There have been a lot of shockingly bad performances among macroeconomists in this crisis; but if I had to pick the one that is most startling, it is the way freshwater economists have demonstrated that they don’t understand one of their own doctrines, that of Ricardian equivalence.
Ricardian equivalence says that what determines consumption is the lifetime present value of after-tax income, and hence that, say, a temporary tax cut won’t stimulate spending, because people will figure that whatever they gain now will be offset by higher taxes later. It is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability.
But even if you assume that the doctrine is right, it does NOT imply that government spending on say; infrastructure will be met by offsetting declines in private spending. In other words, Robert Lucas was betraying a complete misunderstanding of his own doctrine when he said this:
“If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.”
If you´re looking for a refresher course on Ricardian Equivalence, here´s a sample of responses to Krugman:
In his op-ed at today´s NYT Krugman again comes in defense of his brand of Keynesian economics:
The boom, not the slump, is the right time for austerity at the Treasury.” So declared John Maynard Keynes in 1937, even as F.D.R. was about to prove him right by trying to balance the budget too soon, sending the United States economy — which had been steadily recovering up to that point — into a severe recession. Slashing government spending in a depressed economy depresses the economy further; austerity should wait until a strong recovery is well under way.
Why is Krugman so obsessed with fiscal stimulus? Maybe because he has “decreed” monetary policy to be ineffective since the economy is, according to him, in a liquidity trap.
But, although Krugman does not mention because it would “spoil” his story, much more relevant to the 1937 drop in output than the tightening of fiscal policy was the Fed´s decision to increase required reserves and the Treasury´s decision to sterilize gold inflows, with the effect of both policies being a significant tightening of monetary policy. In April 1938 when those decisions were reversed economic activity rebounded strongly. The chart below shows the behavior of industrial production.