Friday, 1 March 2013

Modern Monetary Theory makes a mockery of Ricardian equivalence.

 “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” – Joseph Stiglitz.

“It is a dubious doctrine even done right..” Krugman.

Ricardian equivalence says that if government cuts taxes and borrows instead, taxpayers will think that this borrowing needs to be repaid, so they’ll forego consumption and save while the borrowing takes place so as to pay for the inevitable tax increases needed to fund repayment of the government borrowing. And taxpayers will do this, according to Ricardian equivalence, for the supposedly logical reason that taxpayers will want to smooth their monthly spending.
That idea is nonsense. To explain why, let’s consider the two basic reasons why governments borrow. One is that government wants to do some traditional Keynsian “borrow and spend” stimulus. The second is that government aims to leave GDP unchanged, and simply fund some expenditure via borrowing rather than via tax. We'll take the first one first.

If a government effects stimulus, THE WHOLE OBJECT OF THE EXERCISE is “income smoothing”!!! That is, governments effect stimulus where there is an unexpected drop in aggregate demand, which in turn means a drop in household incomes.
If households DO FOREGO CONSUMPTION, that just thwarts the objective of the borrow and spend policy. Put another way, if households were to forego consumption en masse, and government spotted what was going on, government would just do EVEN MORE borrow and spend with a view to getting households to consume more!!
As for repaying government so called “debt”, there is no point in government doing this unless and until private sector spending gets excessive. That is, the effect of borrow and spend is to increase private sector net financial assets which will probably have the desired stimulatory effect. But the effect may also last longer than is needed: i.e. lead to excess demand once the above mentioned drop in aggregate demand is over. In which case government would have to raise tax and repay its creditors.
Put another way, the only scenario in which it makes sense for government to raise taxes is where household incomes and spending are excessive. Thus there is no point in households saving so as to be able to afford those taxes – i.e. if and when those taxes increases come, household income will be EXCESSIVE ANYWAY. Households will have no trouble maintaining their income and spending at the maximum feasible level, while in addition paying the extra tax.

Borrowing replaces tax.
Now for the second reason for government borrowing, namely to fund a portion of government spending from borrowing rather than from tax.
Why does the government / central bank machine (gcbm) borrow? As MMTers have pointed out ad nausiam, it is NOT strictly speaking to fund government spending. And that’s for the simple reason that gcbm can print any amount of money any time it wants.
Rather, the purpose of  borrowing is to supress private sector spending, and ideally by the same amount as the proposed increase in government spending. That way, the extra government spending is not inflationary.
And gcbm will actually do the above by borrowing from the private sector and letting interest rates rise a bit. That will have a deflationary effect which will counteract the tax cut.
And note: THERE IS ABSOLUTELY NO REASON why the amount borrowed is necessarily equal to the amount government proposes to spend. The important point, to repeat, is that the deflationary effect of the borrowing equals the stimulatory or inflationary effect of the spending. That being the case, it’s quite conceivable that if gcbm wants to spend £Z funded by borrowing, it will need to borrow not £Z, but £2Z. Or it could be £Z/2.
Now that all makes a nonsense of the above Ricardian claim that that households should forego consumption in order to fund the increase in tax needed to repay government borrowing. Reason is that the above borrowing will AUTOMATICALLY cut their income and spending by an amount that balances the INCREASED income and spending that comes from the tax cut.
And when it’s time to repay the debt, taxes will be cut so as to negate the deflationary effect of repaying the borrowing. So there’s no need for households (a la Ricardo) to save up in order to pay some sort of mythical tax needed to fund repayment of government debt. That is, if and when the debt is repaid, a rational government will CUT TAXES so as to give a stimulatory effect that cancels out the deflationary effect of repaying borrowing.

1 comment:

  1. Our government borrows because they have a captive market who must buy the debt and the politicians don't have to beg for tax increases.

    Not only that, I buy bonds for my retirement so I would not be happy if it wasn't available.

    And I'm sure the our trading partners like the bonds to put their trade surpluses of American money into insuring a return.

    And it strikes me that when this borrowing is spent and or, the interest is received, it all eventually is taxed and returned to the Treasury or am I missing something?

    Like the big black hole that consumes all that government borrowing that will bankrupt our children!

    It's true I'm not an economist but just where does that money go if not back to the Treasury?


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