Did Ricardian Equivalence kill the Pigou effect?

For macroeconomists

After the last time the world got into a liquidity trap, there was a debate about whether price flexibility would be sufficient to get us out of the trap. That debate tended to assume a fixed money supply. With that assumption, the answer today would be yes, if falling prices raised inflation expectations (given long run neutrality) and therefore reduced real interest rates. Back then that story was not so popular, perhaps because the debate pre-dated rational expectations. Instead the argument at the time focused on the Pigou or Real Balance effect. Falling prices raised the value of outside money, so everyone would feel wealthier and spend more.

We do not hear this argument so much nowadays. I have not seen this discussed in the advanced textbooks I know well (for example neither term is in the index of Romer or Obstfeld and Rogoff), so I was wondering why that was. Is the Pigou effect not what it was once thought to be? I could not find a clear answer to this question anywhere, but of course that may be my failing. So here are my thoughts, but they come with the possibility that I have just missed something. If I have, I will rewrite the post accordingly.

What I did find were a few papers that appeared to suggest that Ricardian Equivalence (REq) killed the Pigou effect. Here is a quote from a paper by Peter Ireland. After talking about REq, he writes

“Less widely appreciated, however, is a closely related finding, presented most explicitly by Weil (1991) but also implicit in earlier work by Sachs (1983) and Cohen (1985). These authors show that government-issued fiat money will not be perceived as a source of private-sector wealth if the households owning that money are the same households that, first, receive all of the transfers or pay all of the taxes associated with future changes in the money supply and that, second, incur all of the opportunity costs associated with carrying the money stock between all future periods. We are used to the idea of Ricardian Equivalence implying that government debt is not net wealth. Essentially consumers internalise the government’s budget constraint. But that argument applies to outside money as much as government debt. We can replace initial values of debt and money by the discounted future stream of primary surpluses they support.”

The easiest way to describe REq is that the infinitely lived representative consumer consolidates the government’s intertemporal budget constraint (IBC) into its own. Suppose this consumer owns some nominal (non-indexed) government debt, and the price level falls. Is that consumer better off? The real value of the future interest they receive on that debt will be higher, but this will be offset by the higher taxes in real terms that the government will raise to pay for this. The same argument applies to the higher real redemption value of the debt.

Ireland argues that exactly the same points can be made about outside money. Suppose money pays no interest, but consumers hold it because of the liquidity services it provides.

But if the consumer already has all the liquidity services they need (as they do in a liquidity trap), a fall in prices that creates more of this asset in real terms does not make the consumer better off on this account. So what about the redemption value of the additional real balances?

Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors.

Now a standard response is to say that a money financed tax cut does not make the consumer better off because the price level will rise, reducing the purchasing power of that money. It seems to me that is a different argument to REq – it requires going beyond just thinking about budget constraints. It is also an argument that does not apply to the Pigou effect, which is what happens if prices fall, raising the value of real balances.

Does the irredeemable nature of money rescue the Pigou effect from the REq argument? Yes and no. There is a crucial difference between Buiter’s analysis and the traditional view. In Buiter, it is the present discounted value of the terminal stock of base money that is net wealth for the consolidated private and public sectors, rather than its current value. To see why this matters, consider the liquidity trap case again.

As we have already noted, there is no liquidity trap in the flexible price case when the government holds the nominal stock of money constant, because falling prices today imply higher expected inflation. We do not need a Pigou effect. But the more interesting case, which I have talked about before, is where the government or central bank has an inflation target. In this case the authorities prevent inflation expectations rising, so real interest rates do not fall.

In that case nominal money will not be held constant when prices fall. Instead, the authorities will contract the nominal money stock in line with falling prices, to make sure inflation does not rise. As a result, there will be no increase in consumption, because the terminal value of nominal money falls, and its real value stays constant. Or, to put the same point another way, higher future taxes required to reduce the money stock will offset the wealth impact of higher current real money balances. There is no Pigou effect.

This is all terribly stylised and unrealistic, so there is no need to add comments that just point this out. However, I hope I’m not the only one who thinks this thought experiment is 
interesting. I also think that the proposition that inflation targets prevent macroeconomic ‘self-correction’ even when prices are flexible has a symbolic importance.

[1] Buiter, W.H. (2003) Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap, NBER Working Paper No. 10163.

Advice for potential academic bloggers

I wanted to mark a year of blogging by encouraging other academics (particularly outside the US) to do the same. So lets use my experience to tackle some of the worries that may be holding others back.

1) How do people find out I’m blogging? I’ll be writing to myself!

When I started, I thought my posts would mainly be a useful resource for my students. Things I did not have time to say or elaborate on in lectures. In my case that is all the publicity I gave it, beyond something on my homepage and email signature. But if other bloggers discover that you are writing interesting stuff, it will be picked up. (In my case, I probably have to thank Jonathan Portes, Chris Dillow and - of course - Mark Thoma.) That is one of the great things about this medium.

Now there will almost certainly be a point where you become fixated by audience numbers.[1] But of course it is as much who reads your posts as how many read them. Here I have discovered something that is not that surprising when you think about it, but which should be a great incentive for many academic economists. Economists in policy making institutions read blogs. They do not have time to read many academic papers, but they want something a little deeper than even the FT can provide, and blogs can be ideal from that point of view. So if you have a message you want to get across to those who advise on policy, blogging is the way to do it.

2) I can imagine a few things I could write about, but I’ll quickly run out of things to say.  

Yes, I thought that too.[2] Now I admit macro is a bit special at the moment: events just keep providing material. But even so, you may surprise yourself. You certainly do not have to write as many posts as I do, and they can be shorter. (Who just said they couldn’t agree more!). No one is going to ‘unsubscribe’ you just because you have not posted for a month. How many times have you read a post, or a newspaper article, which you have disagreed with in part because you have better expertise or knowledge? Why keep that to yourself?

3) But I do not fancy getting into online debating contests

This was one issue I had to deal with early on. After writing this, I found myself being drawn into that kind of situation. (I was being provocative, so I’m not complaining.) So I pulled back, as I described here. How much you want to participate in this kind of thing is up to you.

One issue I would be careful about is tone. I once had a colleague who was always politeness personified in face to face conversation, but then could occasionally unleash the most hostile and aggressive emails or memos. I now understand better where this comes from. As I described here, when writing about contentious issues like austerity it is perhaps too easy to be rude.

4) But who am I writing for: other academics, or the public?

That is up to you. I try and make what I write accessible to non-economists, but I know that I often fail, in part because jargon comes so naturally. There are a large number of non-economists out there who are genuinely curious about economic issues, and know that the stuff they get from the conventional media is either simplistic or just wrong. If you do try to write for that audience, but also want to write something more technical, you can flag that at the beginning of the post, as Paul Krugman and others do.

5) But I should be doing research, or reading papers, rather than writing blogs.

The main activity that blogging has displaced for me is watching TV. I write the initial drafts of most of my blogs between 9pm and midnight. Now I try and avoid posting them immediately, because my mental faculties are not great at that time, but instead post them 24 hours later. By that time my unconscious mind has probably spotted most errors. You can also integrate scholarship with writing posts, as I suggest below.

6) But if I stray too far from my area of expertise, I may make mistakes.

Or, in my case, even if you are writing within your area of expertise. But as long as it does not happen too often, I think admitting and correcting mistakes does you no harm.

7) Do I have to put all those links into my blogs?

It would be easy to say at this point its up to you, but I think its good practice to link to others where you can. Bruegel said ‘Europeans can’t blog’, not because there are not European blogs, but because they tend not to link to each other. You will find your readership increases if other blogs link to you, so you should reciprocate.

This requires a little organisation and extra time. I try to keep a note of what I read, which I probably would not do if I was not writing a blog. No system is perfect, of course, and many a time I have come across a note of a post I really should have referenced. But it is worth trying.  

8) But what if my academic colleagues find out I’m blogging?

I may have to explain this for any US readers. In the UK, and perhaps elsewhere, there is a view that for academics to attempt to write for non-academics is a bit vulgar. I like to think this view is old-fashioned, but I’m not sure. However I think this will change. US academics do read blogs, and are not afraid to say so. And in the UK, there is - in ESRC and REF speak - impact!

9) Still, its not going to actually help my academic work, is it?

I’m not so sure about this. Blogging has undoubtedly improved my teaching. I do not mean students just reading my posts. In many areas, writing posts has helped me clarify my ideas, and my lectures are better as a result. I few weeks ago I wrote a refereed article that I would not have been able to write if I had not been blogging, just because writing posts forced me to think about issues more carefully. I have also occasionally found that an article that I have just read contains material that may be of more general interest, and so I have written a post on that (here is an example). As a result, I am more likely to remember what the paper said, and I hope that paper may have got one or two more readers.

10) Any other advantages?

Well, at the end of the year, you can write: thanks for reading the posts, and happy new year!

[1] Blogger says I get around 3,000 pageviews a day, and feedburner says I have around 1,750 subscribers. Is this a lot or a little? Google reader does in principle allow you to compare subscriber numbers across blogs, but it has been saying I have exactly 842 subscribers for about six months, so something tells me this may not be reliable. So,  using myself as an example again, this tells you that you do not have to know much about the technicalities of blogs to be a blogger.

[2] I should have known better. My grandfather on my mother’s side loved spending hours arguing about all kinds of things, my father wrote newspaper articles and books about a wide range of topics, my mother was a sort of journalist for a short while, and my brother is head of a media studies department, so I guess it comes naturally. On the other hand my father-in-law also liked pontificating on political issues at great length, so maybe this just says something about what many men of a certain age like to do.

Is academic macroeconomics flourishing?

How do you judge the health of an academic discipline? Is macroeconomics rotten or flourishing? Stephen Williamson is right that in one sense it is flourishing: many interesting avenues are being explored, and lots of interesting papers are getting written. Furthermore there is a common language. Of course there are pronounced local dialects, but there is mobility to, so having a freshwater dialect does not stop you giving a seminar that will be appreciated in a saltwater department, or indeed working in a saltwater department. So as an intellectual pursuit, one could claim that times have never been better for academic macro.

Society does fund some academics to engage in purely intellectual pursuits, but macroeconomics is not one of these. Yet much of the flourishing of ideas and research that is currently taking place has been inspired by recent events, and is directly or indirectly policy relevant. However having lots of ideas that are relevant to policy is not sufficient to make an academic discipline useful. It also needs to respond to the evidence in sorting out what ideas are helpful and what are not, so that it can be a progressive endeavour. In this respect, academic macroeconomics appears all over the place, with strong disputes between alternative schools.

Is this because the evidence in macroeconomics is so unclear that it becomes very difficult to judge different theories? I think the inexact nature of economics is a necessary condition for the lack of an academic consensus in macro, but it is not sufficient. (Mark Thoma has a recent post on this.) Consider monetary policy. I would argue that we have made great progress in both the analysis and practice of monetary policy over the last forty years. One important reason for that progress is the existence of a group that is often neglected - macroeconomists working in central banks.

Unlike their academic counterparts, the primary goal of these economists is not to innovate, but to examine the evidence and see what ideas work. The framework that most of these economists find most helpful is the New NeoClassical Synthesis, or equivalently New Keynesian theory. As a result, it has become the dominant paradigm in analysing monetary policy.

That does not mean that every macroeconomist looking at monetary policy has to be a New Keynesian, or that central banks ignore other approaches. It is important that this policy consensus should be continually questioned, and part of a healthy academic discipline is that the received wisdom is challenged. However, it has to be acknowledged that policymakers who look at the evidence day in and day out believe that New Keynesian theory is the most useful framework currently around. I have no problem with academics saying ‘I know this is the consensus, but I think it is wrong’. However to say ‘the jury is still out' on whether prices are sticky is wrong. The relevant jury came to a verdict long ago.

It is obvious that when it comes to using fiscal policy in short term macroeconomic stabilisation there can be no equivalent claim to progress or consensus. The policy debates we have today do not seem to have advanced much since when Keynes was alive. From one perspective this contrast is deeply puzzling. The science of fiscal policy is not inherently more complicated. What I have called a pure countercyclical increase in government spending (higher government spending now, financed by debt which is paid off by lower government spending once we are no longer at the Zero Lower Bound) can hardly fail to be expansionary in a New Keynesian framework if that debt can be sold.

What has been missing with fiscal policy has been the equivalent of central bank economists whose job depends on taking an objective view of the evidence and doing the best they can with the ideas that academic macroeconomics provides. This group does not exist because the need to use fiscal policy for short term macroeconomic stabilisation is occasional either in terms of time (when the Zero Lower Bound applies) or space (countries within the Eurozone). As a result, when fiscal policy was required to perform a stabilisation role, policymakers had to rely on the academic community for advice, and here macroeconomics clearly failed. Pretty well any outside observer would describe its performance as rotten.

The contrast between monetary and fiscal policy tells us that this failure is not an inevitable result of the paucity of evidence in macroeconomics. I think it has a lot more to do with the influence of ideology, and the importance of what I have called the anti-Keynesian school that is a legacy of the New Classical revolution. The reasons why these influences are particularly strong when it comes to fiscal policy are fairly straightforward.

Two issues remain unclear for me. The first is how extensive this ideological bias is. Is the over dominance of the microfoundations approach related to the fact that different takes on the evidence have an unfortunate Keynesian bias? Second, is the degree of ideological bias in macro generic, or is it in part contingent on the particular historical circumstances of the New Classical revolution? These questions are important in thinking how this bias can be overcome.

The New Classical Revolution: Technical or Ideological?

Paul Krugman: “The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged”

The cult here is freshwater macro, which descends from the New Classical revolution. In response

Steve Williamson: “At the time, this revolution was widely-misperceived as a fundamentally conservative movement. It was actually a nerd revolution.” “What these people had on their side were mathematics, econometrics, and most of all the power of economic theory. There was nothing weird about what these nerds were doing - they were simply applying received theory to problems in macroeconomics. Why could that be thought of as offensive?”

The New Classical revolution was clearly anti-Keynesian, in the sense of Keynesian theory of the 1960s/70s, but was that simply because Keynesian theory was the dominant paradigm? As Williamson says, these guys were outsiders, and they wanted to revolutionise the discipline, which meant attacking the dominant theoretical framework of the time, which was Keynesian IS/LM.[1]

I have no particular expertise here: when this was all happening I viewed it from afar and with a lag, although perhaps that is also an advantage. But for what it is worth, I think there is some truth in what Stephen Williamson (SW) says. I certainly think that New Classical economists revolutionised macroeconomic theory, and that the theory is much better for it. Paul Krugman (PK) and I have disagreed on this point before. It was New Classical economists who recognised the importance of Muth’s rational expectations idea, and it is hard to imagine making sense of what the Fed has done this year without it.

But this is not where the real disagreement between PK and SW lies. The New Classical revolution became the New Neoclassical Synthesis, with New Keynesian theory essentially taking the ideas of the revolutionaries and adapting Keynesian theory to incorporate them. Once again, I believe this was a progressive change. While there is plenty wrong with New Keynesian theory, and the microfoundations project on which it is based, I would much rather start from there than with the theory I was taught in the 1970s. As SW says “Most of us now speak the same language, and communication is good.” What New Keynesian theory does is allow central banks to apply New Classical ideas in a way that is relevant to the task they have to perform, which is inflation control through demand management.

I think the difficulty that PK and I share is with those who in effect rejected or ignored the New Neoclassical Synthesis. I can think of no reason why the New Classical economist as ‘revolutionary nerd’ should do this, which suggests that SW’s characterisation is only half true. Everyone can have their opinion about particular ideas or developments, but it is not normal to largely ignore what one half of the profession is doing. Yet that seems to be what has happened in significant parts of academia.

SW likes to dismiss PK as being out of touch with current macro research. Lets look at the evidence. PK was very much at the forefront of analysing the Zero Lower Bound problem, before that problem hit most of the world. While many point to Mike Woodford’s Jackson Hole paper as being the intellectual inspiration behind recent changes at the Fed, the technical analysis can be found in Eggertsson and Woodford, 2003. That paper’s introduction first mentions Keynes, and then Krugman’s 1998 paper on Japan. Subsequently we have Eggertsson and Krugman (2010), which is part of a flourishing research programme that adds ‘financial frictions’ into the New Keynesian model. You would not think of suggesting that PK is out of touch unless you are in effect dismissing or marginalising this whole line of research.[2]

I would not describe the state of macro as rotten, because that appears to dismiss what most mainstream macroeconomists are doing. I would however describe it as suffering from two unhelpful biases. The first is methodological: too much of an obsession with microfoundation purity, and too little interest in evidence. The second is ideological: a legacy of the New Classical revolution that refuses to acknowledge the centrality of Keynesian insights to macroeconomics. These biases are a serious problem, partly because they can distort research effort, but also because they encourage policy makers to make major mistakes.[3]
   



[1] The clash between Monetarism and Keynesianism was mostly a clash about policy: Friedman used the Keynesian theoretical framework, and indeed contributed greatly to it.

[2] It may be legitimate to suggest someone is out of touch with macro theory if they make statements that are just inconsistent with mainstream theory, without acknowledging this to be the case. The example that most obviously comes to mind is statements like these, about the impact of fiscal policy.

[3] In the case of the UK, a charitable explanation for the Conservative opposition to countercyclical fiscal policy and their embrace of austerity was that they believed conventional monetary policy could always stabilise the economy. If they had taken on board PK’s analysis of Japan, or Eggertsson and Woodford, they would not have made that mistake.