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Sunday, August 11, 2013

Ricardo and his followers

"Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits, of adopting a hypothetical world remote from experience as though it were the world of experience and then living in it consistently. With most of his successors common sense cannot help breaking in — with injury to their logical consistency." J M Keynes (1936) "The General Theory of Employment Interest and Money appendix to chapter 14).

With decades of effort, economists have managed to keep common sense from breaking in even when Ricardo himself couldn't.  Ricardian equivalence is a totally silly idea. Even Ricardo had enough sense to see that.  In this case he understood that actual real world economic agents weren't rational in the sense of having beliefs consistent with his model.

Numerous commentators over at Krugman's blog (link for a link and thanks) challenge Krugman's claim about the extreme implications of Ricardian equivalence.


Even leaving aside the implausible assumptions, what rational householder would plan present and future spending on the proposition that government debt must be repaid with future taxes? The United States has never paid its national debt and never will. It simply accumulates. Moreover, there is no discernible relationship between the level of taxes and debt. How is it rational to assume something will happen in the future that has never happened before?

However, the fact that the national debt never reaches zero and even the fact that budget surpluses are small and rare does not mean that there is no Ricardian equivalence  What would be needed is for the present value of debt at time t discounted to time now to not fall to zero as t goes to infinity.  So not the debt but the debt discounted to now.  That condition about the discounted value has to hold in models with a rational representative agent.  So it is a requirement of (foolish) consistency to assume it.

  • Done
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  • Verified

"is that even a helicopter drop of money has no effect in a world of Ricardian equivalence, since you know that the government will eventually have to tax the windfall away."
No. True helicopter money doesn't have to be taxed away. But even if it did, Ricardian equivalence has nothing to do with the hesitation of consumers to spend when given some extra cash.
This state is doubly wrong.
I reply
1) damn autocorrect and
2) We are commentino on Friedman Who (reasonably) calla the reduction in valute of money holdings due to inflation "inflation tax". With a helicopter drop either the economay stays in the liquidity trap forever or eventually the real balances reach the same equilibrium value so the added money exactly equals the present value of added losses due to inflation. Krugman did the math right (he tenda to).

my wife's iPad corrects my English to Italian. To tradurre

We are commenting on Friedman Who (reasonably) called the reduction in valute of money holdings due to inflation "inflation tax". With a helicopter drop either the economy stays in the liquidity trap forever or eventually real balances reach the same equilibrium value, so the added money exactly equals the present value of added losses due to inflation. Krugman did the math right (he tends to).

In reply to another comment about how money is not like bonds because it doesn't mature, I note that commenters think that Krugman solved a simple model with a representative consumer wrong over a decade ago and hasn't noticed the error nor has anyone pointed it out.  This is not likely.  Contemporary macroeconomists may have no common sense at all, but we can handle a bit of math.

Also Krugman has some common sense, but the point here is that he can do standard macro math.


Ashok Rao said...

I think we can very much defend helicopter drops even under Ricardian equivalence. I've written about it here:

I'd say the important consideration is that we should treat fiat money as an asset to the private holder but not – paradoxically, but non-trivially – as a liability to the public issuer.

This means a helicopter drop adjusts the HH and G budget constraints asymmetrically, allowing – even under Ricardian conditions – for a drop to be expansionary.

A lot of the argument is from a 2003 paper by Willem Buiter.

I also think that expansion with a helicopter drop is game theoretically rational. "In this case, superrational agents note that the provision of helicopter money will not be expansionary if everyone saves their cheque, and note the Kaldor-Hicks efficient solution would be for everyone to spend the cheque, thereby increasing prices and aggregate demand.

This may be too rich an argument – in a superrational world we would not have the Paradox of Thrift, for example – but is more robust against imperfections. For example, as an approximately superrational agent who understands the approximately superrational nature of my friends, I know that they will probably spend their money (I mean they’ve been wanting that new TV for so long). I know that will create an inflationary pressure, and while I would like to save my money, I know they will decrease its value and I’d rather get there before everyone else.

I see this as a Nash Equilibrium in favor of the money-print financed tax cut."

As I write, however, this is consistent with a liquidity trap – so we can have our cake and eat it too.

Simon van Norden said...

"That condition about the discounted value has to hold in models with a rational representative agent."

Well put: the representative agent assumption is generally necessary for this result. There's quite a bit of work over the past decade and more relaxing this assumption (some of the work by Morris and Shin comes to mind) while maintaining the assumption of rationality. I don't think many macroeconomists understand how different rational behaviour can be once agents are aware that they are not representative.

Anonymous said...

If you are planning one of these helicopter drops can you do it above my loan? Please..!

Robert said...

@Ashok Friedman's point is that seignorage isn't just revenue for the state but also a cost for money holders. Consider long after the helicopter drop when the economy has returned to normal, real balances will have returned to normal. This means that the extra money is exactly equal to the extra loss of wealth due to extra expected inflation. The Pigou effect is a wealth effect of the extra real balances assuming they do not correspond to extra loss of wealth due to inflation. It only occurs if consumers are not forward looking.

Now there is another way out of the inflation trap. It is the Fisher effect -- investment depends on real interest not nominal interest so expected inflation can cause higher demand. That is a different mechanism than the Pigou effect.

Robert said...

OK most of the comment describes a good Nash equilibrium. I think this can occur without a helicopter drop. In general new Keynesian DSGE models often can have a continuum of equilibria, because expected inflation can cause inflation (often this depends on future monetary policy -- that is the parameters of the Taylor rule).

The standard approach is to make whatever assumptions are needed to eliminate the indeterminacy. The argument is that if equilibrium is indeterminate then we can't forecase and can't determine the effects of policy. Note these are argument for why indeterminacy is embarrassing for macro economists not arguments that it is unlikely.

In fact, we can't forecast well. There are models which explain this fact. It is just assumed that, all failure in the past notwithstanding, we must be able to forecast well if we just improve the model, because ... well basically because otherwise there would be no point in paying us to do research.