Tuesday, 9 January 2018

What proportion of economists have a grip on reality?

The Cambridge economist Ha-Joon Chang said  “Unfortunately a lot of my academic colleagues not only do not work on the real world, but are not even interested in the real world.”

Nothing illustrates that lack of interest in reality better than Ricardian Equivalence (RE). For those not acquainted with RE, it’s an idea which is about as realistic as witchcraft or astrology, and it’s as follows.

It’s the idea that if government deals with a recession by spending more and funding that extra spending via more debt, then it will have to raise taxes to repay that debt at some time, and the average individual or employer will realize that tax hike is in the pipeline, thus they’ll try to save so as to meet that tax obligation. Plus that saving will partially or wholly nullify the latter extra spending.

Incidentally I’ve dealt with the nonsense that is RE before on this blog, but a bit of repetition never goes astray when trying to get a point across. Plus the paragraphs below make a few points not made in earlier articles on this subject.

The first obviously unrealistic aspect of RE is the idea that the average individual, household or employer actually knows what the deficit is in terms of dollars, pounds, etc, and sits down  with a calculator to work out what the resulting future increased tax liability might be. I suspect the proportion of the population (individuals and employers) who know what the deficit is in terms of dollars or as a percentage of GDP is around 1%. But perhaps I’m out by a two or three hundred percent there, and the real percentage is 2% or 3%. Makes no difference: it remains true that almost NOBODY does or event tries to do the sort of calculation that RE enthusiasts claim they do.

How many of your friends spend time with their calculators working out the alleged effect of a deficit on their future tax liability? None of mine do, and I’ve never known anyone do that. Provisional conclusion: RE is an idea straight out of La-la land.

But that hasn’t stopped hundreds of economists, if not thousands, turning out papers where the validity of RE is explicitly assumed, or at least in which its partial validity is assumed.

Inflation and increased real GDP.

The second blatantly unrealistic aspect of RE is that governments basically just don’t repay their debts via increased tax. What actually happens is that a higher than normal debt relative to GDP declines over the years and decades, first because inflation eats away at the real value of the debt, and second because of increased GDP in real terms (which cuts the debt/GDP ratio assuming the debt remains constant or more or less constant in terms of dollars).

A classic example is the UK’s public debt which just after WWII was around 250% of GDP and declined to around 50% in the 1990s. But according to the chart just below, produced by Roger Farmer, economics prof in California, the whole of that debt reduction took place because of the latter two factors: inflation and increased real GDP. Put another way, according to Farmer’s chart there was a deficit every single year between WWII and the 1990s, i.e. no surplus (which would indicate repayment of debt).

Actually Farmer’s chart is not quite right: I believe there were one or two years in which THERE WAS a surplus. But never mind: the chart is BASICALLY RIGHT. That is, the vast bulk of the fall in the UK’s debt/GDP ratio came about because of the above two factors: inflation and increased real GDP and not because the debt was repaid in the conventional sense of “repay a debt”.

Conclusion: for anyone interested in reality, RE is complete nonsense. Or as the Nobel laureate economists Joseph Stiglitz put it, “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.”

A third flaw in Ricardian Equivalence.

Just by way of driving a final nail into this coffin, there is actually a third flaw in RE which is relevant where there is no inflation or real growth. Of course that “no growth or inflation” assumption is a bit unrealistic, but this is worth pursuing since the above demolition of RE was based on the assumption that THERE IS inflation and real growth. I.e. by way of closing off every possible escape route for RE supporters, it is worth explaining why RE is nonsense even where there is no real growth or inflation.

But a word of warning: this third flaw in RE is a bit complicated. Plus my explanation of this third flaw doubtless leaves much to be desired. So stop reading now if you like: arguably you won’t have missed much. Anyway, here goes.

First, as is little more than common sense, there are numerous factors that determine aggregate demand (AD ): there is for example consumer and business confidence. Thus to keep things simple, let’s assume (as per standard scientific experiment) that all variables other than the ones we’re interested in are constant.

The variables we’re interested in are AD, the deficit and the resultant stock of base money and public debt held by the average person.
(The idea that there is some sort of average person who holds a stock of base money and government debt is of course itself a simplification in that private individuals do not DIRECTLY hold a huge amount of public debt: in as far as they do hold it, they hold it (in the UK) via accounts at National Savings and Investments, unit trust holdings and via pension funds. But never mind: individuals in the UK and elsewhere are effectively owners of public debt).

Next, bear in mind that public debt is effectively more or less the same thing as money (as explained for example by Martin Wolf in the Financial Times).

Now the more money people have (both base money and public debt, which is the sense in which I’ll use the word “money” from now on) the more they’re liable to spend. Thus there must be some stock of money per average person which gives a level of AD which results in full employment.

And given a recession, governments run deficits which result in the average person’s stock of money rising, which in turn encourages more spending, which in turn brings and end to the recession. (Of course demand is also raised by the mere fact of additional public spending.)

Now why in a “no growth / no inflation” scenario does it not make sense for people to save so as to meet the tax liability that RE enthusiasts are so keen on? Well first people cannot be sure that that tax liability will ever arise: that is, if there’s been a PERMANENT increase in the amount of money people want to hold, there is no point in government withdrawing that money from people. If government does, that will simply lead to a recession.

Alternatively, suppose the increased money supply deals with a recession till the end of year X, at which point there’s an increase in consumer and business confidence, which more or less equals a reduced demand for money (aka increased desire to spend) by the private sector, so government has to withdraw some of the private sector’s stock of money.

If people save BEFORE the end of year X, that will tend to prolong the recession, in which case government will have to feed yet more money into peoples’ pockets.

Thus we are led to the absurd conclusion that if a tax increase is actually necessary at the end of year X, and people save before that time in order to meet that tax liability, that will force government to deal with the deflationary effect of that saving by running an even bigger deficit, which will presumably induce people to save even more in order meet the even bigger tax liability, which in turn exacerbates the recession even further! We appear to be going round in circles!

In short, if people do have the amazing foresight that RE supporters claim they do, people will not save in order to meet any alleged future tax liability because the mere fact of that saving means government will run an even bigger deficit, which increases the future tax liability even further.

Conclusion: this is clearly a total and complete farce.

Final conclusion: Ricardian  Equivalence is a farce.


  1. Hi Ralph! Like your analysis on RE (though you lost me on the last argument). Where's private debt in this story though? Private debt (mortgages mostly) amounts to a huge part of our current debt and credit (=also money) pile. Booms and busts from this huge credit bubble also influence inflation and deflation. Do you think this might make a difference?

    Cheers and keep up the writing.

    1. Hi Jaap, Important as private debt is, I don't think it's relevant here. Private debt influences things in two ways I think. First it imparts stimulus (or the opposite) in a random fashion, according to the whims of consumer and business confidence. So that element is not relevant here. Second, private debt amplifies the effect of state sponsored stimulus. E.g. whether state sponsored stimulus consists of just printing more base money and spending it, or whether it consists of a cut in interest rates, private debt amplifies that. A could have mentioned that, but that doesn't change the basic argument above.

      Re the third/last argument, I agree that is complicated or put another way, maybe I got my knickers in more of a twist than I needed to!


Post a comment.