Wednesday, April 08, 2009

Paul Krugman On Ricardian Equivalence

The issue of Ricardian equivalence is being increasingly debated today. Ricardian equivalence is the theory that if the government budget deficit increases then people will increase their savings by an equal amount in order to help them pay for the higher future tax bills. Given the massive increase in the budget deficit discussed in the previous post, this is of increasing interest.

I personally don't believe that it really holds true fully, because of for example liquidity restraints (meaning that it is easier to save than to borrow) and the fact that many people don't consider the negative effects of future fiscal austerity on their future disposable income when they make spending decisions today. However, because many others do consider the effects of future fiscal austerity, it likely holds true partially (which is to say, both savings and spending will increase). And for that reason, a discussion of its implication is not uninteresting.

Many people have recently spread misunderstandings about these implications. Here is for example Paul Krugman:

"if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year."

Note how Krugman here confuses two different issues: the effect of an increase in government spending at the expense of private sector spending assuming the life cycle hypothesis is correct and the effect of weakening the budget balance assuming Ricardian equivalence. If there is a permanent increase in government spending financed by higher taxes then this will reduce consumer spending by an equal amount. If on the other hand the increase in government spending and taxes is only temporary then people will reduce their consumption by less than the increase in taxes (assuming the life cycle hypothesis is correct).

A fiscal stimulus policy of temporarily increased government spending and unchanged taxes is really a combination of a temporary increase in government spending financed by higher taxes and a separate tax cut of equal size. Ricardian equivalence will mean that consumer spending will be just as high as if the increase in government spending had been financed with a temporary tax increase.

At the same time it should be noted that while the increase in government spending will exceed the decline in consumer spending if the increase in government spending is temporary, that doesn't mean that total demand will increase, as interest rates will be higher, something which will reduce private investments. To the extent that higher interest rates increase capital inflows this will limit the decline in investments, but on the other hand increase the trade deficit (A trade deficit is the flip side of a net inflow in capital).


Blogger Unknown said...

Stefan, it appears that you entirely agree with what krugman says: that decrease in C will be outweighed by increase in G if it is temporary. The effect of government spending on investment is seems to me irrelevant to the simple point Krugman is making and subject to another discussion.

10:02 AM  
Blogger stefankarlsson said...

No, it is not irrelevant, because first of all Krugman mistakenly identified the implications of the life cycle hypothesis as the implications of Ricardian equivalence. And secondly, the effects on investments is not irrelevant as the point was the overall stimulative effect.

12:43 PM  

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