07/10/2011: Ricardo equalizes Keynes

The dismal science has seen a practitioner lauded with a Nobel Prize since 1969, to be awarded this year on 10 October. Dismal as the present economic situation appears, the reigning confusion on what should be done to get us out of it hardly seems like science.

In the US, for example, the monetary base has tripled since fall 2008 on two sprees of quantitative easing (QE), Fed fund rates are at zero, where they will stay until 2013, and Operation Twist as well as angst about the overall economic outlook have lowered 10-year Treasury yields to some 1.7%, a low for the last 60 years. Lending is stalled, the housing market still ails and unemployment hovers over 9% for three years running.

Monetary policy seems useless. This is a typical liquidity trap, in my view. John Maynard Keynes studied this, a situation in which monetary policy becomes ineffective. Households and firms are not spurred by low interest rates to consume or invest, but hoard cash due to a grim economic outlook and/or because they are deleveraging. Hence, in this environment neither Operation Twist nor still more QE would boost the faltering US economy.

So should we do nothing? Keynes and prominent successors, most notably 2008 Nobel Prize winner Paul Krugman, argue loudly instead: no, to the contrary. Fiscal policy provides greatest traction to an economy stuck in a liquidity bog.

Moreover, low interest rates ease government deficit financing and can stimulate the business cycle through infrastructure investments. This is the theory, and is how one would have reacted in the 1930s, when Keynes wrote his General Theory.

Today, though, a major caveat undermines such fiscal policy. The Ricardo equivalence theorem, after the classical English economist David Ricardo and rediscovered in 1973 by “neoclassical” economist Robert Barro, states that rational subjects are indifferent to the financing origins of government expenditures, i.e., to whether these are taxes or deficits. Why? Because deficits can be seen as future taxes, and one can show that discounted future taxes correspond to the current tax one would pay if government expenditure were financed through tax receipts instead of deficits.

The Ricardo equivalence has been downplayed in economics articles as a nice theory removed from reality, criticized among other reasons because it assumes that individuals have perfect foresight about the future of taxes. However, the present context in the US could make it more relevant. In the recent debt ceiling debate the US government agreed to reduce the debt later, though it is still making deficits now. So future tax increases should not surprise anyone.

In anticipation thereof, citizens might start to adapt and reduce their consumption and investment patterns now. But what of those, who despite the US government’s commitment, do not expect future tax increases to reduce debt? They fall under another “neoclassical” theory developed by 2004 Nobel Prize winners Edward Prescott and Finn Kydland about the “time inconsistency” of political decisions. In its simplest form this theory grants that a government commitment to reduce debt at a later stage is worth only as much as the paper on which it is written.