And for those who want to argue that it’s the cuts to come. That everyone is pulling in their horns now given the future cuts. Erm, you do realise that’s a form of Ricardian Equivalence.
The RE which, if true, means that Keynesian stimulus cannot work?
Come again? That doesn’t sound like the Ricardian Equivalence I know about.
Ricardian Equivalence says that the timing of taxes do not matter, it implies that temporary tax cuts have no effect because people will save any short term tax cuts to cover the higher taxes in the future. It is basically the Modigliani-Miller theory for governments: Things cost other things and in competitive markets differences in the price of things should be arbitraged away.
Ricardian Equivalence implies stimulus spending cannot work if and only if “what the government buys (and distributes to households) is exactly what households would buy for themselves. [Ricardian Equivalence] by itself doesn’t do it.” Because that is pretty much impossible, you can only categorically say that if Ricardian Equivalence holds true then temporary tax cuts will have no stimulative effect. This rather awkwardly puts Tim in the position of arguing that his own policy suggestions are wrong. [1]
On the other hand, suggestions additional spending are stimulative are entirely logically consistent with Ricardian Equivalence. If the government buys something with borrowed money then your future self is going to end up paying for it one way or another, so under Ricardian Equivalence, you save towards it. But, because the cost is amortized, you don’t save as much today as the government spends more today, hence total outlays increase, hence stimulus. (c.f Bastiat)
The same story can be told in reverse. The government spends less, so you anticipate lower future taxes so you spend a little more today. But you don’t spend as much more today as the government spends less today, hence total outlays decrease, hence contractionary contraction.
If the government says it’ll spend less and others don’t pick up the slack then total spending must decrease and this in combination with stick prices and wages can depress economic activity. Now this won’t depress economic activity as much as a debt crisis but that is an entirely separate argument, so I hope Tim doesn’t try to change the subject from his misunderstanding Ricardian Equivalence (what terrible violence that phrase does to Ricardo’s reputation).
Of course all of this assumes the central bank will allow total nominal spending to career around. If it narrowly targets nominal expenditures then all of this talk is academic. However, we do not live in such a world, so this discussion is very important and Timmy is doing it wrong.
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[1] That is unless Tim is arguing some people are liquidity constrained and must spend the extra income now rather than save it. But this is several levels of nuance deeper than Tim usually opts for.
Filed under: Economics, History, Bastiat, Fiscal Policy, Monetary Policy, Ricardian Equivalence, Tim Worstall
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