I thought I would add my two cents to a blog discussion about Ricardian equivalence. Here's a summary of what is going on:
1. Justin Yifu Lin, Chief Economist of the World Bank, was discussing the effects of fiscal policy. He thinks it is important to worry about the implications of a higher government deficit for future tax liabilities, and also thinks that productive government spending is good. Seems hard to argue with, right?
2. Antoinio Fatas invokes Keynesian Cross. Yes, Virginia, there is a multiplier. Who cares whether the government spending is actually well-thought-out and productive? We have an output gap, so don't worry about it.
3. Krugman weighs in. Well, we don't exactly have a multiplier. At most, it is 1. And by the way, "Ricardian equivalence types" (whoever they are) are so stupid, they don't know how their own models work.
4. Nick Rowe points out that well, in fact, if you had your choice, you might prefer the productive government spending to the dig-holes-and-fill-them-up kind.
5. Krugman replies to Rowe in a "seriously wonkish" fashion: Not so fast, Nick, you might want to dig holes and fill them up should you find yourself in a liquidity trap. Krugman marshals his argument in the form of a "little wonkish paper" he wrote in 1998. "Wonkish" here apparently means something on the level of a core-PhD-macro exam problem: an endowment economy with a Friedman-rule-type liquidity trap, and no fiscal policy in sight. The government spending implications are some words at the end of the paper.
Now, I think it is important here to separate the implications of government spending on goods and services from the financing of that spending. Ricardian equivalence relates to the financing, i.e. the timing of taxation, and I'll focus on that first.
If you have never run across Ricardian equivalence, here's the basic idea. Say the government cuts our taxes today, holding constant present and future government spending on goods and services. The tax cut does not come out of thin air - the government has to finance this by issuing debt. But the debt must be paid off sometime in the future. How? The government must increase future taxes. Consumers, being forward-looking and rational, figure out that their current tax cut is exactly offset (in present value terms) by an increase in their future tax liabilities, and they save all of their tax cut rather than spending it, so they can pay the future taxes. The government is saving less in the present, but the private sector is saving more. Everything nets out, and there is no effect on anything.
As I tell my students, Ricardian equivalence is very special. For it to work exactly in this fashion requires a lot of assumptions: lump sum taxation, no redistributive effects of taxation (across people or generations), frictionless credit markets, etc. But the idea is very powerful, and an important organizing principle for understanding why government deficits matter. At the minimum, it helps us understand the importance of the intertemporal government budget constraint, and the idea that a tax cut is not a free lunch.
What are the typical criticisms of Ricardian equivalence?
1. This is too complicated. The average consumer is never going to figure it out. According to this line of argument, consumers will see a tax cut, incorrectly infer that their lifetime wealth has increased, and we can therefore trick them into spending more. Of course, in the future, they will wake up to the notion that their taxes are higher than they would have otherwise been, and that they were too profligate in their spending at an earlier date. This hardly seems like the basis for sound fiscal policy. Like all bad behavioral economics, assuming that the average Joe or Jane is stupid puts you on a slippery slope. Maybe private citizens are so bad at making consumption/savings decisions that someone at the Treasury Department should be making those decisions for them.
2. Credit markets are not perfect. Here, the basic idea is that a tax cut in the present, matched by higher taxes in the future, is essentially a loan by the government to the private sector. The loan is the current tax cut, and you pay the government back with future taxes. The government can borrow at a lower interest rate than I can so, voila, this acts to increase economic welfare, by relaxing binding debt constraints for at least some consumers. The problem here is that the government needs to have some kind of advantage as a lender in credit markets, over private sector lenders, in order for this to work.
To think about this, we have to dig deeper, and ask what exactly a "credit market imperfection" is. Basically, we think there are two kinds: private information and limited commitment. Private information frictions in the credit market basically relate to the problem of sorting credit risks. Who is creditworthy and who is not? Here, it is hard to argue that the government has some special advantage. If someone is an alcoholic and likely to go on a bender, lose his or her job, and default on his or her private debts, their tax liabilities to the government are also in jeopardy. What about limited commitment? Here, the problem is that a person can potentially run away from their debts. In private credit markets, this problem can be mitigated by the use of collateral, but of course seizing collateral and selling it is costly, so this does not work perfectly. Here, it may be possible to argue that the government has an advantage. Possibly we can think of the power of the state to collect taxes as much more formidable than the power of Bank of America to collect on credit card debt. But this is far from clear. Through bankruptcy laws, the state attempts to minimize the cost to the private lenders of collecting on their debts, and in principle the government can set up the legal system so that its powers of debt collection transfer to private sector lenders.
Conclusion: A hardcore Keynesian wants you to think that Ricardian equivalence is a pretty flimsy idea, but it's not.
But there is another way out. Here's where New Monetarism comes in. One idea, that comes out of work by Guillaume Rocheteau, Ricardo Lagos, Randy Wright, and yours truly, for example, is that we should not get too involved with defining what "money" is. Different assets are exchanged in financial and retail transactions to different degrees. Asset "liquidity" has to do with how an asset is used in exchange, and this potentially gives rise to liquidity premia. The most obvious liquidity premium is reflected in the difference between the nominal rate of return on money (zero) and the nominal return on a Treasury bill. We can also think of the low nominal return on T-bills relative to other assets as reflecting a liquidity premium on T-bills. Now, there are events - a financial crisis for example - which can effectively hamper (or totally destroy in some circumstances) the private sector's ability to create liquid assets (asset-backed securities for example) for use in financial exchange. What should the government do? It should run a deficit and create more government debt to relieve the liquidity shortage and reduce the liquidity premia which reflect a scarcity of liquidity. But the need for the extra government liquidity is presumably temporary, so the government should plan to increase taxes in the future to retire the extra government debt, once the private sector is up to speed again. This is basically a Ricardian-type experiment, but with non-Ricardian results. Everyone is in fact better off due to the intervention.
So, it seems perfectly sensible that, during a financial crisis like the one we just had, that the government plan to run a larger deficit temporarily. But, with the intertemporal budget constraint in mind, there should also be a plan for raising taxes in the future to retire the extra debt.
But what about government spending on goods and services? What's the problem with that?
1. Implementing a temporary tax cut is far simpler and less costly than implementing changes in programs for government spending on goods and services.
2. A waste of resources is a waste of resources. We don't want to spend on anything.
3. The usual Keynesian argument is that we have an output gap. There are idle resources and we get the extra output for free. But (i) If the unemployed workers are in Nevada, and the jobs are in Washington, that is a problem. (ii) If government spending employs nurses, but the unemployed are roofers, that is a problem. (iii) If the government uses up all the idle resources, how will the private sector recover, when it takes a mind to?
I was quite happy to vote in favor of a school bond issue to rebuild the middle school at the end of my street, as it seemed to me a prime time to do so. Interest rates are low, construction costs are low, and the job can be done quickly. To me, that seemed like productive government spending, and the timing was right. It seems that Krugman and company have decided that they would like a larger government. They think that there are some things that federal and state governments do not support that they would like to see them support. I would rather have them forgo Keynesian arguments, which I think are weak, and go straight to the heart of the matter. Tell me what you want the government to do, and how you think that government activity should be financed. Then we can argue about that.
Steve: there was a bit more to my post than that. I was saying that *even if* there were no choice, so that the only government spending were on useless stuff, it wouldn't make sense to do it, under Ricardian Equivalence. The maximum value of the multiplier would be 1, but the whole of that 1 is useless. Paying the unemployed to do something useless is the same as simply giving them a transfer payment (except for the loss of their leisure, which only strengthens my case) and transfer payments have no effect under REP. But useful government investments, which yield a return, raise net wealth, and so will have a bigger multiplier, as well as being useful stuff.ReplyDelete
Here's my fiscal policy anecdote: Me and my neighbours voted to get our street paved, and agreed to pay for the paving ourselves. The municipality gave each of us a choice: pay the cost in a lump sum now, or have the cost amortised on our tax bill over the next 10 years. That second bit is where Ricardian Equivalence came in. For me, it didn't make much difference which method of financing I chose.ReplyDelete
There's no such thing as RE. Putting aside the ridiculous assumptions of RE there's no empirical evidence for it's existence. After Robert Barro dreamed up RE the first test case whether people actually behave that way was 1981.ReplyDelete
In August 1981 the US congress gave out large tax cuts to stimulate the US economy. RE groupies with their chieftain Robert Barro were allover the place with their predictions how hopeless such an endeavour is. What actually happened is the US personal saving rate fell from 7.5% in 1981 to average 5.7% in 1982-1984.
In regard to "Tell me what you want the government to do, and how you think that government activity should be financed." I think it would be a good idea for the US federal government to alleviate the budget problems of states and municipalities by sending some US$s their way.
How to finance it. A guy in the treasury fires up his computer and with some key strokes he credits some bank accounts. Then he marks up/down the appropriate numbers in the federal balance sheet and reports to his superior that he has recorded the transaction. Done.
The so called "government budget constraint" is an invention by conservative economists who simply dislike any government activity and hope to eliminate it by coming up with such artificial constructs. The GBC is not applicable to a government who is the monopoly issuer of it's non-convertible, free-floating FIAT currency.
Excellent post. If I were teaching undergrad money/macro right now, I would surely use parts of it for students to critique on the final.
Although I hate to single out one part of your comment for attention--there is so much of interest--but I must give special note to the claim that there is not GBC for governments who issue their own currency. This is a fallacy of true beauty.
I hate to break it to you but I am certain that Paul Krugman, Brad DeLong and Christina Romer would agree that the GBC exists. (You don't think that they are conservatives, do you?)
Almost all hyperinflations have started because governments choose to pay for non-trivial fiscal deficits by issuing new currency. That historical regularity is a very well documented.
I could explain why QE and QE2 should not be confused with that practice but space and time restrain me.
According to this line of argument, consumers will see a tax cut, incorrectly infer that their lifetime wealth has increased, and we can therefore trick them into spending more. ... Like all bad behavioral economics, assuming that the average Joe or Jane is stupid puts you on a slippery slope.ReplyDelete
We already know that many taxpayers believe tax cuts pay for themselves through some Laffer curve mechanism. They might also believe the additional public debt will simply be rolled over until after their lifetime, or that Congress will later tax someone else to pay it, or they may simply not follow every spending bill being discussed in Washington. Whether you consider any of this "stupid" has nothing to do with a slippery slope; in reality people have limited rationality.
Thanks for your answer. To be honest: I give a damn what Krugman, DeLong, … are saying. They are part of the problem (or shall I better say conspiracy against the public good) ;-) Krugman once came up with a model for GBC to counter Galbraith. It was really pathetic. Anyway I hope I can calm down your hyperinflation paranoia another day but it is too late and I've to catch an early flight tomorrow.
I assume that you meant that you don't give a d*** about Romer, Krugman, and DeLong and your text in the post was a typo?
Just to be clear on my own views, I am not saying that QE or QE2 will lead to hyperinflation. I meant that I can draw important distinctions between current US policy and the usual circumstances in which fiscal policy drives monetary policy to hyperinflation.
But if any government starts simply printing currency to cover large deficits, that will generate hyperinflation in short order. (That does not describe QE.)
I do like the New Monetarist story, but I think the old liquidity constraint story is more solid than the account you give. The advantage the government has is the ability to compel repayment even when the original borrower is not capable of repaying. It's not so much about enforcement as about cosigners: a loan in the form of a tax cut has over 100 million cosigners, so it's a lot more solid than a private loan that has at most maybe one or two. And there are a great many people who have neither collateral nor cosigners for their private loans. As an empirical matter, we often observe such people borrowing at much higher interest rates than what the government pays.ReplyDelete
Please don't bother replying to him. Waste of time.
"The advantage the government has is the ability to compel repayment even when the original borrower is not capable of repaying."
What do you mean by "compel repayment?" The government cannot force you to work or send you to debtors' prison.
"As an empirical matter, we often observe such people borrowing at much higher interest rates than what the government pays."
You'll notice that I allowed for that. People pay higher interest rates than the government pays because of default risk and screening costs, among other things. You have to think about whether the government faces the same costs in effectively "lending" to people. Obviously we know who the US government is and that it will not default (hopefully), which is why it borrows at a low rate.
When an line of thinking puts you on a slippery slope, it does not automatically mean that this line of thinking is wrong. It just means that you need to be more careful.ReplyDelete
Sure, but what would "being more careful" amount to in this case?
"Like all bad behavioral economics, assuming that the average Joe or Jane is stupid puts you on a slippery slope."ReplyDelete
What if the average Joe and Jane ARE stupid? We take as axiomatic that they aren't, but perhaps they are. Shouldn't we help them out? And if not, shouldn't we think carefully and systematically about not as opposed to simply getting nauseated with the idea of paternalism, dismiss the whole idea and look the other way?
But don't we get on a slippery slope again? How smart is the average person sitting in Congress? How smart is the average economist? What is the model you have in mind? Would "helping people out" just involve teaching them some economics?ReplyDelete
"The government cannot force you to work or send you to debtors' prison" but it can (and will) collect your debt from someone else if you are unable to pay it. Whereas you can't organize 100 million people to take out a loan from a bank and be jointly liable for repayment.ReplyDelete
"How smart is the average economist?"ReplyDelete
I would say that the average economist is about 1/2 as smart as he/she thinks he/she is. The fraction varies among economists, of course. It is almost always less than 1 though.
I haven't spent much time with Congresscritters so I don't know about them.
In alll seriousness, I think that there is a case to be made for "paternalistic libertarianism," in which default choices are designed to offset people's known biases but people are still free to override those defaults.
The classic example is to make the maximum amount the default choice for 401K contributions as many people will not choose to participate in 401Ks even if they get matching contributions from their employer.
I am sure that we can think of sound reasons why an optimizing person would choose not to participate in a 401K, even with matching, but my guess is that most people make that choice on the basis of less fully rational analysis.
What do you think of those ideas, Steve?
What role does the danger of putting one on a slippery slope have in scientific inquiry? It seems obvious that whether people are rational is independent of the implications of that determination. What's next? Are we to reject evolution or a heliocentric solar system on the grounds that accepting them might put us on a slippery slope to atheism?ReplyDelete
"One idea, that comes out of work by Guillaume Rocheteau, Ricardo Lagos, Randy Wright, and yours truly, for example, is that we should not get too involved with defining what "money" is. Different assets are exchanged in financial and retail transactions to different degrees."ReplyDelete
How is this different from earlier ideas expressed by Kaldor et al in the Radcliffe Report of 1959? And Tobin's "New View"?
"but it can (and will) collect your debt from someone else if you are unable to pay it"
Yes, but how does the government collect from that guy?
"Whereas you can't organize 100 million people to take out a loan from a bank and be jointly liable for repayment."
A large financial intermediary does not typically get up to 100 million, but it's plenty large enough to make this work. One borrower at Bank of America defaults, and the other borrowers are effectively making up for it. It's the same thing.
Little time here, but have you ever seen or heard of anyone who really behaves in a Ricardian equivalence way?
They monitor what the government does closely in all its complication, including forecasting what the future return will be on government's public investment, learn the government and political processes very well (live forever), and when taxes are cut, or government spending goes up, they do an elaborate analysis, and say, ok, my savings has to increase by 7% so I'll have the increased tax money in the future when taxes go up to compensate?
My life, and vast reading of the world, must have been some kind of freaky, amazing twilight zone outlier, with someone intercepting my newspapers and editing them to hide the evidence of this, because I've never heard of anyone behaving like this. Most people don't even have anywhere near the knowledge and understanding of what government does and spends money on to even try – as survey after survey shows – people are extremely uninformed on these issues, so then how could they perform these Ricardian analyses with so little knowledge of what government even does?!!
Oh, I forgot, the aliens are intercepting my newspapers and changing the reports of the survey results.
As Mark Thoma points out, there's not much empirical evidence, and what empirical evidence there is, I would think is either:
1) People don't tend to spend lump sum tax cuts much. But this could easily be due to income smoothing and because these lump sum tax distributions tend to come during recessions when people are scared to spend an/or are highly in debt.
2) During recessions when there may be stimuli people save more. Again these are scary times; people tend to save more due to the recession, not due to some complicated analysis of government spending, taxing, and investing, when they have little idea any way, as every survey shows, of what government spending, investing, and taxing are, and most people don't even know what NPV even means.
And by the way, of course this doesn't mean people are stupid. It just means they don't have massive time to learn degrees worth of economics, finance, and government, and study massively all the information on what government does everyday and do elaborate analysses on it, and then do their jobs and spend time with their families. Maybe if they had 1,000 hours in their days, but now we're back to the aliens again. Is that part of freshwater theory, along with the assumption of living forever?
Yes, some paternalism is useful. People need deadlines. People should wear their seat belts. No one has ever convinced me that this transfers to fiscal policy.
Very good. Rationality is just optimizing given your constraints. But that's not testable. What we are interested in are models that fit the facts and are useful for policy analysis, which requires that those models be structurally invariant to the policies that we want to think about. Human beings behave in predictable ways. But then there are some people we call "crazy," who behave in ways that appear to be inconsistent with how "normal" people behave. Some people look at Charlie Sheen and say "that man is crazy." I look at Charlie Sheen and say "that is a man with bipolar disorder." The policy prescription is clear. Charlie needs to take his medication, which would give us a Pareto improvement.
You'll have to remind me what was in the Radcliffe report. Something about credit rationing? Also, remind me about Tobin's New View. I read it once, but can't remember what it was about.
A model is a model, intended to simplify the world so that we can understand a few small elements of how it works. No model is a literal description of reality though there are cases - like auction theory - that come close. If we used your criteria for sensible economic analysis, we would give up and go home.
I think models are great, as long as you interpret them intelligently, which is not literally, or overly literally.ReplyDelete
The problem is many freshwater economists do seem to interpret and apply Ricardian equivalence literally, or very literally, rather than something that maybe occurs to some vague extent some times.
In your Jan 25th post, you lamented that you "have to explain the Keynesian models to the Keynesians," and you today cite Krugman's lament at having to explain Ricardian equivalency to its proponents.
I don't think that people need to keep track of their marginal tax rates and make hyperrational decisions to get some decent amount of Ricardian equivalence to hold.
Suppose that Joe Sixpack takes home $2000 a month and has chosen his standard of living --lodging, car, entertainment,etc--to fit his budget. At the end of the month, Joe might have a $100 or $200 left, which he randomly either spends or puts in the bank to save. (Joe knows that he will be old someday and that his kids might want some post HS education.)
Now suppose that the goverment gives him a tax cut, to which he pays no attention. Now Joe has $500 or $600 left at the end of the month. He might consider slowly upgrading his lifestyle if he has habit utility or Joe might just think that he is more frugal than he thought and he might save the extra money.
Seems reasonable to me.
"1. This is too complicated. The average consumer is never going to figure it out. According to this line of argument, consumers will see a tax cut, incorrectly infer that their lifetime wealth has increased, and we can therefore trick them into spending more. Of course, in the future, they will wake up to the notion that their taxes are higher than they would have otherwise been, and that they were too profligate in their spending at an earlier date. This hardly seems like the basis for sound fiscal policy. Like all bad behavioral economics, assuming that the average Joe or Jane is stupid puts you on a slippery slope..."ReplyDelete
This is funny!!! Economists do not even agree on the existence of the Ricardo equivalence ....and consumers should be smarter than them and even guessing who will pay those taxes???? I thought that economists were the experts not viceversa:-)
"...many freshwater economists..."
Who exactly are you talking about?
"Krugman's lament at having to explain Ricardian equivalency to its proponents."
You understand that he's just being rhetorical, right? There are some nameless "proponents." Then he claims that the nameless proponents are confused. Obviously we can't verify that, as the proponents are unnamed. My undergrads understand Ricardian equivalence at the level Krugman does.
What's your point??????
"Consumers, being forward-looking and rational"ReplyDelete
That's where the entire idea of Ricardian equivalence goes out of the window. Consumers are neither forward-looking (at least not for random timer periods) nor rational. Any economic theory based on rational and forward-looking agents (that, incidentally, all believe the same thing about economics) is not going anywhere.
The Ricardo equivalence is one of the most clear example to what nonsense leads studyng the economy as a whole, by aggregatesReplyDelete
While is true that if I get into debts to buy a car I have to save to repay it, it is no more than a joke applying the same reasoning to an entire society. Government interventions are not free exchanges, they simply benefits someone at the expenses of others. Public debt is wealth redistribution and government expansion. So public debt does not represent some agreement between debtors and creditors
As Bastiat said "L'État, c'est la grande fiction à travers laquelle Tout Le Monde s'efforce de vivre aux dépens de Tout Le Monde".(The state is that great fiction by which everyone tries to live at the expense of everyone else.)
I guess you think the whole body of post-1968 macroeconomics - Minnesota macro, New Keynesian economics, etc. - did not go anywhere, as all of it is based on forward-looking rationality. This is what dominates macroeconomic thought and policymaking currently. It has been awarded various prizes, including the Nobel, more than once. Like it or lump it.
Seems to me that what is science is not decided by majority vote or by those who grant prizes. Otherwise we'd be still dealing with the sorcerer's stone and the phoenixReplyDelete
Tobin, 1963: "A more recent development in monetary economics tends to blur the sharp distinction between money and other assets and between commercial banks and other financial intermediaries; to focus on demands for and supplies of the whole spectrum of assets rather than on the quantity and velocity of "money"...."ReplyDelete
There is more to the new view than that, but it sounds quite similar to: "we should not get too involved with defining what 'money' is. Different assets are exchanged in financial and retail transactions to different degrees."
Yes, very good. This is Tobin at his best (at his worst, he was a destructive force in the profession). Another good piece is this one:
Some of those ideas ended up in Wallace's work, for example, and some of what Wallace did was very anti-quantity theory of money. For example, this:
"Seems to me that what is science is not decided by majority vote or by those who grant prizes. Otherwise we'd be still dealing with the sorcerer's stone and the phoenix"ReplyDelete
Yes, this is certainly correct. I'm also pleased that I don't need to have a New York Times column to write things like this.
Thanks for the link. I can't help but notice that one difference between monetarism and new monetarism is that monetarists usually aligned themselves with the currency school in the old currency vs. banking school debate, whereas new monetarists have crossed the floor to align themselves with the banking school.ReplyDelete
"Different assets are exchanged in financial and retail transactions to different degrees."
What of your papers best describes the above idea?
In a crude way, it's in here:
Also see the two "New Monetarist Economics" surveys with Randy Wright. But there is a lot of work than needs to be done on this to explore it properly in a formal way.
"Yes, this is certainly correct. I'm also pleased that I don't need to have a New York Times column to write things like this."ReplyDelete
Right! But notice that you and Krugman share the same view: there is nothing immoral with granting the monopoly of printing money out of nothing nor this is bad economics
I read through "Liquidity, Financial Intermediation, and Monetary Policy in a New Monetarist Model".ReplyDelete
It's written in a language that I have troubles understanding and identifying with. I make a living very close to actual markets. Daytime Walrasian/Nighttime random matching markets are not how I see my world, nor how I abstract from it.
That being said, I'm willing to give these ideas a shot.
I think we both agree that there is no sharply defined line between monies and non-monies. Nor should there be a defined line between what is liquidity and non-liquidity.
But in your first line you say that "liquidity consists of a class of assets...". Next you say that "some of these liquid assets are government liabilities."
By using the word "class" you are engaging in the process of classification; adding boundaries and distinctions. Which contradicts the notion that money and liquidity are blurry concepts. Furthermore, if some government liabilities are liquid assets, then you are implying that some are not, and in the process are drawing a line between liquidity and non-liquidity, money and non-money.
Unfortunately my math is not good enough to understand if this language carries into your actual model.
Lines between what is liquid and what is not are blurred, but it important to make some distinctions. The distinction between government and private liabilities is important, and it is important to recognize that some government liabilities (currency) are designed for use in some decentralized retail transactions but are of no use in large financial transactions, for example.ReplyDelete
Fair enough, but if you could humor me... what sorts of government liabilities are not worth classifying as "liquid assets"?ReplyDelete
...and vice versa what sorts of private assets are worth classifying as "liquid assets" and what sorts aren't?ReplyDelete
If you can intermediate the "illiquid" assets, whatever they are, and therefore make them liquid, then lots of assets can be essentially liquid, though sometimes we may think there is some fragility in the intermediation. Gary Gorton likes to talk about that with respect to the "shadow banking" system.
Ok, but every asset can be intermediated. So every asset is a liquid asset. Therefore there is no real distinction to be made.ReplyDelete
Maybe. Maybe not. I hold some of my wealth in a S&P 500 index fund. The fund puts some limitations on how I can liquidate it (they really don't want me to actively trade it), and if I fall within those restrictions it will take me a day to get the funds in my checking account. Of course, my Bank of America checking account is more liquid than that. But why is the index fund less liquid than my checking account? Is that just due to some regulations, or what? The Fed thinks it matters if it swaps reserves for long-maturity Treasuries, i.e. it thinks it can somehow increase the liquidity of the private sector's porfolio of consolidated-government liabilities. It thus thinks it has an intermediation advantage over the private sector. How come? Why can't the private sector do just as good a job of intermediating the long-maturity Treasury securities? Unanswered questions. You're thinking about the right things.ReplyDelete
Just a few further questions:ReplyDelete
On page 10-11 you say that L(r) is the total quantity of loans extended by financial intermediaries (presumably the total quantity of private assets?).
But on pg 21 you say L(r) is the total quantity of private liquid assets.
So what goes into the quantity L(r)? Any private asset a,b,c,...,z or just liquid assets a,b, and c? And if only some quantity of liquid assets can be included in L(r), what criteria can be used to exclude non-liquid assets x,y,and z?
This gets right to your point. The financial intermediaries make loans, and lending is costly, due to the verification (default) costs. There are a lot of would-be borrowers, but in equilibrium only some of them get loans. There is a limitation (endogenous) on how much lending can happen in this economy, due to the costs of lending, and the opportunity costs associated with lending. Now, when loans are made and intermediated, they become liquid (due to the liquidity transformation done by the intermediaries). But the private economy is limited in how much liqudity it can produce, and becomes more limited as the costs of lending go up and as risk increases. I quite like this.
Thanks for this conversation. I'll have to sign-off for a while. I sympathize with the overall goals of your paper, which you summarize in the above quote.ReplyDelete
But I feel that you have not really responded to my questions, which are directed not at your overall conclusions but at one of your initial assumptions, namely the way you choose to conceptualize "liquidity" before inputting it into your model.
It seems to be that you are on the one hand holding a blurry notion of liquidity and on the other a categorical notion of liquidity, and this is inconsistent. I'm not sure which is most important to you. But since your L(r) comprises the total quantity of "private liquid assets", and therefore not the illiquid ones, I think you come down on the categorical view of liquidity.... that there is some rule by which the economist can place assets into illiquid or liquid bins.
"(iii) If the government uses up all the idle resources, how will the private sector recover, when it takes a mind to?"ReplyDelete
The total amount of resources grows, making new resources for the private sector to use.
And you haven't presented very strong evidence for the if parts of your statements, while Krugman appears to me to have presented stronger evidence against them.ReplyDelete
"2. Credit markets are not perfect.-- The government can borrow at a lower interest rate than I can so, voila, this acts to increase economic welfare, by relaxing binding debt constraints for at least some consumers. The problem here is that the government needs to have some kind of advantage as a lender in credit markets, over private sector lenders, in order for this to work.ReplyDelete
-->If the government is capable of borrowing at a lower rate than private sector institutions then it doesn't necessarily need to also have an advantage in lending as well if it has this advantage in cost.