleles, "Household Expenditure and the Income Tax Rebates of 2001," AER (Dec 2006):1589-1610.

    They use the fact that tax rebates were mailed out at different times to different households in a more or less random way (it depended on the last few digits of the social security number) to estimate the consumption response of a tax rebate. The setup provides them with a "natural experiment". Cribbing from their abstract, they found that 20-40 cents of the rebate was spent on nondurable consumption in the quarter in which the rebate was received (and more in the subsequent quarter), with higher fractions going to those who you would expect to be "credit constrained".

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  4. Joe: I'm sorry, but I'm not sure I understand what you are saying.

    Anonymous: Yes, Lucas is what Williamson calls an "old monetarist" in the Friedman tradition. Go and read the full speech. In it Lucas admits that he finds it difficult to distinguish between monetary and fiscal policy. He calls a money financed increase in G monetary policy, but is not sure...maybe it is fiscal policy. It really does not matter what we label it. Krugman clearly does not get it.

    Angelo: Ah yes, thanks for that reference! I do remember seeing that paper too, but could not recollect it.

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  5. Krugman has noted the common occurrence of people claiming he "doesn't get it" (hasn't understood the depth of their thought) when in fact the other guy has just made a simple intellectual error. I don't mean to slip too deeply into argument by authority, but there is a decade-long history of people, including some serious light-weights, claiming that Krugman doesn't understand economics or got his math wrong or whatever. Dismissing Krugman as unable to grasp an economic argument is a mighty suspicious thing to do. You can't after all, look into his head to know.

    And what a coincidence. I have had people tell me I don't understand them when I simply disagree with them. It seems like this "does not get it" approach to argumentation tempts one into error as often as not. It's a cheap and easy way to move around an objection to one's point that can't be gotten over.

    Allow me to state my point more briefly. No party to an argument is qualified to say that another party has been unable to grasp the first party's point. It may be true, but you can't usually know it to be true and really shouldn't be relying on dismissing the other guy's grasp of the issues to go for the win. Your job is to make your argument. Dismissing Krugman in no way does that.

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  6. Thank you, Anonymous. I can only assume that you sent the same message to Krugman, right?

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  7. I'm just saying that almost every discussion I read about the RET is related to a discussion about the effectiveness of fiscal stimulus. You never hear anyone putting a vacuum only around a discussion about financing methods -- which is what you have done in your original post, by saying that "[t]he G is so unimportant in the RET, that it is useful to ignore it completely" and only focus on how G is financed. It may be true that, theoretically, the RET is only about financing methods, but almost every description of the RET includes the implication that consumption will be unaffected by debt-financed fiscal stimulus -- see, for example: http://www.econ.hku.hk/~wsuen/ls/immortal/r2.html. Just Google the Ricardian equivalence theorem and see for yourself.

    The point is, it seems to me that you're attacking Krugman for linking a discussion about the RET with a discussion about the effectiveness of fiscal stimulus, but almost every one always does this! I'm not saying that Barro necessarily did this in the quote Krugman showed, but it's a fairly common thing to do.

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  8. But Joe, the irelevance of financing decisions is what RE actually says.

    The fact common usage is different is not part of an argument about who does or doesn't understand the theorem.

    I don't recall David once accusing Krugman of misunderstanding the common usage of the theorem, he claims only that Krugman has missed what the theorem itself actually says.

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  9. OK, then I would please like David to provide all of the links to posts in which he has previously criticized conservative economists for using the RET as a platform for railing against fiscal stimulus. If it's a mistake for Krugman to use the RET to claim that stimulus works, then it's also a mistake for conservative economists to use the RET to claim that stimulus doesn't work. And yes, it literally took me 2 seconds to find a conservative economist using the RET as a platform to claim that stimulus doesn't work: http://everydayecon.wordpress.com/2009/02/09/the-stimulus-will-fail/

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  10. You are right to point out that the argument Krugman uses to dismiss Lucas, even though logically flawless (at least in my knowledge of macro) can't be labeled directly a Ricardian Equivalence argument, at least if you are so petty sticking to textbook denominations. Nevertheless, It is actually not right to write up a post like you did and to cling to denominations. and not logical consistency, or factual relevance of any argument to make a "point" against another scholar.
    I wonder why so much people like you, who are yet active in research life, blog so much against people like Krugman or Lucas, who are already almost inactive in actual research. Take more time to write a paper more ! You'll have more authority then when you get as old as them !

    Alas, as a poet in 18th century Germany used to say: The best wish you can make to someone (in this case Krugman of course) is : Wish you earn the envy of younger people !

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  11. I think there are two notions of what Ricardian Equivalence actually is at play here. David thinks RET is the theory that states the conditions under which deficit financing doesn't matter, whereas Krugman thinks it is the theory of what occurs when consumers take the government budget constraint into account (which they don't do under basic Keynesian theories).

    The difference is important, because in Krugman's version, RET can hold and the method of financing a deficit can still be important (if you stimulate now and tax later, you can get a different outcome than if you stimulate now and tax now). In David's world, if RET holds then the method of financing cannot possibly be relevant.

    The crucial difference is that David assumes as part of RET that government spending is a perfect substitute for private spending - that is, RET assumes that government supplies the goods that households would have provided on their own. Krugman, however, does not think this assumption is part of RET. Neither does Brad DeLong. On his blog Brad writes:

    "I learned this from Andy Abel and Olivier Blanchard before my eyes first opened: increases in government purchases are ineffective only if (a) "Ricardian Equivalence" holds and (b) what the government buys (and distributes to households) is exactly what households would buy for themselves. RE by itself doesn't do it."

    So DeLong clearly thinks that perfect substitutability of government provided and privately provided goods is an extra assumption, outside of RET. My textbooks also do not mention perfect substitutability as an assumption of RET, but instead talk about the usual assumptions (perfect capital markets, lump sum taxes etc.) and the consumer taking the government budget constraint into account.

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  12. "Thank you, Anonymous. I can only assume that you sent the same message to Krugman, right?"

    Small-mindedness suits you. My mom taught me from a young age that "he does it, too" is not an excuse for bad behavior, but you pull it off with such style. Really. Great way to climb into the intellectual big leagues.

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  13. And cowardness appears to suit you, anonymous. My mom taught me not to hide behind walls, when throwing spitballs.

    Patrick: You are almost right. However, I do not assume that C and G are perfect substitutes. That part has nothing to do with RET. I am suggesting that Lucas might be thinking C and G are perfect substitutes. That would be his driving assumption; not RET. I am going to post once more to make myself clearer.

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  14. Patrick,

    Actually, that DeLong quote above is a correct one.

    Now, since Lucas argued that a money-financed increase in G is effective, he could not have been relying on RET, right?

    Anyway, I think I will write something up on this, just for the record.

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  15. David

    On my reading, (and Krugman's) Lucas seems to be saying that an increase in G is never stimulatory, except if it results in money creation. You say this violates RET, because Lucas thinks the method of financing G is important.

    However, it is my understanding that RET rests on the assumption (among others) that any debt-financed deficit is not monetized.

    See http://www.econ.mq.edu.au/Econ_docs/econ842/econ842week10.pdf where the relevant assumption is “govt. provided goods must be paid for through taxes over time, (ie bond financing only, no debt monetization).”

    So, the only way that Lucas can think of for an increase in G to be expansionary is for it to result in debt monetization, but debt monetization is not allowed by RET. This implies that Lucas thinks if RET holds, there is no way for an increase in G to be stimulatory.

    In other words, if we said to Lucas "assume RET holds, then can an increase in G be stimulatory?" he would say "no, it can't, the only way for an increase in G to be stimulatory is if a debt-financed increase in G is monetized, but this isn't allowed under RET, so an increase in G cannot be expansionary if RET holds".

    And we know that this is wrong - even if RET holds (precluding the case of debt monetization) an increase in G CAN still be stimulatory, so long as C and G are not perfect substitutes. You know this, Krugman knows this, I know this, Lucas doesn't appear to know this.

    THe only possible defence of Lucas is that he is assuming the specific case that C and G are perfect substitutes. But any commentator acting in good faith would have to note such a large assumption. There are two possibilities: he understood RET and was deliberately trying to gloss over the substantive issues in order to support a politically motivated position or he didn’t understand RET.

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  16. Patrick:

    I do not agree with those lecture slides you provided me. Money finance is perfectly legitimate in statements of RE.

    I do not agree with your concluding paragraph. I think that if you sat down with him over a beer, and talked about things (as I have), you'd come away with a much less cynical view of what motivates the man to say things in an informal speech and off-the-cuff.

    Please take a read of my recent post. I'd be interested to know your opinion.

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  17. Ricardian equivalence is bunk. If people were rational enough to calculate the impact of government spending changes on their future income as the hypothesis implies, they'd also be rational enough not to re-elect people who started trillion-dollar wars for no good reason. Or, if you prefer an economic example: if people were rational enough to calculate the impact of government spending changes on their future income as the hypothesis implies, people wouldn't expect housing to go up at 10% for the indefinite future when average incomes are going up at 3% per year.

    People aren't rational; people rationalize.

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  18. http://www.whataboutstlouis.com/?p=49

    We would rather have DeLong

    http://delong.typepad.com/sdj/2012/01/understanding-the-chicago-anti-stimulus-arguments-a-response-to-kantoos.html

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  19. it fails to adequately explain the data? Making the Ricardian equivalence assumption might be okay as a first approximation for some questions--though I'd argue that it mostly isn't--but in any case the theory does not adequately capture economic behavior. China sourcing

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