The Great Ricardian Equivalence Misunderstanding
Paul Krugman attempts to provide some aircover:
One more time: Brad DeLong is, rightly, horrified at the great Ricardian equivalence misunderstanding. It’s one thing to have an argument about whether consumers are perfectly rational and have perfect access to the capital markets; it’s another to have the big advocates of all that perfection not understand the implications of their own model.
So let me try this one more time.
Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.
But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.
Is that explanation clear enough to get through? Is there anybody out there?
It won't work, Paul:
Robert Lucas: would a fiscal stimulus somehow get us out of this bind...? I just don't see this at all. 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... 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.... [T]here'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...
Now Paul, will you also disabuse them of the blithe implicit assumption that the interest elasticity of money demand is 0 when we think--given that exchanging cash for a Treasury bill right now is exchanging one zero-yielding government asset for another--that this is a time when, in Milton Friedman's words, the right number for the approximate elasticity of money demand is -∞?
