In my post yesterday, I explained why if one believes, as do Robert Lucas and Robert Barro, that monetary policy can stimulate an economy in an economic downturn, it is easy to construct an argument that fiscal policy would do so as well. I hope that my post won’t cause anyone to conclude that real-business-cycle theory must be right that monetary policy is no more effective than fiscal policy. I suppose that there is that risk, but I can’t worry about every weird idea floating around in the blogosphere. Instead, I want to think out loud a bit about fiscal multipliers and Ricardian equivalence.
I am inspired to do so by something that John Cochrane wrote on his blog defending Robert Lucas from Paul Krugman’s charge that Lucas didn’t understand Ricardian equivalence. Here’s what Cochrane, explaining what Ricardian equivalence means, had to say:
So, according to Paul [Krugman], “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.
Cochrane was a little careless in defining Ricardian equivalance as a theorem about stimulus, when it’s really a theorem about the equivalence of the effects of present and future taxes on spending. But that’s just a minor slip. What I found striking about Cochrane’s statement was something else: that little qualifying phrase “in a well-functioning economy,” which Cochrane seems to have inserted as a kind of throat-clearing remark, the sort of aside that people are just supposed to hear but not really pay much attention to, that sometimes can be quite revealing, usually unintentionally, in its own way.
What is so striking about those five little words “in a well-functioning economy?” Well, just this. Why, in a well-functioning economy, would anyone care whether a stimulus works or not? A well-functioning economy doesn’t need any stimulus, so why would you even care whether it works or not, much less prove a theorem to show that it doesn’t? (I apologize for the implicit Philistinism of that rhetorical question, I’m just engaging in a little rhetorical excess to make my point a little bit more colorfully.)
So if a well-functioning economy doesn’t require any stimulus, and if a stimulus wouldn’t work in a well-functioning economy, what does that tell us about whether a stimulus works (or would work) in an economy that is not functioning well? Not a whole lot. Thus, the bread and butter models that economists use, models of how an economy functions when there are no frictions, expectations are rational, and markets clear, are guaranteed to imply that there are no multipliers and that Ricardian equivalence holds. This is the world of a single, unique, and stable equilibrium. If you exogenously change any variable in the system, the system will snap back to a new equilibrium in which all variables have optimally adjusted to whatever exogenous change you have subjected the system to. All conventional economic analysis, comparative statics or dynamic adjustment, are built on the assumption of a unique and stable equilibrium to which all economic variables inevitably return when subjected to any exogenous shock. This is the indispensable core of economic theory, but it is not the whole of economic theory.
Keynes had a vision of what could go wrong with an economy: entrepreneurial pessimism — a dampening of animal spirits — would cause investment to flag; the rate of interest would not (or could not) fall enough to revive investment; people would try to shift out of assets into cash, causing a cumulative contraction of income, expenditure and output. In such circumstances, spending by government could replace the investment spending no longer being undertaken by discouraged entrepreneurs, at least until entrepreneurial expectations recovered. This is a vision not of a well-functioning economy, but of a dysfunctional one, but Keynes was able to describe it in terms of a simplified model, essentially what has come down to us as the Keynesian cross. In this little model, you can easily calculate a multiplier as the reciprocal of the marginal propensity to save out of disposable income.
But packaging Keynes’s larger vision into the four corners of the Keynesian cross diagram, or even the slightly more realistic IS-LM diagram, misses the essence of Keynes’s vision — the volatility of entrepreneurial expectations and their susceptibility to unpredictable mood swings that overwhelm any conceivable equilibrating movements in interest rates. A numerical calculation of the multiplier in the simplified Keynesian models is not particularly relevant, because the real goal is not to reach an equilibrium within a system of depressed entrepreneurial expectations, but to create conditions in which entrepreneurial expectations bounce back from their depressed state. As I like to say, expectations are fundamental.
Unlike a well-functioning economy with a unique equilibrium, a not-so-well functioning economy may have multiple equilibria corresponding to different sets of expectations. The point of increased government spending is then not to increase the size of government, but to restore entrepreneurial confidence by providing assurance that if they increase production, they will have customers willing and able to buy the output at prices sufficient to cover their costs.
Ricardian equivalence assumes that expectations of future income are independent of tax and spending decisions in the present, because, in a well-functioning economy, there is but one equilibrium path for future output and income. But if, because the economy not functioning well, expectations of future income, and therefore actual future income, may depend on current decisions about spending and taxation. No matter what Ricardian equivalence says, a stimulus may work by shifting the economy to a different higher path of future output and income than the one it now happens to be on, in which case present taxes may not be equivalent to future taxes, after all.