Wednesday, January 18, 2012

Once More on Ricardian Equivalence

I can’t let this rest.  Why should anyone bother with this idea?  RE depends on the specification of an intertemporal government budget constraint: any increase in the fiscal deficit in the current period must imply a corresponding decrease in the future, so that the relationship between the present value of the tax and spending streams remains unchanged.  But why?

Here are three arguments against the assumption of such a constraint.

1. The government’s debt/GDP ratio can and does change permanently.  Governments can borrow a lot, run up this ratio and then continue to live at their new level of indebtedness.  There is no reason why the US government cannot continue at the current debt/GDP ratio rather than the one we had on the eve of the financial crisis.  There is also no reason why this ratio cannot be increased to some higher level and maintained in perpetuity.  No doubt there is some level of indebtedness that is not sustainable, but we don’t know what it is, and in particular there is no compelling argument that says we are up against that constraint today.  (Credit markets, for what it’s worth, think US debt sustainability is a non-issue, given that they do not require a risk premium.)

2. The debt/GDP ratio is predictably altered by changes in nominal GDP.  Both real and price level effects matter.  Robust real economic growth can reduce the debt burden with no contribution from fiscal stringency, and if deficit spending increases subsequent growth (both through capacity utilization and hysterisis effects on potential income) a portion of the debt burden is directly offset.  (Models that assume away such effects simply beg the question.)  Just as relevant is the price level impact: inflation can erode the debt burden, and the question of whether such erosion is “optimal” from a representative household point of view (whatever that means—probably nothing) is irrelevant to whether such inflation will actually occur.  Note, incidentally, that the net effect of inflation on private sector wealth depends on whether the country in question runs a persistent current account surplus or deficit.

3. Finally, what we should now know from history is that it is far more likely that governments will default on their debts than pay them off.  Show me an RE model that accounts for even the possibility of default.....I’m waiting.

What does it say about the state of economics that a theory with no apparent connection to reality can spawn untold dissertations and journal articles and even crowd out rational thinking about current policy alternatives?


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