Ricardian Equivalence Redux

I just read Paul Krugman's most recent blog post. This is typical. Krugman is repeating an argument he has been making for a long time. He wants you to think that he has it right, and that there are some "freshwater" (whatever that is) bad people out there who have it all wrong. How could they be so stupid?

For reference, here's something I wrote back in March of this year on Ricardian equivalence, when Krugman was on about this before.

Krugman tries to pick on Lucas in his blog post, as "betraying a complete misunderstanding of his own doctrine," and quotes this, which comes from a panel discussion at a conference:

If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

…

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

I don't agree with everything Lucas said in that quote, but I think I can safely say that I know Lucas better than Krugman does. I think I understand what ideas he is attached to, and there is nothing in the quote that is inconsistent with those ideas. Further, for something pulled out of an off-the-cuff panel discussion, it's reasonably coherent.

Lucas of course was a primary force behind the revolution in macroeconomic thought that occurred post-1970. But he is also very much an old-school Milton Friedman quantity theorist - an Old Monetarist if you like. That's what is behind the first part of the quote. He's thinking that it's monetary policy that is important, and that monetary policy effects will drive the effects of the stimulus. You may think that's wrong, but that's part of what he thinks.

In the latter part of the quote he has a particular view of the effects of the spending package put in place in 2008. Supposing it is funded by taxation - current or deferred - he thinks it doesn't matter much. Now, even in the context of non-Keynesian macroeconomics, there are reasons why government spending can matter. There are wealth effects; public spending and private consumption might be complementary; a recession may be a good time for public investment in infrastructure. Maybe in the context of the 2008 spending package, Lucas thinks that those things do not matter so much. Maybe he thinks that the planned spending was not thought through very well, and we are better off without it. In any event, I don't see anything in the quote that we would want to condemn Lucas for. The weird part of this is that Krugman is picking on Lucas over Ricardian equivalance. The only piece of the quote that relates to that is the last part: "And then taxing them later isn't going to help, we know that." That's just stating the Ricardian equivalence proposition, which is that the timing of taxation does not matter. Tax me now; tax me later; it does not make any difference. Lucas certainly isn't getting anything wrong.

Next, Krugman wants you to think, not only that Lucas is confused, but that he's somehow besmirching Christina Romer. If you read the quote, Lucas is not saying anything bad about Romer, he's just thinking about the realities of government. In my opinion, Christina Romer deserves besmirching, but all Lucas is saying is that, likely, Romer was not driving the policy, and that her job was to defend it, which is what she did.

Here's the really funny part of Krugman's post:

I’ve tried to explain why Lucas and those with similar views are all wrong several times, for example here. But it just occurred to me that there may be an even more intuitive way to see just how wrong this is: think 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 (I know, it’s hard to find houses that cheap, but I just want a round number). 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 Lucas’s 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.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.

Apparently that is supposed to be an "intuitive" way to think about Ricardian equivalence. This is an excellent illustration of Krugman's confusion. The example actually tells you nothing about Ricardian equivalance, or anything remotely related to the effects of government actions on the behavior of private economic agents.

What's going on? In Krugman's example, a family takes out a $100,000 mortgage loan to purchase a house. This family now has $100,000 in debt, and someone else in the economy has a $100,000 asset. What is happening in the aggregate? If this is a new house, then the private sector collectively is foregoing current consumption, and investing in a house which will provide a future stream of consumption. If it's an existing house, then this could be a wash. For example, suppose that the family that sold the house takes the $100,000 it receives from the sale and puts it in a bank that makes the mortgage loan to the family that buys the house. Where is the Ricardian equivalence lesson in all that?

Ultimately, Krugman should be able to do better than this. We're accustomed to his nasty side, but at least he could provide some useful instruction.