Does Krugman Understand Ricardian Equivalence? (Wonkish)

Suppose that the government wants to acquire the resources necessary to implement a new expenditure program G = {g₁, g₂, g₃ … }, where g_t denotes government purchases of goods and services at date t.

Let us take G as given. To begin their evaluation of G, macroeconomists ask the following two questions. First, what are the likely macroeconomic consequences of implementing program G? Second, does the answer to first question depend on how G is financed? (Financing is assumed to take the form of taxes, deficits, and money creation, or some combination thereof).

The Ricardian Equivalence Theorem (RET) is a proposition that helps us answer the second question above. In particular, the RET lays out a set of conditions that must hold for the following proposition to hold: It does not matter how the government finances G. 

Whether the set of conditions holds in reality is a separate issue that need not concern us here. (You may be interested to read this article from the Economist on the subject page 1 and page 2). For now, let me emphasize what the RET does not say: The RET does not say that G does not matter (it says that the method of financing G does not matter). 

The G is so unimportant in the RET, that it is useful to ignore it completely when teaching the theorem to students for the first time. That is, set G = {0, 0, 0 …} and then ask whether it matters how G is financed. One way to finance such a program would be to cut taxes today and raise them tomorrow. Since G is fixed (at zero, in this case), this implies running a deficit today, which is matched by a surplus tomorrow. The RET states the conditions under which a deficit-financed tax cut like this does not matter.  A deficit today simply represents a higher future tax bill; and people really don’t care whether they are kicked in the a$$ today or tomorrow–it’s still an a$$-kicking.

What I have just described is the stuff of elementary macro textbooks. We should all understand now that the RET has nothing to do with G. In particular, we should all know enough never to write a column with the title: A Note on the Ricardian Equivalence Argument Against Stimulus.

The title of Krugman’s post shows that it is he who does not understand the Ricardian proposition. There is no “Ricardian Equivalence argument against stimulus.” Indeed—the proposition can be used to defend bond-financed stimulus. (In particular, if deficits do not matter, then why not bond finance?)

Now, perhaps you might want to entertain the idea that Paulo knows all this and only chose the title to mock that horrible Bob Lucas fellow. Could be. Except for the fact that Lucas makes no reference to the RET in his informal speech.

In fact–good lord, can it be true–it appears to me that Lucas is making distinctly non-Ricardian arguments in his assessment of fiscal policy. Take a closer look at the passage quoted by Krugman. First, Lucas asserts that a money-financed increase in G will be stimulative; but that the stimulus part comes from the manner in which the spending is financed.  (Because money can be thought of as zero-interest debt, this is virtually the same thing as saying that a deficit-financed increase in G will be stimulative.) Second, Lucas goes on to argue why he thinks a tax-financed increase in G will not be stimulative. In other words, his argument could be interpreted to be mean the method of finance matters. Needless to say, this is not a  Ricardian Equivalence argument against stimulus. 

One may agree or disagree with what Lucas has to say on any given issue (certainly, I do at times). But to come out and publicly declare the man to be ignorant of high-school economics–repeatedly–and on the basis of an informal speech–from a fellow Nobel-prize winner–who is himself is guilty of the charge leveled against his own colleague in the profession—well—holy cow, I don’t know what else to say.

PS. A couple of related blog posts on this subject:
Responding to Krugman on Ricardian Equivalence (Andrew Lilico, The Telegraph)
Ricardian Equivalence Redux (Stephen Williamson)

Addendum (Dec 29, 2011)
And in my defense:
On what is and is not an argument about Ricardian equivalence (Andrew Lilico)
Ricardian equivalence heat (Steve Williamson)
In PK’s defense:
The great Ricardian equivalence throwdown! (Noahopinion)