Ricardian equivalence

Ricardian equivalence: A mere day before second quarter spending stats were released in late July of this year, the Hoover Institute’s John Taylor was a guest on PBS’s News Hour. He argued that the reason the U.S. recovery was weaker than some might have hoped for was due to less rapid growth in investment spending. Taylor argued that this drop in growth was due in turn to worries about high budget deficits: “And now the slowdown is because investment has slowed down, and people are getting nervous about the increased debt that has partly resulted from the stimulus.” (A very small part due to President Obama's stimulus package. According to the Heritage Foundation's Brian Riedl’s only 6% of it. His paper is available online). This argument that the impact of government spending on overall macroeconomic equilibrium is relatively weak because of the effects of budget deficits on expectations is referred to as Ricardian equivalence. With Ricardian equivalence higher deficits now create the fear that taxes will eventually increase. This lowers the net expected return to investment. It lowers expected real disposable income of consumers as well. According to this, bond financed increases in government spending provide no more stimulus than tax financed ones would because we are smart enough to realize that –at some point in the future- the piper must be paid. The day following Taylor’s appearance on PBS’s News Hour Q2 2010 (the second quarter of 2010) spending stats (real GDP figures) were released. They indicated a year over year increase in investment spending of 23%. So much for weakened investment spending. The stupidity of Ricardian equivalence: If one stops to consider what we must assume when we try to apply this general idea to the real world all sorts of logical problems present themselves. Will there not be a range of opinions about exactly when budget deficits will have become too burdensome to tolerate? Given this, will there not also be a range of opinions about when leaders who have the commitment and power to push through higher taxes will appear to save the day and put our financial house in order? Furthermore, won’t the confidence with which these opinions are held also differ widely? Finally, there is question of how much weight will be attached to any of this. Say that I am the owner of a profitable business who plans to retire soon. I plan to sell the business to someone else. I believe –perhaps with good reason- that the bulk of potential buyers are oblivious to the threat of higher future taxes and lower net income. I also do not care about the financial fate of future generations. I could care less about what impact the choices the government makes now might have on my descendants. My indifference towards those who follow is exemplified by the fact that I can’t help but roll my eyes when someone says that we do not inherit the planet from our ancestors we are borrowing from those who come after. All this said, I attach relatively little weight to the long distant prospect of higher taxes. It would seem that the question of how to interpret the impact of the increased spending from added road repair and the added amount left after taxes in my pay check from current tax cuts (or the reverse of these, spending cuts and tax increases now) would be much easier than trying to figure out than the following : (1) If we don’t get deficits under control by date x, what the consequences will be. (2) If the leadership needed to chart a course through such politically dangerous waters of tax increases and spending cuts will ever appear. (3) Whether I am the only one to be concerned about such things, whether or not those of us who are worried about such things are correct in our assessment of how bad the situation will become by date x and whether politically we will be able to do anything about it . (4) What the likely consequences of failure might be. (5) The question of whether balance or surpluses might be achieved not via raising taxes –which would affect me directly- but instead via cuts in spending. If I have faith in the self-correcting tendencies of the market would have at most an indirect and very temporary affect on my situation. Besides all of this there is something else that is key and is missing from the discussion. This is the question centers on the issue of how what the composition of increased spending and the mix of tax cuts. If the deficits that have emerged are the result of governments simply continuing to do what they need to (vis-à-vis things such as primary and secondary education, police and fire protection, road repairs and so on) in the face of temporarily lower revenues should I be that concerned? Why are we not considering what I would like to call the Rohatyn effect? Rohatyn in his 2009 book Bold Endeavors: How Our Government Built America, and Why It Must Rebuild Now argues that much of the prosperity of the U.S. economy is based on private sector investment made far more productive and profitable in the wake of government investment in things like education, infrastructure, and overall economy stability. Add to the list of complicating factors that a more nuanced view of Ricardian equivalence demands then one more item in honor of Mr. Rohatyn and his book. Increased government spending and tax cuts, if directed at areas that increase the long-run productive capacity of the country, while they may lead to larger deficits now, via growth in capacity and earnings (assuming that the effective demand is there), over the long-run will lead to lower deficits, balanced budgets or possibly even generate surpluses. As summarized in his survey of work done on Ricardian equivalence North Carolina State’s John Seater notes: Finite horizons, nonaltruistic or inoperative bequest motives, childless couples, liquidity constraints, and uncertainty all can lead to failure of Ricardian equivalence, and it seems virtually certain that some of these sources of nonequivalence are operative. It appears likely that the world is not Ricardian. (p. 155 – 156) Stupid or not, it seems to fit the facts?: Despite this, Seater goes on to argue that as implausible an explanation as Ricardian equivalence might be, that it somehow or the other fits the facts reasonably well. In short, the evidence that Seater has examined would suggest that fiscal stimulus has been relatively ineffective. Almost two years ago I tried to untangled the equally twisted knot of Barro’s objections to ARRA: that the evidence suggested that increased government spending was ineffective. Barro pointed spending multipliers for 1941-42, 1942-1943, and 1943-1944 that were either below or just barely above one. I again come back to the same point that I raised in my posting in response to this from almost two years ago: that as the federal government applies stimulus to the overall economy the effectiveness of this is weakened considerably if –at the same time- state and local governments are doing the opposite. They did in this period that Barro refers to and they certainly are now. As the federal government has increased spending and cut taxes, state and local governments have been increasing taxes and cutting spending to balance their budgets. According to the National Organization of State Budget Officers (NABSO), despite projected increases in state level spending and revenues over the course of fiscal year (FY) 2011 both will still be well below their 2008 levels. Not even adjusting for inflation, state spending will be 7.6% lower in FY 2011 than it was in 2008. In real terms, it would of course be lower still. In the case of revenues, NASBO estimates that they will still be 7.8% lower in nominal terms in 2011 when compared to 2008. Not only have state and local governments been a drag on recovery but it is also true that a fairly high fraction of the production being generated to satisfy growing spending on both investment goods (23%) and exports (14%) in the fourth quarter was being covered via increased imports. Over the same period that both investment spending and export spending grew so rapidly in real terms (from Q209 to Q210) import spending grew in real terms 17.2%. Christian Weller notes this in his piece “Recovery Continues Amid Worrisome Trade Deficit”: The story of U.S. imports is not all that complicated, and it is directly related to struggles in the manufacturing sector. U.S. businesses are now operating in an expanding economy where other businesses and consumers demand more of their products. Domestic businesses thus need to ramp up production to meet that demand. They need more inputs for this added production, and they often turn to overseas suppliers for these. Imports of industrial supplies, for instance, increased by 20.2 percent in the second quarter, and imports of capital goods such as aircrafts and computers rose by 51.7 percent. The lack of domestic manufacturing capacity to supply these goods thus lowers the momentum for economic growth. (emphasis added). Finally, the over 6.5% growth in hourly productivity of labor since the crisis began might also have something to do with what we are seeing in terms of employment, especially when couple with the drag import spending growth, state and local government tax increases, and cuts in state and local government spending. Putting so much faith in others’ rationality, why would economists continue to offer an explanation that it implausible simply because it would appear to fit the facts as some argue Ricardian equivalence does? Why especially when there are other, more straightforward explanations to offer? The dangers of Ricardian equivalence: For those who wish to dress others in the sack-cloth and ashes of austerity Ricardian equivalence does offer an explanation of why “fiscal responsibility” can’t wait and austerity is needed now even if an economy could be counted on to pop right back on its own. In honor of Ed Prescott, what I refer to as the “pop back” theory is the neoclassical argument that if only wages and other resource costs were to move down along with the general level of prices to a sufficient degree the economy would self-correct. “Fiscal responsibility” means simply balancing government budgets when deficits emerge. Even though in 2007 the federal government was running a budget deficit, in 2007 - according to the NASBO report already cited above- state budgets were overall in balance. Their budget woes emerged as their economies moved into recession and were largely due to the natural decline in tax revenues that followed from economic weakness. Budgets that might have been in balance when state economies were stronger and unemployment lower moved toward deficit. Shouldn’t such economies if they are left alone –if they do indeed adjusts or pop right back- see their revenue picture improve considerably once recovery has been achieved. In fact, all else being equal, budgets should be back in balance again once long-run full-employment equilibrium is restored. In such a situation, to argue for austerity in the midst of a crisis would seem unnecessary. It is tantamount to saying that you think that even more pressure should be placed on labor and other resource suppliers to adjust than they would have to anyway. Ricardian equivalence provides a very dangerous answer to this question. Given increased deficits and its negative impact on private spending, whether governments cut spending , raise taxes, or carry out some combination of the two now or do so later, spending at the present time will be depressed. Labor and other resource supplies will be asked to carry the heavy burden of adjustment no matter what. The heavy burden of adjustment might be due directly to austerity measures put into place now. Lacking the political moxie to do something now, given Ricardian equivalence, the burden will be no lighter anyway as private households and businesses, seeing that the future will bring with it higher taxes unless something is done, cut their own spending in anticipation. God forbid that you live in an economy whose political leaders are so foolish to add even further to current and future budget deficits via expansionary fiscal policy such as we have. Households and businesses will only see still higher taxes in their future and cut back even more in order to get themselves ready. Waiting means that the final day of reckoning is further delayed and an even higher toll would have to be later than has to be paid now. This would be all well and good if true but it's not. Austerity is attacking the symptoms and not getting at the causes of our present difficulties. In economics we have a situation akin to modern medicine (with all its strengths and limitations) being practiced alongside bloodletting and humorism. It's too bad.