Sunday, August 7, 2011

Ricardian equivalence and the debt ceiling

I used to snicker at Ricardian equivalence in first year graduate school until I had to take them seriously in order to graduate (emphasis mine):

The Ricardian equivalence proposition (also known as the Barro-Ricardo equivalence theorem[1]) is an economic theory that suggests consumers internalize the government's budget constraint and thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy being the same.
In 1974, Robert J. Barro provided some theoretical foundation for Ricardo's hesitant speculation[4] ...
Barro's model assumed the following:
  • families act as infinitely lived dynasties because of intergenerational altruism[10]
  • capital markets are perfect (i.e., all can borrow and lend at a single rate)
  • the path of government expenditures is fixed

But according to Samuelson (the other one):
We’ve had dueling budgets with differing mixes of spending cuts and tax increases. But we’ve heard almost nothing of the main problem that makes the budget so intractable.

It’s the elderly, stupid.
By now, it’s obvious that we need to rewrite the social contract that, over the past half-century, has transformed the federal government’s main task into transferring income from workers to retirees.
These transfers have become so huge that, unless checked, they will sabotage America’s future. ... Older Americans do not intend to ruin America, but as a group, that’s what they’re about.

Is it time to take that model out of every macroeconomic textbook? But in the spirit of presenting opposing view, here is a spirited defense from academia in a very academic fashion:

As I tell my students, Ricardian equivalence is very special. For it to work exactly in this fashion requires a lot of assumptions: lump sum taxation, no redistributive effects of taxation (across people or generations), frictionless credit markets, etc. But the idea is very powerful, and an important organizing principle for understanding why government deficits matter. At the minimum, it helps us understand the importance of the intertemporal government budget constraint, and the idea that a tax cut is not a free lunch.

This is all true of course, yet the crucial assumption to me is intergenerational altruism, which seems to have broken down. If we want an unrealistic baseline model, why not go with the infinitely-lived agent in the first place. It struck me then and now that the Barro model was essentially a (lame) attempt to resurrect the representative agent model.

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