Ricardian Equivalence, benchmark models, and academics response to the financial crisis

Mainly for economists

In his further thoughts on DSGE models (or perhaps his response to those who took up his first thoughts), Olivier Blanchard says the following:

“For conditional forecasting, i.e. to look for example at the effects of changes in policy, more structural models are needed, but they must fit the data closely and do not need to be religious about micro foundations.”

He suggests that there is wide agreement about the above. I certainly agree, but I’m not sure most academic macroeconomists do. I think they might say that policy analysis done by academics should involve microfounded models. Microfounded models are, by definition, religious about microfoundations and do not fit the data closely. Academics are taught in grad school that all other models are flawed because of the Lucas critique, an argument which assumes that your microfounded model is correctly specified.

It is not only academics who think policy has to be done using microfounded models. The core model used by the Bank of England is a microfounded DSGE model. So even in this policy making institution, their core model does not conform to Blanchard’s prescription. (Yes, I know they have lots of other models, but still. The Fed is closer to Blanchard than the Bank.)

Let me be more specific. The core macromodel that many academics would write down involves two key behavioural relationships: a Phillips curve and an IS curve. The IS curve is purely forward looking: consumption depends on expected future consumption. It is derived from an infinitely lived representative consumer, which means Ricardian Equivalence holds in this model. As a result, in this benchmark model Ricardian Equivalence also holds. [1]

Ricardian Equivalence means that a bond financed tax cut (which will be followed by tax increases) has no impact on consumption or output. One stylised empirical fact that has been confirmed by study after study is that consumers do spend quite a large proportion of any tax cut. That they should do so is not some deep mystery, but may be traced back to the assumption that the intertemporal consumer is never credit constrained. In that particular sense academics’ core model does not fit Blanchard’s prescription that it should ‘“fit the data closely”.

Does this core model influence the way some academics think about policy? I have written how mainstream macroeconomics neglected before the financial crisis the importance that shifting credit conditions had on consumption, and speculated that this neglect owed something to the insistence on microfoundations. That links the methodology macroeconomists use, or more accurately their belief that other methodologies are unworthy, to policy failures (or at least inadequacy) associated with that crisis and its aftermath.

I wonder if the benchmark model also contributed to a resistance among many (not a majority, but a significant minority) to using fiscal stimulus when interest rates hit their lower bound. In the benchmark model increases in public spending still raise output, but some economists do worry about wasteful expenditures. For these economists tax cuts, particularly if aimed at those who are non-Ricardian, should be an attractive alternative means of stimulus, but if your benchmark model says they will have no effect, I wonder whether this (consciously or unconsciously) biases you against such measures.

In my view, the benchmark models that academic macroeconomists carry round in their head should be exactly the kind Blanchard describes: aggregate equations which are consistent with the data, and which may or may not be consistent with current microfoundations. They are the ‘useful models’ that Blanchard talked about in his graduate textbook with Stan Fischer, although then they were confined to chapter 10! These core models should be under constant challenge from both partial equilibrium analysis, estimation in all its forms and analysis using microfoundations. But when push comes to shove, policy analysis should be done with models that are the best we have at meeting all those challenges, and not models with consistent microfoundations.

[1] Recognising this point, some might add some ‘rule of thumb’ consumers into the model. This is fine, as long as you do not continue to think the model is microfounded. If these rule of thumb consumers spend all their income because of credit constraints, what happens when these constraints are expected to last for more than the next period? Does the model correctly predict what would happen to consumption if the proportion of rule of thumb consumers changes? It does not.  

Two related confusions about helicopter money

Confusions about helicopter money is something of a generic title (although Martin Sandbu is thankfully not confused). Because a discussion of helicopter money (HM) cannot normally be found in the textbooks (which have only just caught up with central bank independence), the scope for misunderstanding is huge. Here I want to talk about two related confusions. The first is about whether HM would lead to an increase or decrease in nominal interest rates, as discussed in a recent interchange between Tony Yates and Paul Krugman. The second is whether HM is in competition with the use of fiscal policy to get us out of recessions.  

On HM money and nominal interest rates, there is of course the standard and very basic point that in a market you cannot control both quantity and price, still less move them in opposing directions. So if we want to think about a market for money, you cannot raise the supply of money and raise its price - the nominal interest rate - at the same time.

But this observation ignores what else is going on when you have HM. HM is a large fiscal expansion. Please none of this ‘but if Ricardian Equivalence (RE) holds’: we are talking real world policy here not doing thought experiments, and we have all the evidence we need that RE does not hold (for reasons that are not difficult to understand). Let's also not fall into the trap of doing IS-LM. We are in a world of inflation targeting, and anything that raises demand (as a fiscal expansion will) will tend to raise inflation, and so the monetary authorities will tend to raise nominal interest rates. Any temptation to say ‘yes but in the short run’ becomes dubious because of expectations effects. 

So it is really quite simple. Either the nominal interest rate lower bound constraint continues to bite, which means helicopter money will leave nominal interest rates unchanged (but the economy better off), or there is no constraint (or that constraint is removed), in which case rates will rise (sooner) with HM.

The second confusion is that helicopter money in some way precludes undertaking countercyclical fiscal policy. It does not. Right now, for example, governments could and should announce large increases in public sector investment (where I am using investment in the economist’s sense to include investment in human capital, rather than in a national accounts sense). This would negate any immediate need for HM. Monetary policy adapts to fiscal policy.

When people ask me which we should have, helicopters or fiscal expansion, I'm tempted to say I would love to have the choice! If I did have that choice, right now I would take additional public investment over a helicopter drop, because the micro case for investment is in many cases (and countries) very strong, interest rates are low and investment improves the supply as well as the demand side. In any future severe recession where the interest rate lower bound was likely to be hit [1] I would also advise bringing forward public investment. However I do not see this as a competition (countercyclical fiscal action vs HM) for two reasons.

First, one lesson of the Great Recession is that we cannot rely on governments to do the right thing with fiscal actions, so HM is an insurance policy in that sense. If governments do spend more or tax less as we approach the ZLB, that insurance policy may not be needed. [2] Second, even if governments do the right thing, either lack of good projects [3] or information delays may mean they do not do enough, and so the very quick action that central banks could take with HM could be a useful complement. To put it another way, helicopter money is best seen as an alternative to QE rather than as an alternative to fiscal action.

[1] Because of implementation lags, a fiscal response to an impending deep recession should not wait until nominal interest rates actually hit their lower bound. If that fiscal response involves investment, used in an economists rather than national accounts sense, then there is no great loss if the deep recession does not happen, because it is wise to invest when real interest rates and wages are relatively low.

[2] In the proposals put forward in Portes and Wren-Lewis (2015), the central bank would directly tell the government the probability of the lower bound being hit.

[3] I think the argument that the amount of public investment cannot be adjusted to match macro conditions is often overstated. We are not talking HS2 here (the proposal to build a high speed train line between London and Birmingham and beyond), but improving flood defences, repairing roads and schools etc.

Confidence

Mainly for economists

Francesco Saraceno reminds us about the days in which very important people believed in the confidence fairy (aka expansionary fiscal austerity), which are not so very far away. He also points to some recent ECB research which shows that confidence - as measured by surveys - clearly falls following fiscal austerity. The confidence fairy, rather than waving her wand to make everything alright again, may be making austerity worse. 

However, looking at the research in detail revealed some results I found at first surprising. In particular, revenue cuts have a bigger effect on consumer confidence than spending cuts. In terms of GDP impacts, theory - and most but not all empirical evidence - suggests that temporary spending cuts will have a larger impact on overall activity than temporary tax increases, if there is no monetary offset and incentive effects are not very large. Do these empirical results contradiction this?

To answer that you need to ask two further questions. First, what does consumer confidence actually measure? Second, and perhaps more interesting, what information do fiscal announcements actually reveal.

The answer to the first question seems to be a mixture of things, some of which relate to the individual household’s income, and some related to the general economic situation. To the extent that the consumer is thinking about the former, then it would make sense that a tax increase might have a larger impact on confidence than a spending cut. This would tell you very little about the economic impact of the two types of measure.

The obvious answer to the second question is that the information conveyed by an announcement of a spending cut or tax increase is just itself. If we stick to taxes, then if the announcement had not been made, the consumer would have just assumed lower taxes (for a time, or forever?). But this is naive from an intertemporal perspective, and clearly non-Ricardian. In the logic of Ricardian Equivalence, a tax increase today must imply cuts in taxes tomorrow for a given path of spending.

There are three alternative, more ‘rational’, ways of thinking about the announcement of a tax increase. Suppose the current government budget deficit is not sustainable. Taxes either need to rise today, or tomorrow after more borrowing. The announcement then tells us about the timing of the tax increase. If Ricardian Equivalence held it would have no impact on lifetime discounted income, but if for many possible reasons it did not hold, then a tax increase today could depress consumer confidence. However, to the extent that confidence depended on the general economic situation, you would expect ‘bringing forward’ expenditure cuts to have a much greater impact than bringing forward tax increases (with the caveats noted above), because of consumption smoothing. In that case spending cuts should reduce confidence more than tax increases.

A second possibility is that a tax increase could signal something about the future economic situation. Perhaps the consumer had thought the deficit was sustainable because they were optimistic about future growth, but the tax increase told them to be less optimistic. Reduced optimism could lead to reduced confidence. To the extent that the fiscal action conveys information about future pre-tax incomes, the tax increase conveys the same information as a spending cut.

A final possibility, which is generally ignored when discussing the plausibility of Ricardian Equivalence, is that the announcement of a tax increase tells consumers about the composition of any consolidation. Suppose again that the deficit is unsustainable. Either taxes have to rise or spending fall, but the consumer does not know which of these will happen. If spending is then cut, this tells the consumer that taxes will not rise, which in terms of the consumer’s own income would represent a plus. So in that case a spending cut could increase consumer confidence.

Trying to evaluate the impact of past fiscal actions is complicated, in large part because it is difficult to know what the counterfactual was, or what people thought the counterfactual was. Were changes thought to temporary or permanent? (Governments hardly ever say, and even if they did would they be trusted?) To what extent do people internalise the government’s budget constraint? If they do, are fiscal changes telling us about the timing of taxes or spending, or their mix, or something else? It seems to me that these difficulties arise whether we are trying to assess the impact of fiscal changes on confidence, or on activity itself. 

Japan’s consumption tax: a test of modern macro?

Japan’s Prime Minister Shinzo Abe has decided to go ahead with an increase in consumption taxes from 5% to 8% in April 2014, with a further increase to 10% planned for later. Will this be the first step to reducing the very high level of government debt in Japan (in net or gross terms, the highest in the developed world), or will it derail the recovery? In many ways the answer depends on whether you like your macro state of the art, or more antique.

Consider the antique first. Raising the consumption tax takes real purchasing power out of Japanese consumers’ pockets. It is a straightforward fiscal contraction, on a very large scale: the last thing you need when we only have the first signs of a recovery. Now in theory this fiscal contraction could be offset by monetary expansion, but can monetary expansion really be strong enough to offset a fiscal contraction of that size? Some macro antiques were always rather suspicious about the potency of monetary relative to fiscal policy anyway, but in a liquidity trap those suspicions become certainties. Even if the central bank does succeed in reducing real interest rates by raising inflation, is that going to be more powerful than the cut in real incomes that this higher inflation brings?

So why might modern macro be less pessimistic about the impact of the consumption tax increase? For one thing it might be more optimistic about the potency of monetary policy, particularly in an open economy. If the central bank is really committed to bringing about a recovery come what may then it may be prepared to see inflation go well above 2%. But I would suggest the more important difference lies with the fiscal impact of the tax increase. Modern macro could bring two arguments to the table.

The first is Ricardian Equivalence. The consumption tax increase has been planned for some time, so consumers will have already factored in its impact into their consumption decisions. Even if they had wondered if the tax increase might be postponed, some taxes will have to rise at some point. So if all the Prime Minister has done is confirm that tax increases are going to come sooner rather than later, the logic behind Ricardian Equivalence will mean that the impact on consumer spending will be second order.

The second involves the incentive effect of higher sales taxes, which I discussed recently. If monetary policy does not try and offset the impact that higher sales taxes will have on inflation, then anticipation of the tax could lead consumers to bring forward some consumption. What this really involves is fiscal policy mimicking monetary policy. Or to put it another way, if you were doubtful that monetary policy through Quantitative Easing could raise inflation, here is a surer way to achieve the same thing.

The common theme here is the importance that modern macro places on expectations of a fairly rational kind. Yet even if you are happy to go along with this, there is an important proviso that does not get emphasised enough. How did consumers know that the budget deficit would be reduced by raising taxes rather than cutting spending? If they had expected the deficit to be reduced by lower government spending, they will not have expected a fall in their post-tax real income. For these consumers the Prime Minister’s announcement will come as a surprise, and they will reduce their consumption as a result.

This argument is completely consistent with consumers being rational and forward looking, as I emphasise here. All the behavioural assumptions required for Ricardian Equivalence can still be there. What Ricardian Equivalence implicitly does is hold the path of future government spending fixed, but that is an artificial assumption which cannot be true in practice, if only because of political uncertainty. (The argument applies more generally to the small amount of modelling that has attempted to demonstrate ‘expansionary austerity’.)

So we can summarise as follows. If consumption remains on average unperturbed by the sales tax increase (perhaps showing a positive spike before April 2014 which is only partially offset by falls thereafter), then modern macro can pat itself on the back. On the other hand if consumption does take a significant hit, modern macro has an escape clause. Let us hope it does not need it.

Ricardian equivalence and political uncertainty

I like teaching Ricardian Equivalence. Ricardian Equivalence is the idea that consumers will respond to a tax cut by saving the full amount, and not spending any of it. (Here we are concerned only with the impact of the tax cut on income, and we ignore any incentive effects.) It is counterintuitive, so it makes students think.  It illustrates the importance of intertemporal budget constraints: that a tax cut financed by borrowing, and holding future spending fixed, must imply higher future taxes to either pay back the borrowing or pay the interest on that borrowing.[1] So a consumer that thinks ahead (and that faces the same interest rate as the government) will have to decide not just how they respond to the tax cut, but how they will pay for future tax increases. Finally it gets across the idea of consumption smoothing in the absence of credit constraints: if a consumer wanted to spend more today and spend less when taxes go up, they will have already done so by borrowing themselves.

Now macroeconomic textbooks will tell you many reasons why Ricardian Equivalence does not hold. Some of these are also interesting for students to explore. However one basic point often does not get the emphasis it deserves, and that is the assumption that the future path of government spending on goods and services remains unchanged. Only by making this assumption can we say that a tax cut today will mean tax increases tomorrow.

In reality consumers who receive tax cuts have very little information about what the implications will be for future taxes or spending. (Things are probably getting better, but as the IMF paper discussed in this post from Carlo Cottarelli makes clear, there is a long way to go.) Even if the current government did say that the tax cut was temporary, and would require higher future taxes to pay back the borrowing, and the consumer believed that government, it is quite possible that a different government might be in power when the time for higher taxes came. If that different government chose to cut its spending rather than raise taxes, then the consumer would be better off in terms of their income as a result of the tax cut.[2] A tax cut today paid for by lower government spending tomorrow will lead to higher consumption today.

The practical importance of this point for temporary tax cuts is probably not great. One of the points I try to get across when teaching is to distinguish between the implications of internalising the government’s budget constraint (which is ‘economics’ for thinking about how the government will eventually pay for a tax cut) and the implications of consumption smoothing. In the standard consumption model, a temporary tax cut, even if it is eventually paid for cutting government spending, will still lead to a quite small immediate increase in consumption, because the consumer will want to spread the benefits over time.[3] If you want to argue that temporary tax cuts will lead to significant changes to consumption, you need to focus on alternative models of consumer behaviour.[4]

The lack of information provided by governments about future fiscal plans, and their inability to commit to such plans in a democracy, is also relevant in trying to distinguish between temporary and permanent tax cuts. Governments often like to pretend tax cuts are permanent even when they cannot be. Those in the US do not need reminding that occasionally governments pretend tax cuts are temporary when they want them to be permanent. Tax cuts could be permanent if they are paid for at some later date by a permanent reduction in government spending. As a result, a tax cut could be a signal that government spending will at some stage be permanently reduced.[5] If that signal is correct, it makes sense to consume all of the tax cut.


So Ricardian Equivalence is a great thought experiment, but never a realistic possibility in a world where governments cannot commit on fiscal plans. Perhaps useful for the macroeconomist as scientist, but never the final answer for the macroeconomist as engineer. The macroeconomist as engineer needs to think about the possibility that a tax cut today implies a change in future plans for government spending, and that consumers might act on that possibility.

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[1] We also assume no default or printing money.
[2] Whether the consumer’s overall welfare is higher is another matter, but that is beside the point here.
[3] Under certain conditions, a Barro type consumer who cares about their children will just consume the interest their receive on the amount of the tax cut.
[4] In particular, both the existence of credit constraints and precautionary saving really matter here.
[5] A further possibility is that the tax cut represents favourable news about future growth, which also implies that the consumer is permanently better off.