Thursday, December 29, 2011

Partisan Misrepresentation of Ricardian Equivalence is Nothing New

Paul Krugman catches Robert Lucas (not to be confused with Robert Barro - thanks for the comment David) misrepresenting Barro’s claim to fame:

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

Let’s get back to this after this abbreviated explanation of Ricardian Equivalence from David Andofatto. OK David, we know that in a life cycle world where households understand the long-run government budget constraint that households view all tax cuts (even the 1981 and Bush43 tax cuts) as mere tax surcharges that have to be repaid. But this model goes well beyond this. If fiscal policy involved a permanent increase in government consumption, it also involves a permanent increase in taxes which would be a wash as Barro alleges. So if the Obama Administration passed a law where we built a bunch of bridges every summer only to tear them down every winter for the rest of time, then maybe Barro’s claim makes sense.

But this is not the correct policy experiment. The building of a bridge is a temporary blip in spending intending to invest in the public infrastructure where the benefits will be long-term. The financing requirements can be met either by a blip in taxes or very low taxes each year over the future. And in either case, the fall in private consumption in the first year will be small in proportion in the rise in government spending to build this bridge (which it does not intend to subsequently tear down).

One would think this logic was well known. The reason for this blog post, however, is to note that Republican hacks have grossly misrepresented Ricardian Equivalence before. Recall all the fuss over why the Bush43 tax cuts would be better aggregate demand stimulus if that were to be made permanent as opposed to temporary? While that might be good life cycle theory if we could ignore a lot of other economic propositions – such as the long-run government budget constraint (and of course Ricardian Equivalence). Yet some Republican hacks even went so far as to dismiss any concern about crowding-out (even as the FED was already raising interest rates) based on the proposition that tax cuts do not raise interest rates ala Ricardian Equivalence and that Paul Evans AER 1985 paper entitled “Do Large Deficits Produce High Interest Rates”. But wait a darn second – the Ricardian reason for all of this is the assertion that tax cuts don’t encourage more consumption. This incredible dishonest mishmash was most evident when Victor Canto claimed in what National Review November 2002 piece that the Bush tax cuts would be more powerful in encouraging consumption if made permanent, while in another National Review November 2002 piece he used Ricardian Equivalence to argue that the tax cuts would not raise interest rates. To be fair to Mr. Canto – the National Review expects such brazen dishonesty if it is in defense of its rightwing agenda.

I should say that the Evans AER 1985 paper always puzzled me because the Reagan tax cuts did raise aggregate demand by raising consumption during a period when government spending was not reduced. And while nominal interest rates may have declined, real interest rates rose. In other words, we got classical crowding-out from a mix of expansionary fiscal policy and the Volcker tight monetary policy. Now if you wanted to remain a true believer of Ricardian Equivalence, I guess you could have argued that households expected the Reagan revolution to eventually get around to reducing government spending. Domestic spending after all was trimmed a bit even as defense spending soared. But we did eventually get that good old Peace Dividend – in the 1990’s.


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