In defence of crass materialism (temporarily)

Economists are sometimes accused of crass materialism. Normally I would plead innocent, and accuse the accuser of misunderstanding economics. But right now I am in favour of crass materialism. I want government investments which yield a monetary return. Government investments which make people happy but bring in no cash aren't as good right now. And it's not because "people are short of cash right now, and can't afford art galleries". It's because crass materialism leads to a bigger Keynesian multiplier.

Suppose we have a choice between spending $100 on building a new bridge or on building a new sculpture. The bridge will bring in money, either by charging tolls, or by increasing people's incomes. The sculpture won't bring in any money, because people will be able to see it for free, and won't increase anyone's income. But people will enjoy seeing it.

Normally, like any good economist, I would say that it makes absolutely no difference that one investment brings in money and the other doesn't. The only purpose of money is to buy things that we want (that give us utility). If we get more utility indirectly from the bridge than we get directly from the sculpture, then build the bridge. But if the sculpture brings us more utility than the bridge, build the sculpture. Money income is only a means to an end.

But right now it's different. Forget the sculpture; build the bridge. The bridge will have a bigger fiscal multiplier than the sculpture. The bridge will cause a bigger increase in aggregate demand.

Suppose the investment will be financed by increased taxes. $100 spent on construction means $100 extra demand. But $100 extra taxes will reduce disposable income by $100, and reduce consumption by (say) $80. So the immediate (first round) effect will be a net $20 increase in demand. That's correct for the sculpture, but it's incorrect for the bridge. The bridge will also increase future incomes, once it's built. When people expect an increase in their future income, they usually consume more now and save less. The increased consumption from the increased future income will offset some, or maybe all, or maybe more than all, of the drop in consumption from increased taxes.

Or suppose the investment is financed by government borrowing. Both bridge and sculpture create an immediate $100 increase in demand. But if people expect higher future taxes to pay for the government debt, they expect their future disposable incomes to be lower, so they consume less now. That drop in consumption partly offsets the $100 increase in demand, so the immediate (first round) effect will be less than $100. That's correct for the sculpture, but incorrect for the bridge. If the government collects tolls from the bridge, it won't have to increase taxes as much. If the tolls pay the full borrowing costs, taxes won't need to increase at all, so consumption won't decrease now.

It's about the same if the government doesn't collect tolls, but the bridge increases people's incomes. The increase in future income from the bridge will offset the increased future taxes at least partly, maybe fully, or more than fully. So future disposable income won't fall as much, and might even rise. So current consumption won't fall as much, and might even rise.

Either way, whether financed by taxes or by borrowing, $100 spent on building the bridge will have a bigger effect on aggregate demand than $100 spent on building the sculpture. And that's what we need, in these abnormal times. Once the abnormal times are over, and aggregate demand is no longer the problem, we economists can renounce crass materialism, and return to our good old spiritual natures.

[If you are uneasy about this conclusion, because you see the sculpture as giving "psychic income", think of it this way: is the psychic income from the statue a perfect substitute for the material goods you buy with money income? If it is, so that $1 equivalent of psychic income causes the marginal utility of consumption to fall by the same amount as $1 of money income, then $1 of psychic income will have exactly the same effect on current savings as $1 of money income. In this case, the bridge and the sculpture are the same. But it seems much more plausible that the sculpture would be a very imperfect substitute for the consumption goods that money can buy, and would have little or no effect on the marginal utility of future consumption.]

Comments

[ClaudeB]

I'm am not being facetious here, but should I care if it's a bridge or a sculpture? A household either spends on goods (a bunch of it imported) or saves some for a rainy day. So, if I have a lower C and IM, a higher G and I (money saved goes to the bank and the capital-starved bank will lend it). I must be missing something here.

Second question: What's my marginal willingness to pay for new bridges? Do we need 100 new bridges at $100? There was an highway exchange a couple miles from where I live that was built in 1970. It stood there, abandoned, for almost 40 years, before they bulldozed it, just in time for the city's birthday bash.

[Nick Rowe]

Claude:
First question: Yes, you (we) certainly should care whether people consume or save. It does make a difference to demand and output. Just to keep it simple, assume a closed economy. In current circumstances (near zero interest rates, assumed constant, and unemployed resources) a switch from consumption to savings will NOT cause an offsetting increase in investment. That's what all the recent fuss has been about on the blogosphere (see Paul Krugman and Brad DeLong for example. If people *try* to save more, the only effect will be a fall in income, so actual savings (and investment) stays the same. Why? Because nobody wants to invest more, and the extra supply of savings just creates an extra flow demand for money and a lower demand for goods, so sales and output of goods falls, and income falls, until income falls so low that people stop trying to save more.

Second question: it only works if the extra bridge does indeed create extra income. If it's a bridge to nowhere, you had better build the sculpture, since at least it makes us happy, and has the same multiplier as a bridge to nowhere.

[Beezer]

I keep seeing economists make the following statement: "But if people expect higher future taxes to pay for the government debt, they expect their future disposable incomes to be lower, so they consume less now."

Is this literally true? Once the taxes actually hit the mailbox, certainly they will have an impact on consumption somewhere. And bonded funding has an incremental increase, as opposed to paying for something in cash. But I'm a little skeptical that the average taxpayer says "oops, my taxes are going up next year, again, might as well not buy that new coat I want today." Maybe the timing is irrelevant as far as economics goes.

One other matter re: timing and infrastructure spending. If the state was going to repair a highway, for example, but didn't have the money right now and was planning to do it in two years, but the fiscal stimulus gave them money today so they make the repair today, does this actually add to infrastructure spending? Or does it just move it forward in time?

My point is that shovel ready infrastructure spending isn't really adding to infrastructure spending if it was going to be done anyway later. Doing it now, when times are tough, makes it worth doing, of course.

But everyone should understand only infrastructure spending which would not have otherwise be done, is true additional investment in infrastructure. If it is informed with a vision of transforming our economy to sustainability, then the additional spending will be well worth it.

Failure to explain this to the public can lead to problems in the near future because opponents will use the total spending as though it was all net additional spending--which it isn't. And if believed, this opposition could undercut net additional spending we so critically need.

[Nick Rowe]

Beezer: a lot of economists share your scepticism that people figure out and adjust their savings for future taxes. We know that people respond to future disposable income to some extent, but it's unlikely they will all respond fully. It's more a question of how much it is true, rather than whether it is 100% or 0% true. I'm not keeping up on the econometric literature (maybe Stephen is) on this question, but last I heard there was a rough consensus that it seems to be about half true. (Or, people behave as if it were half true).

Some of the investment will be just brought forward. And that's not a bad thing, if now is when we need the extra demand. Would it weaken my argument a bit if the new infrastructure investment spending were at the expense of future infrastructure investment spending? No, because if that future infrastructure spending were at the expense of OTHER investment spending (and it would be if we are back to full-employment normal times in the future), then new TOTAL investment spending now does not, on net, displace ANY future investment spending (it just shifts it around from one investment to the next). I had to think about that one. Good point.

It would be good to explain it to the public better. But I have a hard enough job trying to explain it to myself. The fact that I had to really think about your point above shows that. And I'm not even sure I have explained it to you clearly enough.

[Nick Rowe]

Re-reading, no I didn't explain it very clearly. Let me try again.

Suppose we have a choice between building the bridge now or building the same bridge in the future. Assume we are at full employment in the future. So building the bridge in the future will take resources away from other uses, like other investments. But building the bridge now, when resources are idle, does not take resources away from other uses, like other investments. So if we build the bridge now, total investment (now + future) does increase, even though total bridges (now + future) stays the same. (I'm assuming closed economy for simplicity).

[Don the libertarian Democrat]

Nick,

I don't credit the saving for future taxes argument as well. Everyday we make decisions and plans based on any number of conflicting desires, needs, etc. Some people might save for a tax, or they might save for other reasons. Whether you follow Quine or Wittgenstein you will have problems separating out motives and causes. I'm not saying it doesn't make some sense, but I don't see a straight line of cause and effect.

One argument put forth for infrastructure spending now, in a downturn, is that we are likely to get better terms on our infrastructure contracts at present. I'm a bit bothered by trumpeting this argument because it makes it sound as if we need recessions to improve the efficiency of government spending.

I completely agree with the point about infrastructure investment needing to be just that. However, as I said in your last post, I would market it differently. I'm a fan of the new Trust Index approach( I'd like your views Nick ):

http://blogs.wsj.com/economics/2009/01/28/trust-troubles/

Right now, trust in government is actually falling. In the US, it's hard to sell government spending as competent. Consequently, I'd use different arguments, like trust in our future.Trust in doing things together with our taxes.This can help overcome doubts about competence. However, even if they'll make a pig's breakfast of the spending, it has to also be sold, truthfully, as an attempt to invest in our future. Just telling people we're handing out money for whatever, as if the money acts mechanically, isn't a way to inspire trust. It signals insincerity.

Also, I might note the following:

http://www.nytimes.com/2008/12/27/opinion/27lyubomirsky.html?_r=2&ref=opinion

I feel that, in a downturn, selling communal projects as just that is an easier task.

[roger]

Nick, I think the explanation that behavior caused by the expectation of a future rise in the tax rate is dependent on a class variable. I don't believe the median Joe cares. It is the upper five percent Joe who cares. The investor class comes equipped with a sensing mechanism that the average Joe doesn't have - a whole machinery of accountants and lawyers who are concentrated on the tax question all the year round.

And what the upper five percent see is that the impetus to raise their marginal tax rate will become a lot more attractive to a government seeking to pay down a large debt. We know this from the debts of WWII, for instance. The Republlicans, under Eisenhower, didn't lower the rate to Reaganesque levels for the wealthy. And the debts were paid off.

Now you might say, median Joe will be negatively affected by the investor class who will try to pay for their taxes out of Joe's hide, say by hammering his pay. But this doesn't seem to have happened in the WWII case. Of course, back then, global trade was much different. But this isn't a good argument either, vis a vis median Joe, since his pay and job security is going to be threatened by offshoring whether or not taxes are raised or lowered. This is why the class variable is important here.

[Mark Dowling]

"The sculpture won't bring in any money, because people will be able to see it for free, and won't increase anyone's income."

This is the second successive post where it is implied that investment in the arts creates zero/insignificant economic uplift. (see Point 4 in "Ricardian Equivalence")

Not every investment does, of course - many are sinkholes for public funds - but that's true of many other things government "invests" in.

[Nick Rowe]

Don: On your 1st paragraph. Ricardian Equivalence does follow logically for a rational utility-maximising person who understands the intertemporal government budget constraint plus his own intertemporal budget constraint (plus some other assumptions). Now you might say, "sure, but only economists can figure this out; normal people can't". The party line in economics, following Milton Friedman, is that it doesn't matter what's going on inside people's heads; all that matters is that they behave 'as if' they were fully rational in their reasoning, and this hypothesis seems to work well empirically most of the time.

I sort of like Friedman's argument, but I'm not fully convinced. Funnily enough, Friedman's argument seems to be vulnerable to the "Lucas Critique" (normally applied to ad-hoc old-Keynesian macro models): "If you don't properly understand the mechanism, how can you be confident that patterns of 'as if' behaviour won't change when the rules of the game change?". Dunno.

paragraph 2: I look at it as "If the times give you lemons, invest in making lemonade".

I'm going to have to look at and think about the trust index.

Roger: you could be right, but my money would be on the "middle class" as opposed to the upper or lower. But only in the sense that worrying about the future, saving, investing, education, paying down the mortgage early, is deemed to be a "middle class" (or bourgeois) virtue.

If you are right in saying that the people who think about future taxes are the same ones who will pay the higher future taxes, that means that the Ricardian Equivalence proposition will be (approx) true.

[Nick Rowe]

Mark: (we were posting at the same time). This post is really just an expansion of a small part of the previous "Ricardian" post. It was a surprising (to me) conclusion when I thought this through while writing the Ricardian post. Previously, before thinking about it, I would have said it made no difference whether you invested in art or something else. I didn't want to follow it up there, since it was a digression. Plus it seemed interesting enough and difficult enough to warrant a post of its own.

[Nick Rowe]

Roger, again: I expect you could say I think in terms of Ricardo's model of class structure: dissolute landed aristocracy who spend everything they can get their hands on; farm labourers who live day-to-day; and in the middle the capitalist farmers, who save and invest for the future. (This may have something to do with my Brit agricultural background!)

[roger]

Nick, Ricardian equivalence would be true if there were no other constraints on behavior. My point about global trade is that any behavior stimulated by the expectation of higher taxes would have to be integrated into other profit seeking behaviors, which might or might not cancel it out. However, the behavior one could expect now would be to seek, in the political marketplace, to block legislation leading to that potentially higher tax burden, except when the advantage accrues to the higher income percentile. Thus, you see few economists worry about the higher tax burden implied by, say, TARP - rather, there is the universal assurance that somehow, TARP will pay for itself. I think of the difference in analytic frameworks here as the sort of thing once would predict: if I am right, and the class variable is strongly causal, there will be little if any discussion of the tax consequences of TARP, and a lot of the tax consequences of a stiumulus bill. In other words, if an expenditure tends to benefit the investing class, that expenditure will not provoke the same kind of discussion as one that holds out a diluted benefit to that class, with the threat of increased marginal rates in the future.

Ultimately, I think Ricardian equivalence fails because the investor class is not strong enough, politically or economically, to do anything but absorb the tax loas and move on. Other constraints and stimuluses overpower that effect.

[tc]

Here's a question. Is there a decreasing marginal return on bridges, and how do we know we're not past that point? The FDR period had some famous large infrastructure projects - Hoover Dam, rural electrification, etc. It seems obvious that those projects would pay off, since they created something that was clearly missing before. But for countries like the US, Japan, etc are already built out - how much additional benefit would they get from bridges (to nowhere?) According to this view, stimulus will pay off for a place like China, but for mature economies that already have all the stuff they need, the gain will be minimal (like, well, Japan). What could today's equivalent of Hoover Dam be?

[ClaudeB]

tc asked:

What could today's equivalent of Hoover Dam be?

Mass transit (high speed rail, light rail, subway systems), greener power (to replace coal) and a better power grid, environmental cleanup (waste management, water treatment, forest rehabilitation), among other things.

[Don the libertarian Democrat]

" it doesn't matter what's going on inside people's heads"
This is behaviorism. As such, it's subject to the indeterminacy of translation.I'm agreeing with Roger, I think, in arguing that either:
1) under behaviorism, you can't know the motives. Hence, you are left saying that X caused Y. However, if it doesn't always work, then you need to explain how it can be causal.
2) if you actually consider motives, I need to know how you're disentangling the motive of saving for future taxes from other motives or causes. For example, if I feel that I can invest my money better in the meantime than save for a possible tax increase, I might well do that. Or I might save for other reasons.
Finally, in 1970, I was pretty sure that I was going to end up in the army. However, I pretty much lived my life as if I wasn't. That's because I decided not to let that possibility dictate my life. I'll tell you this, being in Vietnam scared me a hell of a lot more than paying taxes. My only point is that I don't see how, in any real theory of human action, you can phase out the historical and cultural context, for example.

[Don the libertarian Democrat]

" it doesn't matter what's going on inside people's heads"
This is behaviorism. As such, it's subject to the indeterminacy of translation.I'm agreeing with Roger, I think, in arguing that either:
1) under behaviorism, you can't know the motives. Hence, you are left saying that X caused Y. However, if it doesn't always work, then you need to explain how it can be causal.
2) if you actually consider motives, I need to know how you're disentangling the motive of saving for future taxes from other motives or causes. For example, if I feel that I can invest my money better in the meantime than save for a possible tax increase, I might well do that. Or I might save for other reasons.
Finally, in 1970, I was pretty sure that I was going to end up in the army. However, I pretty much lived my life as if I wasn't. That's because I decided not to let that possibility dictate my life. I'll tell you this, being in Vietnam scared me a hell of a lot more than paying taxes. My only point is that I don't see how, in any real theory of human action, you can phase out the historical and cultural context, for example.

[Dee]

Nick?

Savings from a tax cut, given the low interest rates & inflation, will result in a lower FV of that savings. Money is worth more today than tomorrow because money can be invested to offset inflation but people are not investing. Those households who are in the black have their money 'parked'. Confidence in the financial systems has been eroded. If income taxes weren't cut and government money is to be invested to generate future income it would create a greater FV than PV which is what every investor would want. Also, more government revenue can be generated via people working than drawing unemployment. Confidence would be a little better and people would spend a little more. I believe the consumerism we once saw is over and you'll see a higher national savings rate.

Any present income tax cut would have a lower FV if it were saved in a bank account. I don't think people save for future income tax increases but they do save windfalls (I would call this a windfall) to mitigate the inflationary increases or unexpected events. What is concerning to me is future tax increases will be a burden to those whose wages haven't caught up to inflation. The idea of offsetting some or any future tax increases with a reliable revenue stream, such a bridge toll, makes more sense to me. Higher savings will also mean people will want to have a higher FV so it will eventually stimulate consumer investing.

[Mark]

As I recall, economics is the allocation of scarce resources. Isn't economics always about satifying our material needs given the resources available? Individuals always consume with their indifference curve tangent to their budget constraint thus maximizing utility and hence satisfying their crass material needs.

I view people as crass materialistic individuals. Markets, while not perfect, are the best mechanism we have for harnessing that materialism and for providing individuals with incentives

[Nick Rowe]

roger: TARP (the original version) may or may not have tax consequences; it depends on the underlying eventual vale of the assets at maturity. On the other hand, we know that deficits will have tax consequences (unless we cut future spending to repay the debt). And I think a lot of Republicans in the US were against TARP?

But nevertheless, I accept your point that if one group expects to be the ones paying the higher future taxes from current deficits, we should be unsurprised if that group argues against current deficits. Just as we should be equally unsurprised if another group, which expects someone else to pay the higher future taxes, argues in favour of current deficits. The argument seems symmetric.

But I either misunderstand or else disagree with your last paragrapgh:
"Ultimately, I think Ricardian equivalence fails because the investor class is not strong enough, politically or economically, to do anything but absorb the tax loas and move on. Other constraints and stimuluses overpower that effect."
Ricardian Equivalence is not about who wins which political battle. Assume that the investor class loses the political battle, and will also be the class that pays all the higher future taxes, and knows this. Assume the investor class has the same marginal propensity to consume out of permanent disposable income as everyone else. Then the investor class will increase savings by an amount equal to the present value of future tax increases. Then aggregate savings increases by the amount of the current tax cuts or transfer increases. Then Ricardian Equivalence is true.

[Nick Rowe]

Don: Economists flirted with behaviourism at one time, trying to replace rational choice with the Weak Axiom of Revealed Preference, for example. But it never really caught one. Friedman's position was more instrumentalist than behaviourist. But I see your point, and I'm not sure how easy it would be to draw a dividing line between instrumentalism ("Rational choice models are useful for predicting behaviour even if people don't literally think this way") and behaviouralism. Dunno.

Dee: If the government borrows $100 to give a $100 tax cut/transfer, the government needs to sell and extra $100 government bonds. People who save the whole $100 tax cut, and are looking for a savings medium, and will buy that new $100 government bond. Same rate of interest on both sides. So the FV of the $100 savings equals the FV of $100 government borrowing. It all washes out.

Mark: NORMALLY, economics is about the allocation of scarce resources, both at the individual level and at the societal level. But, weirdly, in ABNORMAL times, like now, resources continue to be scarce at the individual level, but not at the societal level. That's the Keynesian insight.

But is economics only about "material" needs? Maybe, and maybe depends on how you define "material". Perhaps I should have used the word "pecuniary" instead. ( But there isn't an -ism for "pecuniary").

[roger]

Nick, Nick, I think you have to decompose what you mean by savings in your argument: “Assume that the investor class loses the political battle, and will also be the class that pays all the higher future taxes, and knows this. Assume the investor class has the same marginal propensity to consume out of permanent disposable income as everyone else. Then the investor class will increase savings by an amount equal to the present value of future tax increases.”

Savings, outside of a blackboard model, where it is simply an abstraction, is actually a real modality in the real world. In other words, you have to save in something, in some real form. Thus, how you save – what those modalities are - is shaped by the total economic landscape confronting the investor. Having assumed the investor lost the political battle, we are assuming, then, that the modalities of saving have shifted. That is, in fact, the whole meaning of our premises: that the investor class lost the political battle, and thus has lost some control of the investment landscape. Now, the blackboard might suggest that the investor class will take all their financial instruments, turn them into gold coins, and bury them in the back yard. But this is not 1600. Reality suggests that when the government intervenes and changes certain fundamental factors in the economy – say, by building interstate highways – the “savings” of investors will follow, even if they seek only to save an amount equal to their tax increases. How? Because the savings vehicles will, in order to return a profit as well as keep up with inflation, seek out enterprises to invest in. Those enterprises, unsurprisingly, will be changed by the building of interstate highways. It might turn out that this, for instance, lowers the cost of delivering food, which makes chains of grocery stores more profitable and farming less so. Savers that have vehicles which invest in farming will find that they are not saving as much as those with savings vehicles that invest in grocery stores. Thus, no matter how the investor tries to save to equal the tax loss, he will end up contributing to the new landscape of investment shaped by the state’s intervention; in fact, by trying to preempt, in the present, the future tax burden, could well amplify the sectors at which the state is throwing money. Given that the investment landscape changes much more quickly than it did in Ricardo’s time, Ricardian equivalence doesn’t really have time to assert itself. It only describes a very temporary phase, then, in economic growth. In real terms, it may be invisible - except as a frequency within other frequencies that make up the sum total of the circulation of capital. Of course, the government intervention could be such that it impacts negatively on those fundamental factors – it could be, for instance, that a war is provoked and infrastructure is destroyed by bombings. But that simply implies that the argument should be about what the particular fiscal interventions are about. Worrying about the investors reaction to future taxes should only operate as a constraint helping to determine which sectors the government funds.

[Nick Rowe]

roger: that was not easy for me to follow. In my (tentative) interpretation, you are (perhaps saying 3 things:

1. "The very fact that the political battle for a changed fiscal policy is won by one side and not the other, changes expectations about political strength and who is likely to win future political battles about fiscal policy" Interesting point, and one which I have not heard before in economists' discussions of fiscal policy, except perhaps partly captured in the idea that deficits create uncertainty about the rules of the game, and this uncertainty may reduce investment, which may offset the effects of fiscal policy.

2. "Depending on what exactly the government spends on, an increase in government spending may increase the profitability of private investment, and may crowd in private investment (or consumption) spending." Agreed, but I would rather consider this under the effects of government spending. It does not affect the validity of Ricardian Equivalence. RE says that bond-financed spending is equivalent to tax-financed spending. Equivalently, RE says that bond-financed tax cuts/transfers have no effect. These indirect effects of government spending you are talking about would be exactly the same if it were tax- or bond-financed, so don't affect the validity of RE.

3. "An increase in savings does not cause a drop in aggregate demand, because savings must be invested somewhere, so the drop in consumption demand caused by an increase in savings will be fully offset by an increase in investment demand". NO!. This is the Fama/Cochrane vs DeLong/Krugman debate. Savings=investment in equilibrium, but this does not mean that an increase in savings has no effect on aggregate demand and output. Under present circumstances (interest rates stuck at zero, excess supply of goods), this will not be true. Under other circumstances, (where the Bank of Canada adjusts interest rates to keep aggregate demand constant, it will be true (or would be in a closed economy). (But maybe you weren't saying this.)

[Dee]

'So the FV of the $100 savings equals the FV of $100 government borrowing. It all washes out.'

One would hope so.

[roger]

Nick, my disagreement with your analysis is, I think, essentially a disagreement about a static model telling us things about a dynamic reality. I think this comment of yours clearly demarcates the differences in analysis:

"Agreed, but I would rather consider this under the effects of government spending. It does not affect the validity of Ricardian Equivalence. RE says that bond-financed spending is equivalent to tax-financed spending. Equivalently, RE says that bond-financed tax cuts/transfers have no effect. These indirect effects of government spending you are talking about would be exactly the same if it were tax- or bond-financed, so don't affect the validity of RE."

That is because the assumption is that the entire investment class drifts to investment in the safest type of instruments in order to save the equivalent of what they would lose via future taxes.

It is at this point that I have to laugh a little. Usually, free marketeers portray the private sector as seeded with entrepreneurial heroes, forging ahead in a risk strewn environment. But apparently all these heros strap on their diapers when they are informed of pending tax increases and act en masse like the codgers in a comfortable old folks home.

Well, I don't think so. In fact, some investors, depending on their positions, will operate like that. Others, however, will take a tax increase like a high jumper takes a higher bar - as something to jump over. Others will see the opportunities that open up due to government funding on a 800 billion dollar scale. These may enlarge their share of of the total wealth of the investor pool. There might even be - gasp! - new entrants. And finally, of those drifting into bonds - we will see how that works in a financial infrastructure that is essentially burning down.

I apologize if my vocabulary or suppositions seem confusing. I have long thought that the models of economics, based on borrowings from 19th century physics, were borrowed from the wrong science. It is biological models that apply more neatly. The ricardian equivalence is simply a picture of a possible investment landscape with one incentive. It is like the picture of an adaptive landscape with one determinant. But as you add other incentives - as you fill in that landscape - you bury that incentive under other incentives. And, I should add, as the adjustment to higher taxes occurs, those whose response to them is to save an equal amount may well be weeded out. We see new dominant players among the investor class emerge for just that reason - cautious players, responding to previous landscapes, can't keep up with new players.

[Nick Rowe]

roger: but the risk-loving classes have already taken on all the risk they want to, so at the margin are no more risk-loving than anyone else. Faced with a new liability, the future taxes, they see a new asset, the new bond issue, which exactly matches that liability, and is therefore a perfect hedge. So, if rational, they will buy it. For example, if unexpected inflation reduces the future tax liability by half, it also reduces the value of the bonds by half.

I don't know about the 19th century physics thing. I agree that economics is sometimes better matched to biology. But then there's a reason for this: Darwin is Malthus plus Adam Smith applied to biology! (OK, I'm oversimplifying slightly, but Darwin did explicitly recognise Malthus' contribution to his thought.)

[roger]

I don't think that is a very good reading of Darwin, frankly, and leaves out Mendel. But more to the point: "but the risk-loving classes have already taken on all the risk they want to, so at the margin are no more risk-loving than anyone else," This simply restates what I said: you are using one determinant to take a snapshot of the investment landscape. If that snapshot was all that was happening, then you'd be correct. But the very premise of the discussion is that that is not all that is happening - the government is injecting 800 billion dollars into the landscape. If you ignore the whole reason for having the discussion, then you would be right a priori. But with that injection, the risk-lovers (or the diaper clad rentiers) are confronting a new and massive fact, which disturbs their expectations - in terms of taxes - and their opportunities (where risk taking is rational).

In truth, the last thirty years have seen an unusual experiment, in the U.S., of low taxes that have not been matched with small government. Rather, the government has stayed about the size it averaged in a higher tax period - the 50s-70s. I'm using, as a measure, the number employed by all levels of government in the U.S., which is currently about 22 million people.

Although I am a left-liberal, I did see the logic of the small government people. I simply thought that they would, if successful, produce benefits for the very few, while decimating the lifestyles and prospects of the many.

As it turns out, the many saw it in the same way, which was why, in spite of the rhetoric, the government never shrank from 1980 onward. Obviously, something was going to give. Rational investors, if they operated from rational expectations, should have looked at the numbers long ago and expected higher taxes. But it turns out that the investing class doesn't drift like a herd in directions suggested by static state models.

And my prediction would be that what has happened in the past, in fact all the history of the past sixty years, tells us that the investment landscape will not stop for a future tax increase, nor can one disentangle, from the mix of new opportunities and constraints, what "savings" even means. Actually, it would be much easier to tax if Ricadian equivalence were a final output - a final description of the effect of deficits. We could simply tax those safe savings havens. After all, supposedly all the money is drifting to them, as the risk lovers have reached the limit of risk.