Debating Ricardian Equivalence

This crisis shows econs are not sure about many topics which are taught as priciples in basics of economics (or Econ 101). One such topic is Ricardian Equivalence:

The Ricardian equivalence proposition (also known as the Barro-Ricardo equivalence theorem[1]) is an economic theory that suggests consumers internalise the government’s budget constraint and thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy being the same.

WB chief econ Justin Lin in a speech says:

In my view, a global push for investment along the line of Keynesian stimulus is the key for a sustained global recovery; however, the stimulus needs to go beyond the traditional Keynesian investment. The products of high-income countries’ manufacturing sectors are mainly capital goods. A push for investment will increase the demand for capital goods and reduce manufacturing sectors’ underutilization of capacity in high-income countries, which in turn will increase the high-income countries’ employment, consumption, demand for housing, opportunity for private investment, and growth. With more revenues from higher growth and less needs for social spending, the high-income countries’ fiscal position will be strengthened and sovereign and state debt issues can be solved or mitigated.

But how can the Ricardian trap be avoided, i.e. an outcome where the government stimulus fails to boost aggregate demand because economic agents expect future tax increases to pay for larger deficits and thereby increase savings?

To avoid the Ricardian trap, it is important to go beyond conventional Keynesian stimulus of “digging a hole and paving a hole” by investing in projects which increase future productivity. So the investment will increase jobs and demands for capital goods now and increase the growth and government’s revenue in the future. The increase in revenue can pay back the cost of investment without increasing household’s future tax liability.

So he pushes Keynes stimulus theory but says it should go into meaningful projects. He points to examples of China which did the same in SE Asian crisis:

The Chinese experience in the East Asian financial crisis shows that a “new new normal” is not only a theoretical possibility but also can be a reality. Facing a situation similar to the recent global downturn during the East Asian financial crisis, China focused its fiscal stimulus investments on highways, railroads, port facilities, and electricity, areas that were bottlenecks to China’s growth. As a result, for example, the highway network in China increased from 4,700 km in 1997 to 25,100 km in 2002. Such investments are growth-enhancing and bottleneck releasing can be seen from the facts that China’s annual growth rate increased 1.3 percentage point from an average of 9.6 percent in 1979-2002 to 10.9 percent in 2003-2010; and prior to 2002, 2-digit growth rate was always accompanied by a 2-digit inflation rate whereas in 2002-2010 the inflation rate was not more than 5 percent. Meanwhile, as a result of increase in growth rate, public debts in China as a percentage of GDP reduced from over 30 percent in the early 2000s down to 23 percent in 2008.

This idea of Ricardian equivalence and getting away with it has been debated bigtime in the blogs. In his blog Lin sums up the links:

In a recent blog post “Ricardian Confusions”, Paul Krugman commented on my paper “Beyond Keynesianism and the New New Normal” delivered at the Council on Foreign Relations on Feb. 28. He points out that the government’s fiscal stimulus generally is temporary and households will not increase savings by the full amount of the stimulus. As a result, the stimulus is expansionary even if Ricardian equivalence holds. His comment triggered a series of discussions (Antonio Fatas and Ilian Mihov, Mark Thoma, Paul Krugman, Nick Rowe, and Brad Delong).  

I have no disagreement with Paul about the possibility of an expansionary effect of a temporary fiscal stimulus. But if the effect exists and the stimulus does not increase productivity as in his example, there will also be a contractionary effect after the exit of stimulus and the increase of tax to retire the public debts. At the end the issue of underutilization of capacity, which my paper attempts to address, will still be there. 

With the existence of large underutilization of capacity in the industrialized countries’ capital goods sector, I see the need for a Keynesian type of stimulus. However, as elaborated in my paper, the stimulus should be used for projects that are bottleneck-releasing, productivity-enhancing and self liquidating instead of “digging a hole and paving a hole”. Such investments will increase jobs and demand now, and increase the growth and government’s revenue in the future. I am delighted to see that this important part of my argument was picked up by Nick Rowe, who differentiated between useless government expenditure and useful government expenditure.

Read all the links Lin mentions and scratch your head as there are wide disagreements…. Say as a graduate student you are asked this question – What does one mean by Ricardian Equivalence? What would students answer reading all these debates? It all boils down to who you follow…

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