Hang on now, Paul, Mark, Progrowthliberal, and Antonio Fatas. Justin Yifu Lin (pdf) is basically right. He's making an important point. It's similar to one I made a couple of years back.
Sure, a temporary increase in useless government expenditure, even under Ricardian Equivalence, will give a bang for the buck. But it's a totally useless bang. No Keynesian economist would recommend it, even if there were no useful alternatives. And useful government expenditure will not only give a useful bang for the buck, it will give a bigger bang for the buck.
The intuition is simple. Paying unemployed resources to do something totally useless is equivalent to giving them a transfer payment. A transfer payment is equivalent to a tax cut. A tax cut has no effect under Ricardian Equivalence.
[Update: Paul Krugman responds.]
The Ricardian Equivalence Proposition says that a bond-financed increase in government expenditure is equivalent to a tax-financed increase in government expenditure. Because consumption depends only on permanent income and so on the present value of current and future tax liabilities. Assume Ricardian equivalence is true.
Assume, for simplicity, that the marginal propensity to consume out of permanent income is one. Ignore interest rates, exchange rates, and supply-constraints.
A permanent $100 increase in government expenditure will have zero effect on output, if it causes an equal $100 increase in permanent taxes, and so an equal $100 decline in consumption.
A temporary $100 increase in government expenditure will cause output to increase by less than $100, because it causes permanent taxes to increase by less than $100, and so consumption to decline by less than $100.
In the limit, as the $100 increase in government spending becomes purely transitory, we can ignore any offsetting effect of increased present value of taxes on current consumption. So output increases by $100. Just like the balanced budget multiplier in the old Keynesian Cross.
Now assume that the $100 increase in government expenditure is spent on something totally useless, like digging a hole and filling it in again. Which is what Justin Yifu Lin assumed. Does output really increase by $100?
Well, if you count that totally useless hole-digging-and-filling exercise as part of GDP, then yes, GDP does increase. And if you don't, it doesn't. And National Income Accountants can have great fun discussing whether the true value added of a filled hole is any different from the value added of a hole that doesn't exist because it was never dug in the first place. But it's still a totally useless activity. And no reasonable measure of output would include digging a hole and filling it in again for no purpose whatsoever. Its market value is precisely zero.
In terms of useful output, the multiplier of a useless project is precisely zero. And remember, there is no effect of increased consumption from the extra $100 earned by the people digging the hole, because it is exactly offset by the extra $100 present value of taxes. No Keynesian should recommend government expenditure on totally useless projects, under Ricardian Equivalence.
Now suppose the government spends the same $100 to dig a hole, plant a seed in the hole, and fill it in again. And the seed grows into a tree, and the tree produces exactly enough apples to repay the $100 the government borrowed including interest. So the government never needs to raise taxes. And people know this. What's the effect on output?
At a minimum, output increases by $100. And it really is a $100 increase in useful output. Unemployed resources, that would otherwise have produced $0, now produce something worth $100. And since that $100 increase in real wealth causes an additional increase in consumption expenditure, there will be a multiplier effect bigger than one.
Now suppose the government plants a tree at the cost of the same $100, but the tree now yields enough fruit to pay back double what it cost to plant. So the government can actually cut future taxes. You get the same direct effect as before, but real wealth has now increased by $200, which induces an even bigger additional increase in consumption expenditure, and an even bigger multiplier.
That's what Justin Lifu Lin is saying. (OK, that's a reasonable interpretation of what he's saying). He's right. If Ricardian Equivalence is true, then useless government expenditure, even if temporary, even if there are zero other sources of crowding out, will have a multiplier effect on useful output of precisely zero. And useful government expenditure, which requires no increase in present or future taxes, will have a bigger multiplier. And if it's even more useful, and allows a cut in future taxes, or an increase in future disposable income, it will have an even bigger multiplier.
Useful government expenditure doesn't just create a useful bang for the buck; it creates a bigger bang for the buck.
Worthwhile Canadian Initiative 
Yes. But Keynes was already aware that sometime we refuse useful spending. ” We are so rationnal that we refuse to build a second railroad from London” (or Birmingham , I Kesey myself on the road to a political meeting so I quote from memory)to Manchester.”
Anyway ,the thing is we must move money income to people who will use it differently if it looks as coming from work thanfrom tax cuts or lower interest rates. So the problem is often not about useful vs useless spending but about spending or not or even doing not very good vs doing detrimental things…
Fantastic post! However, you disagreed with Paul and Mark, so they will ignore you if you’re right and criticize you if you’re wrong.
James:
I see you’re still angry because I didn’t post the incorrect rebuttal to Krugman you emailed to me. Oh well.
Nick:
As you can tell from what everyone wrote, we all assumed he was talking about changes in government spending, or at least I did. For example, he talks about “traditional Keynesian investment” when describing the traditional policies, then asks “But how can the Ricardian trap be avoided” before ever mentioning digging holes and filling them in again (which I took as meaning spending that does not enhance productivity but does have value, i.e. that he was drawing the distinction between government consumption and government investment). So your example is correct, but it’s debatable whether he meant, essentially, pure income transfers given what he says in other places — it’s not at all clear. It seems more likely he meant non-productivity enhancing government spending, i.e. government consumption, but, again, it’s hard to tell.
In any case, contrary to your assertion in the comment you left, what I said wasn’t wrong — I said the empirical evidence does not support a full offset even when the changes satisfy the necessary theoretical conditions. That has nothing to do with whether what he was suggesting can really be interpreted as a change in taxes rather than a change in spending.
It seems to me that three scenarios are economically equivalent:
1) The government pays people $50 to dig holes in the morning and another $50 to fill them in during the afternoon.
2) It pays people $100 to guard random pieces of land to guarantee that they are in the same condition in the evening as they were in the morning.
3) It goes around handing people $100 bills.
In scenario #3, there are two ways to do it: Fiscal policy and monetary policy. If you use fiscal policy, the Treasury has to pay annual interest on the money it borrowed to hand out the $100 bills. If the Fed hands out $100 bills (via open market operations), it pays no interest.
Nick: “Assume, for simplicity, that the marginal propensity to consume out of permanent income is one”
Seems to me that you’re only correct here if the mpc out of transitory income is exctly zero. If it’s positive then Krugman, Delong etc. are right.
The reason is simple, we agree that the dig-a-hole-and-fill-it-again type of stimulus is just transfer, fine. Suppose the $100 transfer is financed from a bond and assume the bond is a perpetuity, it’s coupon would be somewhere around 5% I guess. Let’s assume the coupon is exactly 5%.
Then, if the mpc out of transitory income is 0 then the multiplier is zero as you stated, taxes are permanently higher by $5 per year, causing permanent income to be $5 lower, causing consumption to fall by $5. This is offset by the $5 increase in permanent income from saving the $100 transfer (and investing it in the perpetuity that the government issued).
On the other hand, suppose the mpc of transitory income is greater than 5%, say because the government targets the transfer to low income, liquidity constrained, people. Suppose the mpc of transitory income is 20%.
In this case permanent income has fallen by $1. Since $80 were saved and earn the 5% return, adding $4 back to permanent income to offset the initial $5 decline, the total fall in permanent income is $1.
Further, $20 of the $100 transfer is spent directly out of transitory income. Thus, today we have a $1 reduction in consumption due to the $1 fall in permanent income and a $20 increase, thus today’s AD expands by $19.
If mpc out of transitory income is anything greater than the interest rate on a perpetuity then the transfer expands AD today, even with full Ricardian Equivalence. You are only correct in this post if the mpc out of transitory income is zero.
James: “It seems to me that three scenarios are economically equivalent:” In this case, I’ll choose option (3) please. Seriously, given the very different impacts they have on the well-being of the person receiving the $100, they can’t be economically equivalent. It all comes down to whether or not one enjoys digging holes.
Frances’ point is totally correct (damn micro!). I suspect James would agree. But since it only strengthens my case against useless government expenditure, I’m going to ignore it and assume the unemployed resources have zero opportunity cost and don’t care what they spend their time doing.
Mark: OK. What I should have said was “I think you are all misinterpreting what Justin said and missing his point which is both right and important”. It was late, so I wrote “you are wrong” and went to bed!
He is talking about government spending, not transfer payments. But I don’t interpret him as talking about government consumption (paying for an enjoyable party) vs investment. I think he is talking about investments that are useless vs investments that are useful. Digging a hole and filling it in again sounds more like useless investment than enjoyable consumption. But spending on useless investments is equivalent to a transfer payment (except if the unemployed would prefer getting $100 for doing nothing than $100 for wasting their time doing something useless).
Adam: I’m pretty sure we agree on substance, but disagree on terminology.
Suppose you get a lump sum $100 (stock, not flow). The (real) interest rate on a perpetuity is 5% per year. For the infinitely-lived agent/dynasty assumed by REP, permanent income rises by $5 per year. And if the mpc out of permanent income is 1, consumption rises by $5 per year. Same as the interest rate.
Full agreement on above. Just, terminologically, “transitory” doesn’t strictly mean “temporary”. It means “current minus permanent”. So you can either think of a “transitory” increase as the limiting case where the duration of the increase approaches zero, or as a current increase offset by a future decrease leaving the PV unchanged. So if there’s a flow $100 per year increase in G, as the duration of that increase approaches zero, the effect on permanent G approaches zero, and it becomes purely transitory. If there’s a one-time stock $100 increase in G, spread out over 1 year it will be $95 stock transitory, spread out over 6 months it will be $97.5 stock transitory, etc.
I think I’ve got that right. But you can see why I wanted to avoid getting into this in the post!
But the basic point is that, if consumption depends on permanent income only, and if transitory is defined as current minus permanent, then the mpc out of purely transitory income will be zero, while the mpc out of current income will be above zero, and will equal r times the duration of the increase in current income (approx).
Nick,
so you are saying that starving people will save food stamps?
reason; no.
P.S. I realise adam P. this is your point. I suppose Nick is arguing that are taking the (purely interpreted) permanent income hypothesis as given – and pure Ricardian equivalence. I just think it is a bit hard to take seriously. “Assume you have a can opener…”
reason: OK. But since the whole point of this post is arguing with 4 other bloggers about the implications of Ricardian Equivalence, it does make perfect sense for me to say “assume Ricardian Equivalence”. Which is what I did.
And even if REP were only half true, so there were “Ricardian effects”, the things I am talking about here would still matter.
James: “However, you disagreed with Paul and Mark, so they will ignore you if you’re right and criticize you if you’re wrong.”
Or, maybe Paul will agree with Nick while clarifying that he’s trying to get at a different point:
http://krugman.blogs.nytimes.com/2011/03/11/ricardian-confusions-continued-seriously-wonkish/
Am I the one really confused here? This seems to be a debate about the relationship between events at a discrete time “t” and events at a discrete time “t+1”. Meanwhile, social production spins merrily along on its axis of a continuum.
How do we know that digging and filling holes or burying bottles filled with banknotes is less productive than, say, building a rail line from Birmingham to Manchester? Is the standard of value being used one of subjective utility or of capital accumulation?
The word “employment”, which appeared several times in Paul Krugman’s post doesn’t appear at all in Nick’s. So, is this debate about employment and policies to increase it or is it about abstract “bangs” that may be bigger or smaller? If the issue is really about employment, aren’t there more urgent and realistic questions that need to be addressed than Ricardian Equivalence?
Nick, you are assuming that government funded activities that produce no output cannot increase permanent income — i.e. no spillover or network effects arising from the expenditure that can generate useful economic activity even if the original spending was not useful.
But that will depend on whether there is an output gap or not, not on whether Ricardian equivalence holds.
That’s the point that Krugman was making — even useless activities in a low IR environment have multiplier of 1 and therefore directly add to present period income, and so increase permanent income. “useless” isn’t the same as “ineffective”.
Btw, this is exactly the point that Keynes was making in Chapter 10, except that he also added the observation that
“When involuntary unemployment exists, the marginal disutility of labour is necessarily less than the utility of the marginal product. Indeed it may be much less. For a man who has been long unemployed some measure of labour, instead of involving disutility, may have a positive utility. If this is accepted, the above reasoning shows how “wasteful” loan expenditure may nevertheless enrich the community on balance.”
“[…]If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions [e.g. multipliers], the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.
The analogy between this expedient and the goldmines of the real world is complete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available, our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value and importance to civilisation. just as wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining is the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance; and each of these activities has played its part in progress-failing something better.” [comments mine]
Sandwichman:
1. We could do this in discrete time or continuous time. It’s just a question of which is easier to work with.
2. “Bang for the buck” could be interpreted as either employment or output. That’s not the issue in this debate.
RSJ: We are all assuming there’s an output gap, with involuntary unemployment. So an increase in AD will increase output and employment. That’s not the issue. The question is under what conditions, assuming REP, an increase in G will increase AD, and how much.
Nick: “That’s not the issue in this debate.”
Right. That’s what I’m saying. The debate is sterile because the meaning of “bang for buck” is not even at issue. But Peter Dorman says it better than me at EconoSpeak:
“The question of the day is, why should anyone give RE more than a moment’s attention? In particular, why would smart economists with state-of-the-art training be debating the fine points of what RE would mean if it were true?”
My guess is that RE acts as a kind of screen memory that blocks out other questions where smart economists really don’t want to go.
Sandwichman: I read your blog post. You totally misunderstand this whole question. The debate here is about whether an increase in government spending will increase employment and output. Employment and output are the issue. It’s the distinction between employment and output that is not the issue.
But if consumption depends on permanent income only then recessions don’t occur.
“The question is under what conditions, assuming REP, an increase in G will increase AD, and how much.”
Of course. But I don’t think you got my argument. Any government expenditure, even for a worthless investment, will have a spending multiplier that will tend to cause current period income to go up, and then a tax effect that will cause it to decrease, with some (net) change to income in the current period, but permanent income is the average income (weighted by NPV) of all periods, including the current period. Therefore an increase in current period income will cause permanent income to go up, just not by the full amount, and therefore if people have a propensity to spend of 1 with changes to permanent income, there will be net positive effects even from worthless expenditures if current period income increases at all.
Ricardian Equivalence + PIH doesn’t give you enough information to determine what the net change to current period income will be, it only tells you that the tax effect will be enough to repay the original outlay, with interest.
But you do not know if the cost of repaying the outlay with interest is greater than the benefits of the spending multiplier — even for a worthless expenditure.
Interestingly, this argument says that the deeper the liquidity trap, the more potent fiscal policy will be, which is the opposite situation with monetary policy.
Lord: No. Permanent income can change. Especially since it is an expectation about the future. And investment can change. And consumption can depend on interest rates, etc., as well as permanent income.
RSJ: “Any government expenditure, even for a worthless investment, will have a spending multiplier that will tend to cause current period income to go up, and then a tax effect that will cause it to decrease, with some (net) change to income in the current period,…”
No. Under REP, if the government expenditure is effectively a transfer payment, the net effect on current income will be zero. By definition of REP.
OK you guys: time for you all to read an intermediate macro text.
Nick: “Employment and output are the issue. It’s the distinction between employment and output that is not the issue.”
I dunno, Nick. If you read my blog post, you’re still not getting my point. You say the distinction between employment and output is not the issue. I say that’s a problem right there. There IS a distinction between employment and output and that distinction becomes even more important under the circumstances of policy intervention. Surely you’re familiar with the fading relevance of the rule of thumb known as Okun’s “Law”?
It’s not that I “totally misunderstand this whole question” it’s that I fail to grasp the pertinence of a debate about a model in which the distinction between output and employment allegedly doesn’t matter. Angels on pins on steroids.
Perhaps the difference in outlook between you and I is that you’ve never stared into the abyss of unemployment in spite of ample credentials and years of experience or worked at jobs several grades below your qualifications because the alternative was welfare. So, elegantly hypothetical discussions based on crapola abstractions and simplifications don’t strike you as arrogantly meaningless displays of virtuosity.
O.K. Solving the problems people who are unemployed have is not “the problem”. The problem is getting the symbols on two sides of some blackboard exercise to match up. Fine. I’ve got no objection to your intellectual priorities, then, Nick. It’s your blog, man. Please understand, though, it’s not that I’m “wrong”. It’s that I’m talking about something different.
OK, a transfer from someone that has a lower propensity to consume to someone who has a greater propensity to consume or are liquidity constrained will have zero effect on current income?
And wouldn’t unemployment insurance — or employment of those who, if it weren’t for the transfer, would otherwise have zero income — fall into this category? Even if they were paid to dig ditches?
Moreover, government purchase of output will have a positive multiplier in the current period, and even a ditch digging program will require the purchase of a few shovels, right? Even if the government requires that workers bring their own shovels, still they will need to go out and buy them to join the program.
Which textbook do you recommend to set me straight? I have Blanchard and Fischer, and can’t find your argument anywhere in there — they are much more circumspect in their conclusions.
Sandwichman: Look at the way that Paul Krugman, Mark Thoma, and I argued. We (implicitly or explicitly) set aside a massive host of issues that we would not argue about. We assumed: Ricardian Equivalence; unemployed resources; a bond-financed increase in government spending; and loads of other things. That let us focus in on two questions: temporary vs permanent changes in government spending; useful vs useless government spending. And after 36 hours, with one back and forth, we are all now in basic agreement on these issues, as far as I can see. (Which is damned fast; Yay the blogosphere!).
We actually accomplished something, precisely because not everything was an issue.
One of the issues we set aside was Okun’s Law. We all assumed that changes in output and changes in employment were essentially the same thing. That let us speak a common language, and actually get somewhere.
If you want to argue about Okun’s Law, and labour hoarding, and the relation between changes in output and changes in employment when fiscal policy changes one or the other, that’s fine. But it’s a separate argument, and I can’t see any obvious relation to the argument I was having.
So, from my perspective, your talking about the distinction between output and employment, in the context of this debate, makes about as much sense as a feminist (say) wading into one of your blog posts on the lump of labour fallacy and saying “What about the distinction between male and female employment???” “What do you mean it doesn’t matter???”. She would just come across as someone with an idee fixe, who can only see the world through one lens.
More studies in applied orthogonality.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/07/hst-and-jobs-more-studies-in-applied-orthogonality.html
Sure, there’s a time and place for examining the distinction between output and employment. But this ain’t it.
And, by the way, Keynes’ GT was not about that distinction either.
Please try to consider my (implicit) advice carefully. Because this goes way beyond this particular blog topic.
RSJ: One thing I am really crap at is recommending things for people to read. I am so bad at this myself, I should not have been giving other people advice on this.
Somebody else please help me here. What is a good thing to read on the basics of Ricardian Equivalence?
OK. Wiki is a good place to start: http://en.wikipedia.org/wiki/Ricardian_equivalence
Ricardian Equivalence says that a bond-financed increase in G is equivalent to a tax-financed increase in G. And, as a direct corolorary, a bond-financed tax cut has zero effects. AD does not shift. IS does not shift. AE does not shift. Etc. People save the whole tax cut.
Yes, RE only works exactly under a whole host of assumptions. Permanent Income Hypothesis plus Rational Expectations are just two.
Nick, I do get what you’re saying. And, by the way, it happens quite frequently that the proverbial “feminist” will wade into one of my blog posts to argue about “the distinction between male and female employment”. Usually, though, the idee fixes come from very conventional notions about income being assumed proportional to hours or quasi-fixed costs carved in stone.
Just to reassure you, I don’t resent being told I’m monomaniacal. That’s the story behind the Sandwichman persona, you know. It’s a strategy; not a disorder. The idea is that there are certain topics of conversation that are systematically avoided not because they are irrelevant but precisely because they would shake the foundations of conventional belief. The common metaphor is “the elephant in the room”.
Back in the ’60s, when second-wave feminism started, the only way a feminist would ever get the overwhelmingly male economists to even acknowledge issues arising from “the distinction between male and female employment” would be to inappropriately bring it up in the course of a conversation about something less threatening to male economist privilege.
If I may explicate your implicit advice, you’re telling me to f’ off if I won’t stay on topic. It’s your blog and it’s your call as to what is on or off topic.
Sandwichman: thanks for taking that the right way. Hmmm. Maybe you’re not so monomanaical as I thought!
If you think it’s really on-topic, then have another go at convincing me. But I just don’t see it. Suppose, for example, that firms never laid off workers when sales and output declined. They just kept them on the payroll, doing nothing. Why would it affect the argument here?
Thanks, Nick, you’re too kind. But Sandwichman IS monomaniacal. It’s Tom Walker who is less so.
Unless I missed something, Justin Yifu Lin didn’t say anything about firms never laying off workers when sales declined.
What he was concerned with was 1. underutilization of capacity in high-income countries; 2. state debt problems in the US and sovereign debt problems in several other countries; and 3. low interest rates that combined with capacity underutilization result in capital outflows and 4. spikes in commodity prices that destabilize regimes in poor countries. In response to the dilemmas posed by those conditions, Yin proposed a Marshall Plan-style infrastructure investment in developing countries.
Yin briefly mentioned avoiding the “Ricardian trap” as the rationale for going “beyond conventional Keynesian stimulus of ‘digging a hole and paving a hole’ by investing in projects which increase future productivity.” But it would seem to me that the conditions Yin was concerned with have more in common with the historical post-war European conditions confronted by the Marshall Plan than they do with more abstract theoretical issues of Ricardian Equivalence.
At this point a little narrative correction may be called for. The Marshall Plan has a nice ring to it, enhanced by the reputation of it having been a galloping success. Who remembers (or cares) that half-way through the plan, it was in crisis with no political prospect of being either completed by or renewed in 1952 (See Block, The Origins of International Economic Disorder, pp. 92-108).
That crisis of the Marshall Plan elicited responses from the U.S. Treasury, the European Co-operation Administration and the U.S. State Department. In the end, it was the State Department strategy of massive military rearmament, as proposed in National Security Council memorandum NSC-68, that won the day.
It would be nice if it had been the Marshall Plan and not Cold War rearmament that had resolved the economic conundrums of 1949-50. What we got, instead, was what General Eisenhower denounced during his 1952 presidential campaign as a “deceptive prosperity” based on a “calculated policy” of inflation and “the continued failure of our foreign policy [as] the only way to pay for the failure of our fiscal policy.” In other words, Ricardian Equivalence or no Ricardian Equivalence, it was political expediency that prevailed. To then evoke false memories, 61 years later, of the Marshall Plan’s ultimate success would be to motivate a proposal with a fantasy.
So, I guess that’s my punch line. Yin offered avoiding the Ricardian trap as the theoretical rationale for his proposal, but his selling point and close was a mythologizing of the Marshall Plan.
“In the post WWII period, the United States helped herself and the world avoid a post war recession by an aggressive investment in the inter-state highway system and the Marshall Plan for European reconstruction. The government and financial sector in the United States can play a leadership role again in bringing the world to a ‘new new normal’.”
OK, perhaps you are assuming that part of the definition of Ricardian equivalence is say, homothetic preferences and that the economy is not growing, etc. In that case, you are right!
But from my reading, Ricardian equivalence is an effect, not a model, and you should be able to apply it to a variety of models, even if those models contain growing economies or heterogenous preferences. In that case, the actual stipulation is that perfectly foresighted and perfectly altruistic dynasties will set aside funds necessary to pay the future tax burden created by present government deficit spending. That should be the bare-bones Ricardian Equivalence, and you need to work out what that means, in practice, in each model.
In particular, it does not specify whether preferences are homothetic or not, or what the target debt/GDP ratio is, or that this ratio be zero (e.g. that debt be “repaid”), or even that this ratio is constant over time. Blanchard and Fischer emphasize this point.
Whether or not the increase in G is stimulative is left open — it depends on additional considerations. If preferences are heterogenous, then even tax-financed transfers can be stimulative, in which case tax revenues will go up as a result of the transfer, so that the equilibrium tax burden is lessened. It depends on who is getting the transfer and who is paying the transfer, none of which has anything to do with pre-cautionary savings per se.
Moreover, if the agents really are perfectly foresighted, then they should know that the interest rate on government debt is, on average, less than the growth rate of the economy, which would be the income growth rate of our dynasties. For any target Debt to GDP ratio, L, there is a target deficit to GDP ratio N = f(L), with N > 0 whenever L > 0, so that regardless of the current debt to GDP ratio, or what level of deficits were run in the past, the economy will eventually reach a ratio of L if all future deficits are exactly equal to N. You can say that infinitely lived agents are forward looking, ignoring any past deficits that occurred, as all that matters is the tail of the sequence.
The running of surpluses is never required if you are certain future deficits are capped. If you are not certain and want to run deficits exceeding exceeding N infinitely often (e.g. periodically during downturns), then you may need to run surpluses during booms, but the size of the surplus will always be less than the size of the deficit, provided that L > 0.
For example, from 1946 to 2010, the U.S. ran deficits 80% of the time, with the average deficit being 2.7% of GDP and the average surplus being 1.4% of of GDP, and yet the debt/GDP ratio declined from 110% to about 62% over that time period — and I’m ignoring the huge deficits that were incurred during WW2. Foresighted agents would have saved only pennies for each dollar deficit spent, so that deficits would have been stimulative in every period.
Therefore for a variety of reasons, you can fully accept that households save sufficient income to pay for future tax liabilities while still believing that changes in G are generally stimulative to AD, and that they are not stimulative only in some weird corner cases — e.g. useless spending and homothetic preferences and that you are in a boom period and the current debt to GDP ratio higher than the target ratio.
What he was concerned with was 1. underutilization of capacity in high-income countries; 2. state debt problems in the US and sovereign debt problems in several other countries; and 3. low interest rates that combined with capacity underutilization result in capital outflows and 4. spikes in commodity prices that destabilize regimes in poor countries. In response to the dilemmas posed by those conditions, Yin proposed a Marshall Plan-style infrastructure investment in developing countries.
Careful what you use the Marshall Plan as evidence for. Marshall Plan funds were grants that were used exclusively for purchase of goods from the United States. They were recycled as much into the US Economy as the European economies the program helped. Buyers on the European end had to pay for their imports in local currency. The continuous account surplus this generated was used to finance additional spending. It still is in Germany in the form of the capital of the KfW Bank. Early purchases were staples like food, later purchases focused on capital equipment.
I also fail to see that mythologizing the US Interstate Highway system proves anything. The US already had an effective intercity and interstate transport infrastructure in place in the form of railroads and had had it since the 1860’s. Other than allowing the development of interstate trucking and car travel between cities, I fail to see that the interstates improved point-to-point freight or passenger transportation much.
Though there is the historical point that everyone feared a return to Depression in the late 1940’s. The popular thinking went that the Civil War was followed by the Long Depression of the 1870’s – 1890’s, the First World War was followed by the Great Depression and World War II was bound to be followed by hard times too. Stocks traded at extremely low price-to-earnings ratios like 3 – 5 (I’m serious) in expectation of this. That it never occurred is beside the point, popular opinion was wrong in this case.
Sorta going OT but it’s safer than swimming with the RE sharks…
In discussions about why the world didn’t fall back into the trap of the 1930’s post WWII I think we tend to neglect demographics and psychology. Say you where a young man (American, Canadian or Brit) in your early 20’s when the war started. You’d grown-up in the depression. Your parents had come of age during WWI and lived through the nasty recession that followed, So you’d already had your fill of hardship. Then you spend the better part of your 20’s with someone trying to kill you and watching your friends get killed. Then along comes Nuremberg as the icing on the cake, incase you hadn’t really appreciated the depth of despair and savagery that were possible. They must have been so damn sick and tired of misery, death and destruction by that point. So what did they do? They went home and had sex. Lots of sex. And as a consequence they made babies. Lots of babies. And babies need stuff. And they grow-up into adults who need stuff. And the government has to build schools to educate them in, and libraries and swimming pools and baseball fields, etc … Babies make parents need houses to put them in, and houses need to be filled with stuff. Somebody has to make all that stuff and build the schools etc … So it seems plausible to me that it was babies saved the world from another Great Depression.
Similarly, I think it’s more than coincidence that as the population ages we find ourselves with an increasingly moribund economy.
I have a very strong hunch that Patrick may be right on the demographics. Been wondering about this for some time. Though this is not something I have thought about or looked at enough. Is it a coincidence also that Japan turned Japanese at around the same time it started turning old? Now the whole world is aging, for the first time ever? Someone said recently that China will be the first country to get old before it got rich. This is a big global experiment. And yes, demographics must be the biggest thing affecting savings and investment. Think of all the stuff you buy when you get a job then start having kids. Then stop buying a decade or two later. Add demographic swings to the opening of global financial markets.
But again, this is something I have never sat down to think through theory and data rigourously.
RSJ: REP is about whether bond-financed tax cuts shift the IS and AD curves to the right. It does not assumed the economy is in a boom. It says nothing about AS. Yes, it requires a lot of assumptions to make the conclusions hold exactly. But not that one. The AS curve only decides whether a shift in AD raises P or Y. If the AD does not shift the AS is irrelevant.
Sandwichman: “Unless I missed something, Justin Yifu Lin didn’t say anything about firms never laying off workers when sales declined.”
I would have been very surprised if he had. It would have been totally irrelevant to his topic, as far as I can see.
“Yin briefly mentioned avoiding the “Ricardian trap” as the rationale for going “beyond conventional Keynesian stimulus of ‘digging a hole and paving a hole’ by investing in projects which increase future productivity.” But it would seem to me that the conditions Yin was concerned with have more in common with the historical post-war European conditions confronted by the Marshall Plan than they do with more abstract theoretical issues of Ricardian Equivalence.”
Yep. There is something very very weird about this minor blogosphere war. Yin makes a passing reference to REP, and how productive government investment spending will offset those Ricardian effects by making people richer in future. A perfectly correct point said briefly in ordinary language in what was not a theory paper, and everyone jumps all over him.
Maybe there’s some agenda here. I had never heard of Yin before this blew up. I don’t know who’s who in economics. Maybe he’s a U of Chicago graduate, or something. Dunno.
Bingo! I guessed right! Yin has a Chicago economics PhD, 1986. The first Chicago economics PhD from red China. http://en.wikipedia.org/wiki/Justin_Yifu_Lin
Nick,
Krugman is hardly being uncharitable when he interprets “an outcome where the government stimulus fails to boost aggregate demand because economic agents expect future tax increases to pay for larger deficits and thereby increase savings” as just another rehash of “the supposed story in which government spending is frustrated by a fall in private spending.”
Quite likely Yin’s critics never heard of him before either. They just saw a sadly typical example of Chicago thinking and quite naturally they objected. Of course it’s the likes of Fama and Cochrane who have sensitised them, otherwise they probably wouldn’t have noticed.
@Nick and @Francis: I’s like to echo Frances’ comment in a different way. I dislike Krugman’s comment “And maybe we should consider make-work jobs just a form of transfer payment, so that employment, properly measured, doesn’t rise either — although I would quarrel with that; a job feels like a job whether or not, in the judgment of an outside observer, it’s adding value.”
Sorry, no. A menial job in which you know you are contributing enhances, dignity, well-being, and social cohesion. A job in which you are merely digging filling holes does not. Now, if between digging and filling the hole you place an acorn in the ground, the physical labour becomes meaningful.
A jobs program is great when needed. But build something useful – a park, a road, a new cross-country-ski house (to use a local stimulus example).
Kevin. OK. What Yin said is open to interpretation. Maybe I interpreted him too charitably; maybe they interpreted him too uncharitably. Yeh, I shouldn’t assumed they went for him because he’s from Chicago. But I really did surprise myself when I found my wild guess was right and he was from Chicago!
Christopher. I tend to agree with you. In a previous post, Greg Ransom said that his grandfather quit a job in disgust, in the 1930’s, even though he needed the money, when he learned it was a make-work program doing nothing useful. We all (OK, at least some of us) really want to believe that our jobs and lives are worthwhile. Otherwise, just give the unemployed handouts, and let them try to find something meaningful to do with their time themselves. Some will succeed.
[OT
Nick:”handouts”
Yup. But maybe find a different way to characterize it. Like obviously meaningless work, people are demeaned rather than elevated by charity. The truth is that the earth yields an enormous wealth independent of labour, and that this wealth is increasing with productive capacity of available technologies. Every new human deserves an equal claim on the total unimproved land value of the earth. Entitlement. Property. Dividend. Not a handout. ]
K: Wot! You gonna steal some of my Ricardian land rents? I already pay tax on them! (Same Ricardo, different theory, of course).
Maybe. Not sure it’s quite that easy to re-frame. The English aristocracy lived off Ricardian land rents. Eventually they invented fox hunting, to make their lives meaningful again. It takes a long time to build a culture. Until then, they waste their lives sniffing fine brandies or glue. Paradoxically, the Labour Theory of Value and Distribution is so deeply ingrained within us all now, I’m not sure it could work.
i have a basic question:
” But it’s still a totally useless activity. And no reasonable measure of output would include digging a hole and filling it in again for no purpose whatsoever. Its market value is precisely zero.”
if market value is the determinant of whether or not an activity is included in GDP, then how is goverment spending generally considered to be part of GDP? if its really the provision of goods that arent provided by the market, does that mean these public goods are not counted?
if the public good is UNDER provided by the private market, then govt provision is OVER counting the provision of goods?
GabbyD, government-provided goods are generally included in GDP on a cost basis. But GDP should not be expected to be a reasonable measure of “value”, much less general well-being. It is best used as an indicator of short-term fluctuations in economic activity, which is obviously very useful in a macro context.
Gabby: anon said it very well.
i love nick dearly
how can you not like him
he’s almost perfectly cloud cuckoo
time after time
he’s barking at the wrong bus
usually a parked bus
@nick, anon
thanks. the sentence following my quote says: “And no reasonable measure of output would include digging a hole and filling it in again for no purpose whatsoever. Its market value is precisely zero.”
so, its clear that digging a hole and filling it up is part of govt expenditure, so increases GDP. does this mean that GDP is NOT a reasonable measure of output?
Nick: “You gonna steal some of my Ricardian land rents? I already pay tax on them!”
What ya gonna do about it, Atlas? Stop producing land??? But seriously, I would also get rid of consumption and income taxes so nobody is going to go Galt. You are definitely paying some land tax as a part of your municipal taxes, but not enough. Otherwise you wouldn’t be speculating on land. The whole point is to reclaim the entire unimproved land value: i.e. the land tax has to be equal to the risk free rate on the market value of the land.
Could it work? On the one hand it would increase the wealth of poor people so assuming concave utility, their marginal utility of income is decreased. On the other hand:
1) People would pay a lot less or no income tax, they would not lose welfare if they work (there’s no welfare in the first place), and there would be no minimum wage. Many people would be moving from 100% or greater marginal tax rate to zero. I suspect it would increase the number of people engaged in paid employment.
2) It has been argued that utility of consumption for poor people is convex.
3) the wealthy would have to invest in productive capital rather than just monopolizing idle land (yeah I’m looking at you Nick, and I’m guilty too).
But hey, it’s not all or nothing. The point is to start taxing externalities (unimproved land value is a positive externality created by economic activity in general but earned by the land owner) and paying them out as a citizen’s dividend and eliminating or reducing distortionary taxes (income and consumption). These efficiencies can be phased in gradually so there is no cause for concern that it’s incompatible with our culture. We can observe the effects and adapt the programs (and our culture) as we move ahead.
Patrick’s post on the baby-boom is the standard Richard Easterlin thesis. There have been disagreements ,some quite strong, but it still holds well.
Adding to Determinant
As for the effects of the Marshall Plan
1) in North America it replaced part of the wartime spending and sent money income to workers ( and money income from work is not a tax cut or a transfer in anyone’s head)
2) was structural in Europe. It could not provide money income as the goods were transfered ( the payments was a scheme to balance the books and let the conservatives and republicans think that we were paid, even though in fact we donated the stuff…
3) started or restarted the european retail credit system. The goods were sold on credit to final users and the local currency “paid” to US and Canada so we could pretend we were paid even though these currency balances were worthless as there was nothing to buy ( otherwise there would have been no need for the Plan).Later we would use those balances to pay occupation and then NATO local expenses. We even encouraged veterans to go back visiting the battlefields. What real dollars we collected from them so they could get european currencies was the real payment for the Plan.( plus goods received in exchange for occupation expenses)
4) we provided both foreign exchange and money income to european workers plus useful things through the “Offshore” program. We would pay european factories
in hard currency to produce various things, mostly military goods.
5) the total effect in GDP% was rather small but the psychological and political was huge.
Nick:
Yes, a menial job could feel as bad as a handout,though my grand-parents had no trouble accepting the “perjury law” money once the priests explained that lying to the government under duress to feed your family was no sin ( in fact the civil servant extracting an oath that you didn’t get any other meagre income was himself guity of “simony” which can send you to hell).
That why FDR, perhaps the politician in history who best understood and used psychology, called his hole-digging programs with lofty sounding names like the Civilian Conservation Corps.
“The whole point is to reclaim the entire unimproved land value: i.e. the land tax has to be equal to the risk free rate on the market value of the land.”
A business wants to open a factory, so it buys land and builds a structure, and this requires an investment of $100 for the land, and $100 for the structure. It will need to earn the risk free rate on the $200 investment (otherwise it will not invest).
But in addition to that, it will need to pay the risk-free rate on the $100 of land? That means that it needs to earn the risk-free rate on $300?
You can only charge the risk-free rate on land if land is free, otherwise no firm will be able to afford to buy land. But landlords are firms, with the same cost of capital as everyone else — the risk-free rate.
Similarly, a household borrows to buy a house, paying the risk-free rate on the land twice? Once to the bank, and then again to the government?
That would be a subsidy to (drumroll) landlords!
RSJ, in practice, you wouldn’t tax all of the rent. You’d tax, say, 50% or 80% or 90% of it (depending on what works best) and the market value of land would decrease accordingly. Some of the rent would still be appropriated by the landlord, but it’s better than nothing.
GabbyO “so, its clear that digging a hole and filling it up is part of govt expenditure, so increases GDP. does this mean that GDP is NOT a reasonable measure of output?”
Correct. But, it may still be a useful measure of output for other purposes, even if it does not measure useful output.
Bottom line: just because GDP goes up, doesn’t mean we are better off. We’ve known that ever since GDP was invented. There are lots of counterexamples, this is just one of many.
RSJ: What anon said. In the theoretical case of a tax on 100% of the economic value, the land would have no market value. It should make no difference to your entrepreneur or home owner. Instead of paying interest on the $100 to the bank, they would pay it in tax. Nobody would ever have to finance land, since it would be free. You just have to pay the tax. In practice though, as anon says, you probably have to leave some of the land value to the owner.
K,
There is a MRS between land and produced capital. Someone can build a fancier house in a less desirable area, and sell it for the same price as a lower quality structure in a more desirable area.
Only in the idealized case in which all locations are equally desirable, or there is no substitution between location and amenities can you argue that the tax is efficient.
But in reality, it is an inefficient tax.
Taxes on ownership of land succeed in lowering the price of land only because they succeed in lowering economic activity, so all produced goods become more scarce relative to the non-produced good. You are moving people off of their ideal location/amenities trade-off by making the amenities more scarce. That is the only way that a tax on land ownership can result in the price of land declining.
On the other hand, you will succeed in seizing rents by imposing a tax on the capital gain of the person selling the land, and this will not discourage economic activity.
But a tax on capital gains is not the same as a tax on ownership.