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.