Ricardian equivalence and Fisher effect are actually misnomers..

This is a very important post  by Thorvaldur Gylfason, Helgi Tomasson and Gylfi Zoega. It is another strong reminder of what omitting history of economic thought has done to economics students. We are just being made to use certain terms without knowing whether they are actually true. Quite a few economics terms/relationships are actually weak when tested empirically. So, one should always be careful while stating them as some theory or facts which we often do.

The authors point to two such highly popular terms used by both econs and wannabe econs across the world- Ricardian equivalence and Fisher effect. In both these, even the authors on whom they are named had cautioned on the relationship. But, over time like we see in game of Chinese  whispers, these ideas have become distorted. The weak relationships showed by these two have become a matter of fact leading to all kinds of wrong policies:

In economics, as in other disciplines, it is common practice to name models, theorems, and empirical results after their originators. In macroeconomics, we have the Phillips curve, an empirical relationship between inflation and unemployment first documented for the UK by A W Phillips, an engineer from New Zealand. And we have Okun’s law, an empirical relationship between unemployment and the gap between actual and potential output first laid out for the US by Arthur M. Okun at Yale. Moreover, we have the Solow model that bears the name of Nobel laureate Robert M Solow at MIT, who presented his seminal growth model in 1956. The list also includes the Heckscher-Ohlin and Stolper-Samuelson theorems in trade theory, the Baumol-Tobin and Modigliani-Miller theorems in monetary theory, the Mundell-Fleming model in international finance, and even the relatively recent Taylor and Giudotti-Greenspan rules of monetary policy.

The pattern is pretty clear – you make a discovery (or perhaps you just make a point!) and it may become irretrievably associated with your name.

Or it may not.  Or something completely different can happen. Just ask David Ricardo and Irving Fisher.

On Ricardian equivalence, Ricardo had clarified:

Innocent readers may be excused for thinking that David Ricardo (1772-1823) originated the idea that it makes no difference whether government expenditures are financed by taxation or by borrowing, on the grounds that taxpayers anticipate the increased future tax burden that arises from increased borrowing today, making them indifferent between the two. This simple idea requires you to think that ordinary taxpayers reduce their consumption today to prepare for a heavier tax burden decades from now. If true, this proposition greatly reduces the efficacy of fiscal policy.

The attribution of this proposition to Ricardo is unfair to him because, even if he exposited the logic behind it, he found the proposition unconvincing. In the words of Ricardo (1817): “… it must not be inferred that I consider the system of borrowing as the best calculated to defray the extraordinary expenses of the State. It is a system which tends to make us less thrifty – to blind us to our real situation”. Like modern behavioural economists, Ricardo understood that in their daily lives most people abide by the old saying, “worry about that bridge when you cross it”.

Here is how three modern macroeconomics textbooks handle Ricardo:

  • N Gregory Mankiw (2013) writes: “Hence, financing the government by debt is equivalent to financing it by taxes. This view is called Ricardian equivalence after the famous nineteenth-century economist David Ricardo because he first noticed the theoretical argument”.
  • Olivier Blanchard (2006) writes: “One extreme view is that once the government budget constraint is taken into account, neither deficits nor debt have an effect on economic activity. This argument is known as the Ricardian equivalence proposition. David Ricardo, a nineteenth-century English economist, was the first to articulate its logic. His argument was further developed and given prominence in the 1970s by Robert Barro, then at Chicago, now at Harvard University. For this reason, the argument is also known as the Ricardo-Barro proposition”.
  • J Bradford DeLong and Martha L Olney (2006) get it right: “this alternative view of the long-run (and also the short-run) effects of debt and deficits is called ‘Ricardian equivalence’, after David Ricardo, who does not seem to have held the view; it should be called ‘Barrovian equivalence’, after its most effective and powerful advocate, Harvard macroeconomist Robert Barro” (see Barro 1974).

They all knew human behaviour much more than today’s modern econs would think. BY labeling them neoclassical econs interested only in rational minds has itself done a lot of disservice to their names. Infact, these old economists might not be able to sit through any of today’s modern economics classes and think they have come to an alien world. But they may just find themselves at home in a behavioral economics classroom.

On Fisher effect, which says changes in nominal interest rates equal changes in price levels over a period, is also a misnomer:

The Fisher effect, if described as an empirical relationship, is a misnomer because Fisher’s (1930) own data on interest rates and inflation covering New York, London (see Figure 1), Paris, Berlin, Calcutta, and Tokyo from 1825 to 1927 suggest that nominal interest rates do not come close to mirroring the movements in inflation, as Mankiw (2013) points out, even in the long run. As shown by Gylfason (2016), all of Fisher’s data show interest rates to evolve less rapidly than inflation and to change less than inflation. The assumption of a common dynamic structure in Fisher’s six cities suggests inflation cycles of about six years, cycles that do not show up in the interest rate series. The failure of nominal interest rates to imitate the inflation cycles underlines the lack of sensitivity of nominal interest rates to inflation. The Fisher effect, defined as a point-for-point effect of inflation on nominal interest rates, is a misnomer as an empirical result and must rather be understood as a theoretical possibility that is not supported by Fisher´s data.

….

These results are consistent with those of Fisher himself. As Tobin (1987) and Dimand (1999), among others, point out, both Fisher’s theory of interest and his reading of the historical record suggested to him that real interest rates varied inversely with inflation, and that the adjustment of nominal interest rates to changes in inflation took a very long time (Fisher 1896). In Fisher’s (1930) words: “… when prices are rising, the rate of interest tends to be high but not so high as it should be to compensate for the rise; and when prices are falling, the rate of interest tends to be low, but not so low as it should be to compensate for the fall”. Fisher (1930) describes the relationship between interest rates and inflation also thus: “When the price level falls, the rate of interest nominally falls slightly, but really rises greatly and when the price level rises, the rate of interest nominally rises slightly, but really falls greatly”. Here Fisher means the rate of change of the price level even if he says only “price level”. Fisher (1907) made a clear distinction between the two: “Falling prices are as different from low prices as a waterfall is from sea level.

Hmm. Fascinating stuff.

It is high time we equip students with history of thought courses or else we will keep making these gross mistakes. Economics has truly become a game of Chinese whispers where lot of such thoughts have become distorted over years. It is high time we get to the source from where these whispers started and make students read and hear original stuff.  This way we are not just teaching wrong ideas but even spoiling the reputation of these original minds..

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