February 19, 2015

How to solve almost any problem

Comment on 'Lucas’ bridge and the Ricardian equivalence fairy-tale'


In the preceding discussion (see links below) the important methodological point has been made that there are two fundamentally different systemic configurations:
(1) the pure consumption economy,
(2) the investment economy.

Historically, Ricardo made his argument in the context of (1), however, the discussion oscillates between these two entirely different configurations. This is inadmissible because it makes a real difference whether the economy produces non-durable consumption goods, 'apples' in Nick Rowe's terminology, or infrastructure like dikes and bridges.

We stay in the following in the pure consumption economy (1) which has been explicitly defined in the preceding post 'Nobody understands debt'; see here.

This is the benchmark scenario: the government taxes the wage income [100] in period t [X=20]. Households reduce consumption expenditures in perfect lockstep [from 100 to 80]. Gov fully spends income tax [20], that is, total consumption expenditures remain unchanged [20+80] and the market clearing price remains constant. Both, private and public households fully consume their respective shares of output. There is no real transfer of goods between periods, i.e., no investment goods.

Now, Wren-Lewis's argument runs as follows:
“If you spend X at time t ..., aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.”

Yes! Let household consumption fall from 100 to 90 instead from 100 to 80, then total consumption expenditure is 110=90+20. Aggregate demand indeed rises. In the case of perfect flexibility the market clearing prices rises accordingly and the business sector now makes a profit of 10=110-100.

The households spend 90 but their net income is 80, hence their overdrafts at the central bank increase. Aggregate demand rises because of the deficit spending of the households. This may lead to employment effects in the sequel but has nothing to do with taxation as such or Ricardian equivalence. Whether private or public households run a deficit makes no difference for aggregate demand or the multiplier effect.

If both private and public households stick to strict budget balancing, taxation and public spending has no effect at all.

So, the whole argument shifts to the question of whether households reduce their consumption expenditures in step with taxation or not. Lucas says yes, Wren-Lewis says no, neither knows for sure. To recall, the original question was whether taxation or credit financing of public spending amounts ultimately to the same.

The fuss about Ricardo's equivalence it's not so much a problem of ideology but of the economists' proto-scientific habit of storytelling.

“Keynes always believed that ‘a little clear thinking’ or ’more lucidity’ could solve almost any problem.” (Moggridge)

Egmont Kakarot-Handtke

Preceding posts:
Multiplying confusion
Nobody understands debt – including the shrinks
The true nature of economists’ confusion
Better precisely right than roughly wrong

For the correct employment multiplier see here.