Somewhere Robert Barro is screaming: Keynesians torturing Ricardian Equivalence

January 26, 2011 12:07 PM

All of a sudden everyone is talking about Ricardian Equivalence.  Ed Balls yesterday on the Daily Politics.  Anatole Kaletsky today in a Times column that has got Left Foot Forward incredibly excited.  Balls didn't appear to have a clue what Ricardian Equivalence meant.  Kaletsky at least understands the concept but presents an incredibly misleading account of its genesis and ignores the empirical support the theory has received over the years.  It's pretty painful and torturing such an important debate shows how shallow the Keynesian argument against the cuts has got.

I wrote about what was wrong with Ed Balls' use of Ricardian Equivalence in my ConservativeHome article this morning:
"Bizarrely Ed Balls cited Ricardian Equivalence on the Daily Politics.  Either he is ignorant of the meaning of the concept or he butchered it in a dishonest attempt to make his point sound credible.  The point of Ricardian Equivalence is that people know deficits will have to be paid for and adjust their behaviour in light of that, consuming less so they have the money to cope with the forthcoming spending cuts or tax rises.  As a result Keynesian attempts to prop up the economy with deficits tend to fail.  To the extent Ricardian Equivalence is correct, spending cuts to reduce a deficit will not weaken the economy ever, let alone ahead of time as he was suggesting."

Anatole Kaletsky at least understands what Ricardian Equivalence is but presents an incredibly misleading account of the debate over it.  Here is the critical section of his piece extracted by Left Foot Forward:
"This faith is based on a theory traced back to the works of David Ricardo, perhaps the most respected economic thinker of all time. In a paper written in 1820, Ricardo examined whether a government that went to war would be better off collecting £20 million in taxes or borrowing the same amount at an interest rate of 5 per cent or £1 million a year. “In point of economy, there is no real difference,” he concluded. “For £20 million in one payment and £1 million per annum for ever … are precisely of the same value.

This was seized on by conservative anti-Keynesian economists as Ricardo’s endorsement of their view that government borrowing was indistinguishable from taxation — and therefore that cuts in borrowing would automatically boost private spending.

This came to be known as Ricardian equivalence, but conservative economists failed to mention that Ricardo himself poured scorn on this simplistic idea, pointing out that it was based on unrealistic assumptions about human nature. Just after the passage about the theoretical equivalence of public borrowing and taxation, he added: “But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly … It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1,000.” In other words, Ricardo himself doubted the Ricardian equivalence on which the coalition’s entire economic policy depends. After yesterday’s figures Mr Osborne had better take note."

That is an extremely cheap shot.  Ricardian Equivalence is named after David Ricardo because his comments were the earliest speculation about the basic idea.  But the theory we discuss today was created by Robert Barro, and was never based on the authority of Ricardo but on the theoretical underpinning of rational expectations theory - which rose to prominence out of the failure of crass Keynesianism in the 1970s - and a fair bit of empirical evidence.  Attacking Ricardian Equivalence the way Kaletsky does is like rejecting Darwinian evolution on the grounds that Darwin never gave serious consideration to the possibility of the double helix structure of DNA.  Or refusing to fly in helicopters because Leonardo da Vinci couldn't make his plan work.  Funnily enough, in 1820 a concept that was only properly explored for the first time and then empirically studied in the 1970s wasn't ready yet.

Ricardian Equivalence is controversial, and like lots of the most useful economic theories, the assumptions probably don't hold for it to be true in its strongest form.  There have been criticisms from left and right.  But there is good reason to think it holds up under scrutiny imperfectly but strongly enough to render Keynesian policy ineffective, which is the key point for the purposes of the debate over policy.  In 1993, in the Journal of Economic Literature, behind the academic firewall unfortunately, John J. Seater summed up the evidence:
Needless to say, so revolutionary a theory has not gone unchallenged, and its revival has led to extensive research, both theoretical and empirical, into the effects of government debt on the economy.  The fruit of that effort is the subject of this essay.  Although the aggregate effects of public debt and deficits have not yet been fully determined, two overall conclusions are now clear.

The first appears uncontroversial: it seems almost impossible that Ricardian equivalance holds exactly. The theoretical foundations for any effects of debt on the economy depend on subtle concepts such as the intensity of intergenerational altruism, the possibility of strategic behavior by individuals in their family relations, the nature and extent of liquidity constraints, and the effects of various kinds of uncertainty on the household maximization decision.  Careful examination of those factors suggests that exact Ricardian equivalence is implausible.

The second conclusion is far more controversial: despite its nearly certain invalidity as a literal description of the role of public debt in the economy, Ricardian equivalence holds as a close approximation. Although there is much empirical evidence appearing to reject Ricardian equivalence, a dispassionate reading of the literature leads to the stated conclusion. Testing theories of government debt's effects is not trivial. Estimation is sensitive to the treatment of specification, simultaneity, and data stationarity, as well as simple measurement of the quantities involved, so that careful attention to interesting issues of econometric methodology is essential. Much of the published evidence on Ricardian equivalence, both favorable and unfavorable, fails to attend to those issues and is sufficiently flawed to be uninformative.  When attention is restricted to the more methodologically sound studies, it is difficult to find statistically significant effects of debt, suggesting that Ricardian equivalence holds approximately.

Anatole Kaletsky writes up Ricardian Equivalence as a lazy appeal to the authority of the 19th century economist.  In reality, it is a concept that has been fleshed out in a serious theoretical and empirical debate over the last three decades.  He has misled his readers.All of a sudden everyone is talking about Ricardian Equivalence.  Ed Balls yesterday on the Daily Politics.  Anatole Kaletsky today in a Times column that has got Left Foot Forward incredibly excited.  Balls didn't appear to have a clue what Ricardian Equivalence meant.  Kaletsky at least understands the concept but presents an incredibly misleading account of its genesis and ignores the empirical support the theory has received over the years.  It's pretty painful and torturing such an important debate shows how shallow the Keynesian argument against the cuts has got.

I wrote about what was wrong with Ed Balls' use of Ricardian Equivalence in my ConservativeHome article this morning:
"Bizarrely Ed Balls cited Ricardian Equivalence on the Daily Politics.  Either he is ignorant of the meaning of the concept or he butchered it in a dishonest attempt to make his point sound credible.  The point of Ricardian Equivalence is that people know deficits will have to be paid for and adjust their behaviour in light of that, consuming less so they have the money to cope with the forthcoming spending cuts or tax rises.  As a result Keynesian attempts to prop up the economy with deficits tend to fail.  To the extent Ricardian Equivalence is correct, spending cuts to reduce a deficit will not weaken the economy ever, let alone ahead of time as he was suggesting."

Anatole Kaletsky at least understands what Ricardian Equivalence is but presents an incredibly misleading account of the debate over it.  Here is the critical section of his piece extracted by Left Foot Forward:
"This faith is based on a theory traced back to the works of David Ricardo, perhaps the most respected economic thinker of all time. In a paper written in 1820, Ricardo examined whether a government that went to war would be better off collecting £20 million in taxes or borrowing the same amount at an interest rate of 5 per cent or £1 million a year. “In point of economy, there is no real difference,” he concluded. “For £20 million in one payment and £1 million per annum for ever … are precisely of the same value.

This was seized on by conservative anti-Keynesian economists as Ricardo’s endorsement of their view that government borrowing was indistinguishable from taxation — and therefore that cuts in borrowing would automatically boost private spending.

This came to be known as Ricardian equivalence, but conservative economists failed to mention that Ricardo himself poured scorn on this simplistic idea, pointing out that it was based on unrealistic assumptions about human nature. Just after the passage about the theoretical equivalence of public borrowing and taxation, he added: “But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly … It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1,000.” In other words, Ricardo himself doubted the Ricardian equivalence on which the coalition’s entire economic policy depends. After yesterday’s figures Mr Osborne had better take note."

That is an extremely cheap shot.  Ricardian Equivalence is named after David Ricardo because his comments were the earliest speculation about the basic idea.  But the theory we discuss today was created by Robert Barro, and was never based on the authority of Ricardo but on the theoretical underpinning of rational expectations theory - which rose to prominence out of the failure of crass Keynesianism in the 1970s - and a fair bit of empirical evidence.  Attacking Ricardian Equivalence the way Kaletsky does is like rejecting Darwinian evolution on the grounds that Darwin never gave serious consideration to the possibility of the double helix structure of DNA.  Or refusing to fly in helicopters because Leonardo da Vinci couldn't make his plan work.  Funnily enough, in 1820 a concept that was only properly explored for the first time and then empirically studied in the 1970s wasn't ready yet.

Ricardian Equivalence is controversial, and like lots of the most useful economic theories, the assumptions probably don't hold for it to be true in its strongest form.  There have been criticisms from left and right.  But there is good reason to think it holds up under scrutiny imperfectly but strongly enough to render Keynesian policy ineffective, which is the key point for the purposes of the debate over policy.  In 1993, in the Journal of Economic Literature, behind the academic firewall unfortunately, John J. Seater summed up the evidence:
Needless to say, so revolutionary a theory has not gone unchallenged, and its revival has led to extensive research, both theoretical and empirical, into the effects of government debt on the economy.  The fruit of that effort is the subject of this essay.  Although the aggregate effects of public debt and deficits have not yet been fully determined, two overall conclusions are now clear.

The first appears uncontroversial: it seems almost impossible that Ricardian equivalance holds exactly. The theoretical foundations for any effects of debt on the economy depend on subtle concepts such as the intensity of intergenerational altruism, the possibility of strategic behavior by individuals in their family relations, the nature and extent of liquidity constraints, and the effects of various kinds of uncertainty on the household maximization decision.  Careful examination of those factors suggests that exact Ricardian equivalence is implausible.

The second conclusion is far more controversial: despite its nearly certain invalidity as a literal description of the role of public debt in the economy, Ricardian equivalence holds as a close approximation. Although there is much empirical evidence appearing to reject Ricardian equivalence, a dispassionate reading of the literature leads to the stated conclusion. Testing theories of government debt's effects is not trivial. Estimation is sensitive to the treatment of specification, simultaneity, and data stationarity, as well as simple measurement of the quantities involved, so that careful attention to interesting issues of econometric methodology is essential. Much of the published evidence on Ricardian equivalence, both favorable and unfavorable, fails to attend to those issues and is sufficiently flawed to be uninformative.  When attention is restricted to the more methodologically sound studies, it is difficult to find statistically significant effects of debt, suggesting that Ricardian equivalence holds approximately.

Anatole Kaletsky writes up Ricardian Equivalence as a lazy appeal to the authority of the 19th century economist.  In reality, it is a concept that has been fleshed out in a serious theoretical and empirical debate over the last three decades.  He has misled his readers.

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