Ricardian equivalence — nothing but total horseshit!

14 Mar, 2018 at 17:05 | Posted in Economics | 5 Comments



Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent since debt financing must be repaid with interest, and agents — equipped with ‘rational expectations’ — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

Why?

In the standard mainstream consumption model — used in DSGE macroeconomic modelling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

c t + c f /(1+r) = f t + y t + y f /(1+r),

where c t is consumption today, c f is consumption in the future, f t is holdings of financial assets today, y t is labour incomes today, y f is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(c t ) + au(c f ),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u'(c t ) = a(1+r)u'(c f ).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u'(c) = 1/c, the Euler equation can be rewritten as

1/c t = a(1+r)(1/c f ),

or

c f /c t = a(1+r).

This importantly implies that according to the mainstream consumption model changes in the (real) interest rate and consumption move in the same direction. And — it also follows that consumption is invariant to the timing of taxes since wealth — f t + y t + y f /(1+r) — has to be interpreted as present discounted value net of taxes. And so, according to the assumption of Ricardian equivalence, the timing of taxes does not affect consumption, simply because the maximization problem as specified in the model is unchanged.

That the theory does not fit the facts we already knew.

Now Jonathan Parker has summarized a series of studies empirically testing the theory, reconfirming how out of line with reality is Ricardian equivalence.

This only, again, underlines that there is, of course, no reason for us to believe in that fairy-tale. Or, as Nobel laureate Joseph Stiglitz has it: