Streetwise Professor

One contentious element in the “stimulus” debate is the role of Ricardian equivalence.  That is, that private individuals will take actions that undo the effects of additional government spending or tax reductions financed by government borrowing.  Krugman endorses this relatively intuitive rejoinder to the Ricardians, so it seems like a good place to begin:

Menzie is right about transitional changes in tax policy not being able to change consumption in this Barro-Ricardo model, which is why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool. But what about transitional changes in government purchases? It is interesting that Wikipedia noted Ricardo’s 1820  Essay on the Funding System:

Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that “In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever … are precisely of the same value”.

Let’s modernize this example. Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?

In a blog post today, Krugman repeats the same argument almost word-for-word:

But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes — say, $5 billion a year. That’s a much smaller impact on consumers’ future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I’m not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.)

So economic theory — Milton Friedman’s theory! — says that spending is a more effective form of stimulus than tax cuts.

So this makes it clear: the stimulus is a good thing because even in the presence of Ricardian equivalence, it increases current aggregate demand/consumption/measured output, and the expense of future demand/consumption/measured output.  

So that’s the metric, eh?  Current output goes up. QED.  End of story.  Vote for the stimulus.  And opponents–shut up!  

Well, to put it mildly, that’s a stupid metric.  I, you, etc., are not necessarily better off just because current measured output goes up.  

Framed this way, the “stimulus” and the associated increase in government spending is a forced intertemporal reallocation of consumption.  That is not necessarily welfare improving.  

Note the question that is begged: if individuals prefer to enhance current consumption at the expense of future consumption, why can’t they do this trade themselves?  

There is an implicit assumption here: namely, that there is some constraint on intertemporal resource allocation that precludes people from attaining this putatively superior consumption pattern.  They want to borrow, but can’t for some reason, so the government does it on their behalf and makes them better off by doing so.  

You can make arguments as to why moving consumption from the future to the present is constrained (relative to some ideal, first best world.)  For instance,  it is costly to use human capital and future labor income as collateral for borrowing.  You might also argue that the problems in the banking system have also made it impossible to consummate some welfare-improving trades.  

But, to argue that the government has the ability and incentive to identify and fix the distortion in intertemporal consumption, you have to presume that it can solve the knowledge problem and the political problem.  That is, it must have the ability to determine what the preferred consumption pattern is (which would require immense amounts of information about individual preferences and technological possibilities) and the political mechanism must be able to translate that information into efficient action.  Color me skeptical.  Extremely.

Moreover, even if you overlook those minor details, you can’t use the increase in current income to measure the benefit of the stimulus, because this ignores the cost in future consumption.  If the stimulus does improve the intertemporal allocation, the difference between benefit and cost is positive, but the cost (the value of future foregone consumption) is zero.

In the analysis quoted above, the difference benefit is zero; the $100 million increase in current income is worth exactly the same as the $5 million per year lost in perpetuity.  Given the inefficient constraint on private intertemporal resource transfer, this difference would be positive (i.e., $100 million today is worth more than the $5 million lost in perpetuity), but it ain’t $100 million, or $95 million.  

Even if the inability of individuals to implement their desired intertemporal consumption plans is the rationale for a stimulus package, this does not justify a preference for direct government expenditure, as opposed to a tax cut, financed by borrowing.   Indeed, as the latter allows each individual to choose his or her own consumption bundle so as to maximize utility, rather than consuming a one size fits all bundle chosen by a political process.   Why, pray tell, should we believe for a nanosecond that the bundle of “goods” (more on the use of this word below) selected in a political Bacchanalia is optimal in any sense of the word?  

Arguments over the form of the stimulus also demonstrate a fundamental contradiction at the heart of the government spending stimulus argument.   Advocates of this view vehemently oppose (for the most part) tax relief in place of direct government spending because individuals will save, rather than spend the tax cut.   But, if the fundamental problem is that people are constrained in their ability to implement their optimal consumption plans, and want to borrow more and thereby shift consumption from the future to the present, as is implicit in the stimulus argument, they wouldn’t save the tax cut.   They’d spend it.   So, if one argues that tax cuts are not stimulative because people save them rather than consume them, one cannot believe that people are prevented (due to some capital market imperfection) from trading future consumption for present consumption.   But if you don’t believe that, what is the justification for government borrowing to fund current consumption via direct government spending?     Maybe there’s an explanation, but it seems very hard to square denigration of tax cuts with advocacy of government spending.  

The inability to achieve optimal intertemporal allocation also seems to be inconsistent with another phenomenon observed during the credit crisis; the intense desire to increase holdings of government liabilities (Treasury securities and money).     Certainly, individuals are liquidating private claims (e.g., equity, corporate debt) and using the proceeds to buy government securities and increase their money balances (note the stratospheric increases in base money).     But, if they really wanted to increase current consumption, they could liquidate private claims and use the proceeds to consume.   The evident desire to save in low risk-low return (and close to zero return) forms, rather than consume, is flatly inconsistent with the intertemporal misallocation justification for a fiscal stimulus.

At root, stimulus advocates appear to be substituting their preferences for those of the great unwashed.   People want to save too much, the bastards.   If we give them money, they’ll STILL save it.   So, we’ve got to consume for them.     Traditional Keynesians attributed this demand to save to “animal spirits”—i.e., irrationality, or perhaps, insanity.   Maybe modern Keynesians are of the same view.  

Whatever the rationale, it is fundamentally elitist, and anti-individualist.   It is the attitude of those who know what’s good for us.     They’re from (or for) the government and they’re here to help us.   And we all know how that usually works out.

I suggest it’s better to start from a presumption that people aren’t idiots, driven by irrational impulses, and to try to understand the reason for their behavior.   A substantial increase in the demand to save—i.e., to transfer consumption from the present to the future—likely has a rational explanation.   Like, oh, I don’t know, maybe an incredible increase in uncertainty associated with the potential implosion of the financial system.     Just a guess.     But the stimulus advocates, the neo-Keynesians, argue that people have things exactly backwards, and just don’t know what’s good for them.   What they REALLY want, the NKs are saying, is to consume more today and less tomorrow—even though through their behavior people are revealing the exact opposite.   The arrogance of this is pretty mind blowing.

This further strengthens my belief that the stimulus is akin to identity theft.   People borrowing in our name to do what they want, not what we want.

The decline in consumption, which as Bob Lucas has noted NEVER happens in US data, indicates a strong desire to increase saving.   To consume more tomorrow.   The “stimulus,” whether delivered via direct government spending or a tax cut, implicitly assumes the exact opposite.   Moreover, it means that to understand the situation, and to devise a reasonable, efficient policy response, it is necessary to understand and address the source of this increased demand to save.  

The most immediately obvious explanation is the implosion of the financial system.   This, in turn, suggests that efforts should be focused on ameliorating that problem.   And every dollar p***ed away for ACORN or some bridge in the Right Honorable Foghorn Leghorn’s district is one that can’t be used for that purpose.    Thus, this spending is doubly wasted.   It doesn’t buy anything we want today, and diverts resources from a beneficial use.

Maybe I’m wrong that individuals are increasing their demand to save due to an increase in risk associated with the financial meltdown.   So, by all means, let’s investigate alternative explanations.   But let’s not propose “cures” based on dubious (at best) diagnoses of the disease.     And any diagnosis must explain why the demand to save by LENDING to the government has exploded.

The other key issues is “measured output/consumption.”  That is, from an accounting perspective, the $100 million in government expenditure is counted as income.  But what if the money is largely spent on things that people don’t value, but we have to give up things we do to pay for it?  Much of the stuff in the “stimulus” package is of dubious value.  Hell, to me, some of it has a negative value; they’re bads, not goods.  So, let’s say $100 million in resources are used to buy things that are worth only $50 million (to be generous).  But to pay for it, I–and you–have to pay higher taxes in the future, and give up stuff we do value; in my case, say, travel, books, iPods, a new SigSauer 9mm, leisure.  

So, here’s the real trade-off involved in the stimulus (and remember, economics is all about trade-offs): we give up future private consumption in exchange for current consumption of all the stuff–I wouldn’t say goods, unambiguously–in the stimulus bill.   My view is that the stuff in the stimulus bill is largely worthless–if we’re lucky.  So, the measured increase in income overstates the true increase in income.   The stuff we’ll have to give up due to higher future taxes isn’t worthless.  Moreover, even if there is an argument to justify that a reallocation of consumption over time can (due to some capital market imperfection) improve welfare, it’s clear that the measured increase in output overstates the benefit of this.

In brief, the case “for” the stimulus, namely, that it will increase measured income/consumption, is highly misleading.  It overestimates the benefits and underestimates the costs–when it doesn’t ignore them altogether.

The views I have expressed here are clearly those of a “freshwater” economist, as one wag calls Chicagoans, hard by the shores of Lake Michigan, as distinguished from “saltwater” economists on the seacoasts.     Guilty as charged.   But, I would rather be a freshwater economist than a bilgewater economist any day.   And, in my view, the pro-stimulus arguments are just bilge.   They are bilge because they propose remedies that are flatly contradicted by the symptoms that are there for all to see.     The stimulus would make sense if some market failure precludes an efficient transfer of resources from the future to the present.   But people seem quite intent on doing the exact opposite, transferring resources from the present to the future.     Add to that the fact that the government will use resources to purchase goods of dubious value, and indeed, to purchase some bads, and the case for the stimulus disappears altogether.