Ricardian equivalence, for the last time
Ah, controversy. What a great way to end the year!
I want to comment on Mark Thoma's post today about the Ricardian Equivalence Theorem (RET). Linking up to the interview with Barro was a good idea, Mark. Everyone agrees that the theorem has nothing to say about the effectiveness of G, and Barro explains all of this splendidly. Moreover, everyone agrees that since the conditions needed to render the proposition valid are violated in reality, the proposition cannot possibly be expected to make a perfectly accurate prediction of how altering the timing of taxes (holding G fixed) is likely to impact the economy. I guess that this is about where our mutual agreement ends.
What is there left to argue about? It's the holidays--I'm sure we'll find something. Let's start with Mark's opening paragraph:
I want to clear up a few things regarding that post. First, I was not trying to defend Lucas' views on fiscal stimulus. Lucas's view on the matter (insofar as one can gather it from what was clearly an informal and off-the-cuff speech) appears to be that a money-financed increase in G is stimulative, while a tax-financed increase in G is not. Now, there may be several ways to criticize the "rationale" of his argument. But whatever criticism you pick, it most certainly cannot be centered on Lucas' alleged appeal to the Ricardian equivalence theorem. For crying out loud--the man is claiming that the method of financing matters for a given G. This can only be true if the Ricardian proposition fails to hold in reality.
Now, what of Mark's claim that the empirical evidence does not support the RET? Well, as I said above, given that we live in a world of distortionary taxation, borrowing constraints, finite planning horizons, etc., etc., it would indeed be remarkable if the predictions of RET held up exactly in the data.
But surely that is setting the bar a little too high (not one of us has a theory that can perfectly predict such outcomes). Rather, the question is whether or not the assumptions constitute sufficiently good approximations for the purpose at hand (i.e., for a given policy experiment). Indeed, in the interview posted by Mark, Barro states his view on the matter quite plainly:
In any case, I'm not sure whether Mark's claim about the empirical evidence not supporting RET is entirely valid. I am reminded of a paper I once saw Emanuela Cardia present: Replicating Ricardian Equivalence Tests With Simulated Series. Here is the abstract:
At the end of the day, I think that the key lesson of the RET is not (for example) that "deficit financed tax cuts do not matter." Rather, the lesson should be that "such a policy is likely to be much less stimulative than you would expect if you were to base your thinking on a model that did not incorporate Ricardian forces."
Now who wants to argue with that?
I want to comment on Mark Thoma's post today about the Ricardian Equivalence Theorem (RET). Linking up to the interview with Barro was a good idea, Mark. Everyone agrees that the theorem has nothing to say about the effectiveness of G, and Barro explains all of this splendidly. Moreover, everyone agrees that since the conditions needed to render the proposition valid are violated in reality, the proposition cannot possibly be expected to make a perfectly accurate prediction of how altering the timing of taxes (holding G fixed) is likely to impact the economy. I guess that this is about where our mutual agreement ends.
What is there left to argue about? It's the holidays--I'm sure we'll find something. Let's start with Mark's opening paragraph:
I haven't said much about the recent flare up over Ricardian equivalence. Why? The answer's simple, the empirical evidence does not support it. Why argue about something when we already know it fails to adequately explain the data? Making the Ricardian equivalence assumption might be okay as a first approximation for some questions--though I'd argue that it mostly isn't--but in any case the theory does not adequately capture economic behavior.I'm not exactly sure which flare up he is talking about, but I suspect that I may be involved in it somewhere, owing to this post here: Does Krugman Understand the Ricardian Equivalence Theorem?
I want to clear up a few things regarding that post. First, I was not trying to defend Lucas' views on fiscal stimulus. Lucas's view on the matter (insofar as one can gather it from what was clearly an informal and off-the-cuff speech) appears to be that a money-financed increase in G is stimulative, while a tax-financed increase in G is not. Now, there may be several ways to criticize the "rationale" of his argument. But whatever criticism you pick, it most certainly cannot be centered on Lucas' alleged appeal to the Ricardian equivalence theorem. For crying out loud--the man is claiming that the method of financing matters for a given G. This can only be true if the Ricardian proposition fails to hold in reality.
Now, what of Mark's claim that the empirical evidence does not support the RET? Well, as I said above, given that we live in a world of distortionary taxation, borrowing constraints, finite planning horizons, etc., etc., it would indeed be remarkable if the predictions of RET held up exactly in the data.
But surely that is setting the bar a little too high (not one of us has a theory that can perfectly predict such outcomes). Rather, the question is whether or not the assumptions constitute sufficiently good approximations for the purpose at hand (i.e., for a given policy experiment). Indeed, in the interview posted by Mark, Barro states his view on the matter quite plainly:
As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow...So, to Barro it seems that the empirical evidence broadly supports the proposition, at least, to a first-order approximation. If so, that is bad news for me, because I like to work with models where the proposition fails. It would, however, be good news for those promoting an increase in G in the face of large deficits (the size of the deficit should not factor into the debate, if the proposition holds true).
In any case, I'm not sure whether Mark's claim about the empirical evidence not supporting RET is entirely valid. I am reminded of a paper I once saw Emanuela Cardia present: Replicating Ricardian Equivalence Tests With Simulated Series. Here is the abstract:
This paper replicates standard consumption function tests of Ricardian equivalence using series generated from a model which nests Ricardian equivalence within a non-Ricardian alternative (due to finite horizons and/or distortionary taxation). I show that the estimates of the effects of taxation on consumption are not robust and that standard tests may have weaknesses which can lead to conflicting results, whether Ricardian equivalence holds or not. The simulations also show that no clear conclusions about Ricardian equivalence can be drawn from observing a low correlation between the current account and government budget deficits.In short, I think that the empirical evidence may be somewhat more mixed than what Mark suggests.
At the end of the day, I think that the key lesson of the RET is not (for example) that "deficit financed tax cuts do not matter." Rather, the lesson should be that "such a policy is likely to be much less stimulative than you would expect if you were to base your thinking on a model that did not incorporate Ricardian forces."
Now who wants to argue with that?
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