Ricardian Effects

But then, my understanding of macro theory is based on fast-disappearing memories of my BA coursework.

If you wait till it disappears altogether you can get a job at a big-time news magazine or somesuch.

I guess he’s talking about the possible changes in the risk premium (and hence the real interest rate, and hence investment) resulting from changes in the debt/gdp ratio. Usually though this argument is/has been used in the opposite situation, and yes, there it does have a good bit of empirical support. The argument is that starting from a position where the debt/gdp ratio is growing at an unsustainable, or close to unsustainable rate, a fiscal consolidation (contraction of deficits) may not be recessionary, or at least not as recessionary as you’d expect. This is because the risk premium falls due to improvements in the long term fiscal position of the government, lowering the interest rate and offsetting part of the reduction in demand due to lower government spending. More specifically, it matters what kind of government spending gets cut – gov investment or consumption.
Alesina, Perotti and Tavares (1998) document this happening in several European countries in the 1980’s.
Here however the argument is used symmetrically for an opposite case – starting from the position of sustainable debt/gdp ratio, a fiscal expansion intended to stimulate the economy may not end up getting much bang for the buck because of the rise in the risk premium due to worsening in the long run fiscal situation of the government.
I can’t think of specific research that looks at this case and the relevant multipliers may very well be asymmetric (the argument can work one way but not the other) – because who the hell knows what ends up going in to the risk premium at the end of the day.
But “normal” (as in ‘normal times’, not these ones) estimates of the fiscal multipliers tend to be small. This is more true for tax cuts than gov spending though although the difference is not that big.
But of course these aren’t ‘normal times’ and it’s not like monetary policy by itself is likely to be helpful here. I think the basic thing to take away from this is that any kind of fiscal stimulus should be directed at government investment rather government consumption since the former doesn’t involve as much (if any) “Ricardian effects”.

This is all assuming that this is indeed what he means by “Ricardian effects”. At first I thought he was talking about Ricardian Equivalence – and empirical support for that holding exactly is weak, and which is based on some heroic assumptions (which doesn’t mean that there isn’t some Ricardian Equivalence “effects” which reduce the difference between the effects of bond and tax financed spending) – but the context doesn’t seem to bear that interpretation out.

There are real problems with announcing large expenditures now and saying nothing how they will be financed. But we are already starting to see some governments (UK, for example) saying that they will increase taxes when the immediate crisis is over.

I doubt that, in this context, we are going to see lots of households and businesses taking the view that they should increase saving to deal with their future tax liabilities (the standard Ricardian equivalence line). Most will be grateful if they can stay solvent long enough to face those liabilities, and even more so if they can avoid a severe reduction in consumption along the way.

But to restate and reinforce notsneaky, running big deficits with no apparent thought about the need for subsequent surpluses is likely to increase risk premiums.

From memory, Riccardian equivalence has been offered as a potential explanation for why Japan had so little economic response to its public spending in the 1990s. I don’t know what the current verdict of the literature is on that theory.
Though as my macro-lecturer pointed out, our understanding of Japan’s economic history is hampered by a shortage of native Japanese economic historians writing in English.

I’ve a nasty suspicion that much of Trichet’s concern with Ricardian effects (= “Ricardian equivalence” in economics jargon) relates to the UK and Conservative criticism there of the government’s supposedly “crass Keynesianism” and its proposed fiscal stimulus to soften the impact of the recession. The claim made is that the fiscal stimulus will add too much to Britain’s national debt.

The following quotes with links help to put that claim into perspective:

First, from a comment by Sam Brittan in the FT:

“Those alarmed by UK official projections showing public sector net debt climbing from 36 per cent of gross domestic product last year to 57 per cent in 2012 should bone up on their history. There are long passages in Macaulay showing how the nation prospered despite increases in the national debt – regarded by sages as catastrophic. In his one and only Budget speech, Harold Macmillan noted how the national debt had risen from £600m in 1914 to £8.4bn in 1939 and £27bn in 1956 – representing 27, 133 and 146 per cent of GDP. As Macmillan [Chancellor of the Exchequer 1955-7] put it: ‘Whatever the temporary difficulties from trying to run too fast, if we stand still, we are lost.'”
[Financial Times on 5 December 2008: Sam Brittan: A framework for economic stability]
http://www.samuelbrittan.co.uk/text324_p.html

For international comparisons of projected outstanding Government debt as a percentage of GDP in 2009, try Table 1 in the Lloyds TSB Economic Weekly report of 26 November:
http://www.fxstreet.com/fundamental/analysis-reports/economics-weekly/2008-11-25.html

From the comparative data in the Lloyds Bank report, the UK’s projected national debt/GDP ratio next year is relatively modest compared with that for the US, Germany and the average for OECD countries.

This piece: Complacency rules as time slips away, by Wolfgang Münchau in Monday’s FT is especially recommended for those who, with Herr Steinbrück, the current German finance minister, passionately believe that a fiscal stimulus for an economy in a recession amounts to “crass Keynesianism”:
http://ft.onet.pl/1,18620,druk.html

Googling around, it seems that Ricardian effects is a bit of a hobby horse to Trichet. Here he explains it himself in an interview from 2006:

“the Keynesian argument: the more you spend, the more you activate the economy. But besides that argument, there is what economists call the “Ricardian effect’’. David Ricardo rightly stated that the greater the deficit becomes, the more investors and consumers alike start to realise that such a deficit is not sustainable in the longer run. Somebody will have to pay for it, either through higher market interest rates or through tax increases. Entrepreneurs become nervous and slow down their investments, consumers start saving more and spending less. So the economy slows down and jobs are lost. The more the budget goes into the red, the stronger this Ricardian effect becomes, and the more it outweighs the Keynesian arguments for deficit spending. That is why the stability pact is also a growth pact. “

And when Ricardo was writing, we didn’t have Fiat currency but a gold standard. I think it is odd that people think the situation is the same. And Ricardian equivalence, doesn’t make sense to me, because there is absolutely no reason for people to believe the people receiving the stimulus and the people paying the eventual tax are one and the same.

Re:15 “And when Ricardo was writing, we didn’t have Fiat currency but a gold standard.”

This is relevant to the extent that under a Gold Standard the interest rate would stay the same, so that the exchange rate (or the parity with Gold) stays the same, and the adjustment takes place through Gold flows (i.e. automatic monetary policy) – so no crowding out would take place. It’s analogous to the case where monetary policy is accomodating (keeps interest rates where they’re at) to fiscal policy or when the LM curve is flat (rising incomes don’t have much effect on desired money balances) – which is why Krugman throws that qualifier in there. Since EU countries have basically a gold standard between themselves and flexible exchange rate with rest of the world, then IF monetary policy is not accomodating or LM curve not flat then this is an additional argument for fiscal policy coordination amongst themselves. Part of the reason for the G&S pact is precisely that though in the past that constraint has been readily ignored when “key” countries didn’t feel like it.
It also has some implications for the risk premium through the link between interest rates and expected exchange rate depreciation (which is zero within EU but non zero with rest of the world) – which may be why the first question of the Trichet interview asks about the viability of the euro in the present crisis. Again this is basically another reason for fiscal coordination.

If you remember your Macro 101 then a tax financed increase in spending has no multiplier. dy=dg=dt

If you remember your Macro 201, that only holds if the incidence of taxation is such that the payers of the net tax increase have a marginal propensity to save identical to the inverse of that of the recipients of the spending increase. This implies an equal marginal propensity to save across the income distribution, which is a heroic assumption even by economists’ standards.

Re:19 it may be heroic but it’s standard. Because the point is to show that deficit spending has a bigger effect than tax financed spending (even if you got different MPCs). RE kills that difference. Anyway, once you start talking about different MPCs you’re going to pretty much end up with Permament Income Hypothesis where temporary gov spending increases don’t have a multiplier either.
Re: 20 Of course it’s positive. But in that case it’s not greater than 1.

What accounts for difference in MPC’s? Subjective factors (which more or less one should assume are the same across income classes unless one thinks there’s something ‘intrinsic’ about poor people that makes them not save as much), liquidity constraints and MPC as a function of present and permanent income. I.e. poor people consume more out of every dollar of income because they have lower incomes. But in that case what matters is not just individual’s present income but lifetime income (or permanent income). Liquidity constraints would basically determine the relative weights of present and permanent income in such an MPC.

The classical assumption of “workers eat their wages, capitalists save their profits” if taken at face value would imply that somehow the source of one’s income determines what one does with that income. Which seems silly. Rather it was probably intended as a very simple basic model of the permanent income effect.

Liquidity constraints would basically determine the relative weights of present and permanent income in such an MPC.

In other words, liquidity cnstraints lead to a departure from permanent income. You can only argue that varying propensities to consume reduce to the permanent income hypotheisis if you think liquidity constraints are relatively unimportant.

the source of one’s income determines what one does with that income. Which seems silly.

It only seems silly in a model — as in mainstream macro, where I guess you’re coming from — that doesn’t include firms, only households. In the real world, the division of income between wages and profits is even more important in terms of the MPC than that between households of different income levels.

It would seem to be that the present level of debt of a society is relevant. It’s all well and good for the U.K. to promise higher taxes in the future, but given the indebtedness of British society, it seems doubtful that these taxes will hold. So large deficit spending now is particularly dangerous – maybe the British will manage not to default on their sovereign debt, but they are well on their way.

“In other words, liquidity cnstraints lead to a departure from permanent income. ”

Sure, that’s what I said.

“You can only argue that varying propensities to consume reduce to the permanent income hypotheisis if you think liquidity constraints are relatively unimportant.

Not quite. But I do think that the PIH is the natural way to talk about different MPCs. Why are some people credit constrained? Because their future (permanent) income is low. What are some other reasons for different MPCs? Because people are at different points along their lifetime income path.

“”the source of one’s income determines what one does with that income. Which seems silly.”

It only seems silly in a model—as in mainstream macro, where I guess you’re coming from—that doesn’t include firms, only households. ”

No, no, we got firms and households. But by their nature firms don’t consume and save, they invest, pay out dividends, and pay out income to factors. Again, what should matter is how much income a person has (both temp and perm) not what the source of that income is. Whether or not there are firms or just households’ is sort of irrelevant here.

“In the real world, the division of income between wages and profits is even more important in terms of the MPC than that between households of different income levels.”

It’s really not, and to the extent it is, it is only because the division of income between wages and profits correlates with the differences between household’s incomes. Hence, the assumption that workers have high mpc and capitalists don’t can sometimes be a useful simplifying assumption. But that’s all it is.

Ok, where their expected future income is low, however those expectations are formed. I don’t need an implicit model where all future income flows have a known probability distribution. And surely when deciding whether or not to extend a loan to somebody potential lenders are likely to consider the future income of the potential borrowers? All the other stuff about imperfect credit markets and fundamentally uncertain future is fine but by itself it doesn’t explain why certain people are credit constrained and others are not. I mean, if all that mattered was that the future was fundamentally uncertain and stuff these credit constraints would be randomly distributed or something. Obviously it’s the low-permanent income people who face mostly face these constraints. You’re trying to make this more unrealistic than it is (and are doing this by ascribing implicit models where they ain’t necessarily).

And come on, arguing that saving behavior follows from some kind of hard wired class consciousness or something is wayyyyyy more unrealistic.

I haven’t read Taylor. And as I’ve already said, yes, for some purposes the ‘workers eat wages, capitalists save profits’ can be useful simplified assumption (i.e. a heuristic). But for the purposes of figuring out the effects of transitory changes in income on consumption behavior it’s gonna get the multiplier only by accident. And it won’t differentiate between permanent increases in wages and temporary ones. Which do after all have different effects and that can be seen in the data (whereas this heuristic would tell you it’s all the same).

Remember that the whole PIH came out of an effort to reconcile contradictory time series and cross section evidence on consumption and income. And it was roughly successful at this. Since then the analysis got more refined and currently as far as I know a “PIH with liquidity constraints” does very well at explaining empirical data (for example as in Muellbauer’s work). You control for some demographic effects and you’re golden. So you got a consistent theory, which doesn’t rely on ad hoc assumptions, which takes into account the fact that the future matters, which takes into account ‘real world’ institutional constraints and market imperfections and which does very well when tested against actual data. Why throw that out and rely on a hit or miss unrealistic heuristic (I mean seriously, do you really think that wage earners never save? And that investors never spend their dividends?)?

Just because it comes from a school of thought which has a certain ideological pedigree?

Yeah… I don’t think ‘standard’ Keynesian thinking quite reaches those conclusions. At least I hope it doesn’t. Usually firms which are loss making are loss making not because of under investment but because of lots of stupid investment. Liquidity constrained firms – pretty much small businesses – tend to mostly operate at small scale and small profits (depends on the sector though) – often zero net of owner(s)’ salaries.
I’m sure the sellers of sub prime mortages are quite liquidity constrained and I’m sure there’s some kind of spending multiplier there.