Answering Krugman On Ricardian Equivalence

Andrew Lilico Daily Telegraph December 28, 2011

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By Andrew Lilico Economics Last updated: December 27th, 2011

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Paul Krugman: wrong again

Paul Krugman has a piece up on his blog which he appears to regard as a knockout blow to the concept of "Ricardian Equivalence" (i.e. the doctrine that, under most circumstances, funding government spending with a deficit does not increase output relative to funding that same government spending with tax). Here's what he says:

[T]hink about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan… If the house is newly built, that's $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won't be paid off all at once "” and there's no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like [a] bridge; in this case the household really does know that today's spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.

Does this show that the Ricardian Equivalence claim is nonsense? Krugman's homebuyers spend $100,000 now but today's consumption drops by only $6,000 because they look ahead anticipating the servicing cost – a net stimulus of $94,000 to the household's spending. He invites us to imagine that, similarly, if $100,000 were spent on a bridge then today's spending on other things (socks, cars, machines) would not fall by anything like $100,000 in compensation, so there would be a significant stimulus effect.

Krugman's got this one badly confused. For the issue in Ricardian Equivalence is not whether spending has an effect on output (we shall debate that using other tools shortly); it is whether spending funded by a deficit as opposed to a tax raises output. So the correct analogy for Krugman to have set up would have been a homebuyer that had $100,000 in cash or other assets (much as the government does, we assume, have the ability to raise taxes to fund the bridge) would spend more if buying a house with that cash than if it bought the house with a mortgage. The answer is obviously that (given a few technical assumptions that don't always hold) it will not. If it takes out the mortgage then from the $100,000 it keeps as assets there is an investment return, but that investment return is offset by the commitment to pay back the mortgage. Net stimulus effect: nil.

The all-economy situation that would be like Krugman's scenario would be one in which the government is unable to tax its citizens any more, but does have international lenders willing to fund its deficit. Well, perhaps there are situations like that, but certainly not in the US or UK today. (On the other hand, the UK today does have a broken banking sector and thus may have liquidity-constrained households, breaking Ricardian equivalence, so there may have been some scope for a deficit to provide a stimulus, as I argued here – but not 10% of GDP.)

OK. So funding the bridge with the deficit might not provide a stimulus, but mightn't the $100,000 injected into the economy by building the bridge create some kind of multiplier effect, such that the total increase in output is more than the initial $100,000 outlay? Perhaps, but then why wouldn't similar multipliers apply to the taxes raised to fund the bridge-building (a question asked by Lucas in Krugman's piece)?

Very well. But suppose that the bridge is a value-generating project ("NPV-positive", in the jargon). Doesn't that make the economy wealthier? So mightn't people spend more because of that? Yes indeed, though of course we must ask whether it is the most NPV-positive project available, and whether the government is really better-placed to invest in it than the private sector. But overall, this is the right question: does government spending generate real long-term value and thus wealth to the economy; not, does it provide a stimulus.

Tags: deficit, paul krugman, ricardian equivalence

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