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Sunday, March 22, 2009

DOES RICARDIAN EQUIVALENCE REDUCE OR OFFSET KEYENSIAN MULTIPLIER EFFECTS FOR FISCAL STIMULI?

Today's Buggy Topic

Don't let the little bit of jargon in the subject-tile --- "Ricardian equivalence" --- put you off if you don't know much economics.  Ricardian refers to David Ricardo, a follower of Adam Smith in the early 19th century --- and along with Smith and Thomas Malthus, the most famous of the "classical economists" who, together --- with John Stuart Mill somewhat later --- created the basis of modern free-market economic theory.  

Ricardo's Influence

Ricardo is most famous for explaining the theorem of comparative advantage as the linchpin of free-trade across the borders of countries: namely, even if one country (A) were hypothetically able to produce all its agricultural and manufacturing goods more efficiently and hence cheaper than country B, country A would still benefit if it opened up trade with B.  That's because A's workers and firms can't be equally efficient at all its production.  Similarly, though B is "absolutely" disadvantaged, it is less disadvantaged in some goods than others.  If A and B trade freely with one another --- no tariffs or other trade-barriers --- then market prices of A's and B's goods in their home markets will direct production in each country toward where it is most advantaged and least disadvantaged.  And so both countries will be able to consume beyond the limits of their productive capabilities.

Later on, free trade also was found to entail all sorts of other, more dynamic advantages.  Think of quality: think, more specifically, of how Japanese car companies have improved enormously the quality of autos available to Americans compared to the 1960s and 1970s.  Think of the boost to economic growth: as the US has globalized since 1980, its growth rates in GDP and productivity --- which had been declining over the previous two decades --- have been rejuvenated.  Think of the impact of ideas as they cross frontiers --- and, by adding new competition, facilitate the movement of US firms either to become leaner and more efficient or fail and hence release capital and skilled labor to move into areas like computer software and aerospace where they are world class. 

Enter Ricardian Equivalence

Developed by Ricardo back in the 1820s and 1830s, this concept went into oblivion more or less until it was revived in the 1970s by an influential New Classical economist at Harvard --- Robert Barro.  It is usually called the Ricardian-Barro Equivalence Theory as a result. 

The key idea? 

It doesn't really matter if increased spending by a government --- say, the US federal government to fight recession --- leads to deficit spending financed by new taxes or debt: exactly how the US Treasury does so, by issuing bonds that the Federal Reserve sells to the public now.  Whether financed by borrowings from the public or by current taxes --- say, by a tax increase later this year or by debt --- the public knows that sooner or later taxes will have to be raised to pay both the interest and principal on the debt.  Assume then that the public is rational and understands this.  In the upshot, the public will reduce its consumption and save more, knowing that some time in the future --- maybe years from now, maybe even in the next generation --- they or their heirs will have to pay more taxes.  The increased savings will, therefore, reduce or totally nullify the fiscal stimulus.

Enter the Buggy Slant on This

It's found in a fairly lengthy --- but easy-to-follow --- post that prof bug left earlier today at the web site of Professor Mark Thoma, Economist View.  Click here for the bugged-out comments.

Oh, by the way.  As it happens, there's usually another poster at that site who signs on as Gordon --- no relation to me whatsoever; and with a far different viewpoint on things.  I always log on as the buggy professor, but confusion arises because some people later in the threads refer to me as "gordon" or "BP" and not buggy professor.