Ricardian Equivalence and government spending

If the government takes our money (through taxes), and spends it on our behalf, does that increase aggregate demand?

If the government borrows our money, making us pay back the loan (through future taxes), and spends it on our behalf, does that increase aggregate demand?

The answer is: it depends. It depends on what the government spends the money on. It depends on whether we are able to borrow ourselves. It depends on whether we, or new immigrants, or people not yet born, will pay the future taxes. H/T Kevin Quinn.

I'm going to assume that the central bank wants aggregate demand to increase (because output is below the natural rate), and so does not raise the rate of interest, or allow the exchange rate to appreciate, to offset any effects of fiscal policy.

Let's start with three simple cases.

1. Suppose the government takes our money in taxes, and gives it back to us as transfer payments. It takes $100 from my right pocket and puts $100 in my left pocket. No effect on Aggregate Demand. Unless it taxes the people who would have saved an extra dollar and transfers it to people who will spend an extra dollar.

2. Suppose the government takes our money, spends it on goods we would have bought anyway, and gives them back to us. No effect on AD. The government is just doing our shopping for us. It's like transfers in kind, instead of in cash. If the tax was $100, we cut our own consumption spending by $100, and save the same as before.

3. Suppose the government takes our money, spends it on goods which are totally useless to us (or spends it on useful goods but then throws them away). We are poorer, and so save less, and our consumption falls, but by less than the $100 tax increase. AD increases, output may increase too, but we are not better off. The best that can happen is we get the "balanced budget multiplier" of one, so a $100 increase in taxes and government spending causes output to increase by $100, but useful output to stay the same.

The more realistic cases are where the government spends our money on goods which are useful to us, but are not goods we would have bought ourselves. Unfortunately, these are less simple. It all depends on how it affects savings, and this depends on how the government spending affects our permanent income, current income, and whether the government buys goods that are substitutes or complements for current consumption and future consumption.

4. Suppose the government takes our money, and spends it on goods that will not directly affect our incomes, will give us utility, but will not affect the marginal utility of present or future consumption. Think art galleries, museums, or making the country look nice. The new art gallery does not affect our trade-off between present and future consumption or our savings decision. The result is exactly the same as in example (3), where the new goods were useless, except now they aren't useless. We get the balanced budget multiplier, and we really are happier because of the new art gallery, even though our consumption expenditure stays the same.

5. Suppose the government takes our money, and spends it on goods which are a complement to current consumption. Think of a firework display, which is free, but you need to buy a new lawnchair. (Sorry, I can't think of a more sensible example). This affects the trade-off between current and future consumption. People will save a smaller portion of their disposable income today, to buy a lawnchair. We get "crowding-in" of consumption. The multiplier is bigger than the standard balanced budget multiplier.

6. Suppose the government takes our money, and spends it on goods which are a complement to future consumption. Think of a scenic highway, which won't be completed until next year, and you may need to buy a car to enjoy it. People will now save a larger portion of their current disposable income, so they can buy a car next year. The multiplier is now smaller than the balanced budget multiplier. If the effect is strong enough, it can even be negative.

Now suppose the government spends on new investments, which don't directly make us happier, but do make us richer. Think infrastructure, education, R&D. With this sort of investment spending, it's simpler to think of them being financed by borrowing, not taxes.

7. Suppose the government borrows money, and spends it on a new investment project that will give the same rate of return as government bonds. If the return on the investment goes directly to the government, rather than increasing household income (think government toll road), then future taxes will not need to rise to repay the borrowing. It is exactly the same as an increase in private investment. We get the same large multiplier (1/[1-c] in the simple model). If the return on the investment goes to households instead (think education), then any rise in future taxes to repay the borrowing is exactly offset by the increased future income from the investment. So we get the same large multiplier effect. All this assumes, of course, that the government did not do an investment project that would have been done by the private sector anyway, and does not cause a rise in the rate of interest or shortage of inputs that would otherwise crowd out private investment or consumption.

8. And if the government borrows to invest in a project which has a greater (smaller) rate of return than on government bonds, the multiplier will be even  larger (smaller) than 1/(1-c).

Now to compare spending financed by taxes to spending financed by borrowing. The Ricardian Equivalence Proposition says they are equivalent. The easiest way to do this is to consider:

9. Suppose the government borrows $100 per person and gives a transfer of $100 per person. According to REP, this is equivalent to (1) above, and so should have no effect on AD. The reasoning is that people will save all the transfer, so they can pay the higher future taxes, and will not want to change their trade-off between current and future consumption, since their lifetime wealth or permanent income is unchanged. There are many reasons that REP might be false. The most important are:

A. Some people are borrowing-constrained. They wanted to borrow more and consume more, but couldn't. Now the government has borrowed the money for them, they increase consumption.

B. Some future taxes will be paid by future immigrants, or by those not yet born. So the current generation is wealthier, and will increase consumption. (But some may not increase consumption, because they will want to leave higher bequests to their children to offset their higher taxes.)

C. Some people may not figure out the effect of borrowing on future taxes, so will increase consumption. (But others may panic at the increased debt, and may cut consumption).

D. Taxes may affect incentives, and may discourage future earning, or current investment, and so may reduce current consumption and investment.

Conclusion: if we can think of government investment projects that are productive, and give the government future income or give us future income, and which earn a good rate of return, this sort of government spending is not only good microeconomics, it can be good macroeconomics as well, if what you want is to increase aggregate demand.

Comments

[jp]

So following this to its logical end, you say that if the state always invests in productive projects that earn a good return, we have a good outcome. So why not put the the state in charge of all of society's investment projects ie. a communist system.

[Nick Rowe]

jp: lovely question! Ignoring political risks of a state having so much power. Because there are some investment projects the state seems to do better than the private sector, and vice versa. All the standard stuff about externalities and natural monopolies may make some projects better for the state to do. Where the exact boundary lies is not for mere macroeconomists to decide.

[Mark Dowling]

"It depends on whether we, or new immigrants, or people not yet born, will pay the future taxes."

A bit offtopic/scope for another post but the mention reminded me. Has anyone serious proposed lifting the immigration target to from 250-300k to say 350-400k for a few years, with the express intent of creating increased consumption/demand for housing, furnishings etc. After all, one of the reasons Toronto's housing bubble keeps rising is the net migration into the GTA. The trouble would be forcing through the queue the sort of immigrants that actually have money to spend, but wasn't that the point of the CPC's changes to the immigration system over the last year or two?

[Andrew F]

Mark, I expect that would exacerbate unemployment (and entitlements) over the next few years.

[Mark Dowling]

"1. Suppose the government takes our money in taxes, and gives it back to us as transfer payments. It takes $100 from my right pocket and puts $100 in my left pocket. No effect on Aggregate Demand. Unless it taxes the people who would have saved an extra dollar and transfers it to people who will spend an extra dollar."

In the current environment we might see negative aggregate demand - higher earners having disposable income reduced by higher taxes having increased taxes transferred to those who are burdened with debt obligations. At best, you would be transferring from Paul Martin's bank account to the arrears department of Toronto Hydro and Enbridge.

For point 5 - bike racks at transit stops might be a good example?

Point 9 - unless the government borrows at 0% interest, how is 9 equivalent to 1? Governments don't have to pay a rate of return on taxation, and because we don't use taxation mandate referenda the government isn't even obliged to spend the tax on what it promised to when it imposed it in the first place. In the case of borrowing, not only does the interest affect the net return but it must be repaid on a schedule (defaults excepted) and the interest in the case of State debt is often owed to creditor nations and thus leaves the State entirely.

[Nick Rowe]

On immigration: New immigrants want to by stuff, which increases aggregate demand, but they also want to produce and sell stuff (their labour in particular) which increases aggregate supply. As a first approximation, the two will be roughly equal, so it's a wash (the percentage unemployed stays the same).

In normal times it doesn't matter if the increase in AD is bigger or smaller than the increase in AS. The Bank of Canada adjusts monetary policy to bring the two back into line, if needed.

If monetary policy can't work, then it might matter. If new immigrants arrive and in their first year spend more than their income (consumer durables like house, car, furniture, whatever), then they help us get out the recession. If instead they spend less than their income (because they arrive with no assets, and are saving to buy consumer durables) then they make the recession worse. Dunno. More of a long-run policy, I think.

1. Funnily enough, I was just trying to think this through myself. If some people do use transfers/tax cuts to pay off debt, that might not be such a bad thing, if it prevents default, and eases pressures in financial markets. Still thinking this through. My head's not clear yet. Post brewing...

5. Bike racks are complementary to bikes. So you dissave, to invest in a new bike today, so the govt expenditure on bike racks crowds in consumer (durable) expenditure on bikes. Yes, that works. I like it!

9. Suppose the rate of interest is 10%, to keep the math simple. The government borrows $100, and hands it out in transfers. Next year, the debt is $110, and the government decides to pay it off, so imposes an extra tax of $110. Anticipating this will happen, people think "Hmm, I had better save this $100 transfer, lend it out at 10%, so I've got $110 next year to pay that $110 tax". Effectively, all that happens is they spend the $100 transfer on the govt bond (just like the govt giving them a $100 bond), and then hand over the bond (plus interest) in lieu of taxes next year.

[Don the libertarian Democrat]

"Conclusion: if we can think of government investment projects that are productive, and give the government future income or give us future income, and which earn a good rate of return, this sort of government spending is not only good microeconomics, it can be good macroeconomics as well, if what you want is to increase aggregate demand."

This is true of any investment. The problem is that, even in the private world, there's no guarantee that money invested will be productive.

By the way, since government spends a large amount of our money, we must believe, or at least some of us, that some government spending is warranted.

In other words, neither the productivity argument or argument about whether government can do anything better is very useful here. Rather, in Debt-Deflation, we are trying any number of ways to get out of it. One way is to stop a savings spree that is part of debt-deflation. The question is can government spending stop a savings spree?

I say that it can, because it helps create a perception of investment and employment, as opposed to continual job losses and little or no new investment.My argument would be based on what people say about how they might react to a stimulus. That interests me more than theories, which assume behavior not in evidence. There are so many countefactuals being bandied about, it's hard to see them as anything but a list of possible cases, none of which might occur.

[Nick Rowe]

Hi Don:
" neither the productivity argument or argument about whether government can do anything better is very useful here. Rather, in Debt-Deflation, we are trying any number of ways to get out of it."

Surprisingly, it IS useful here. In normal times, we evaluate a government spending project in terms of whether it makes better or worse use of resources than alternative uses of resources (either government or private). And we choose the project if it has benefits exceeding the (opportunity) costs. But in bad times like these, all we care about is whether it will stimulate total demand - cause spending rather than saving. But surprisingly, it turns out that projects which meet one form of the first criterion - they create money income in the future - also give the biggest "bang for the buck" in stimulating spending now. This is because there is no "drag" from higher anticipated future taxes on current consumption. I may do another post on this, since I can expand on the reasons.

On your last paragraph: economists would phrase this as "yes, expectations matter". In this case, the more successful people expect the policy to be (in increasing income and preventing deflation) the more successful it will be. Usually, people can just learn from experience what the effects of various things will be, even if they don't understand why. But when new stuff happens, people can't rely on experience, so expectations aren't as well anchored.

[Don the libertarian Democrat]

Hey Nick,

"they create money income in the future"

How can you guarantee that? Many projects have enormous overruns ( The Big Dig, The Bay Bridge) . As well, depending upon what we're talking about, the demand can change. For example, gas prices can lessen traffic and tolls. I'm assuming that what you're saying is that some projects can lead to such an increase in revenue.

My view is that infrastructure spending sends the signal that we are confident enough to invest in our future, thereby calming fears of the future.

Here's another problem: Everyday we make choices about what to do, spend, wear, etc. There are too many variables in human action to know how much people will save for a presumed tax. The theory of human action that allows such prediction doesn't exist for me. Perhaps, since you love philosophy, you can tell me what your philosophy of action is.

[Nick Rowe]

Don: all investment yields a return (if any) in the future, and the future is unknown. The same is true of private and government investments. But we make the best estimate we can, make an adjustment for risk, and then cross our fingers.

Sacrificing a goat would also calm our fears of the future, if people believed in it, and could get us out of the recession. But nowadays people have more faith in the future returns to investment in education, bridges, etc, than faith in the future returns to sacrificing goats, so we switch to the modern religion. Admittedly, their faith is less than it was two years ago, but still greater than in goats.

I'm not 100% sure what the right answer would be though, if I believed the modern religion, but knew that the populace believed in goats. I think I would sacrifice a goat. Maybe a lot of goats, to at least get a big effect on current aggregate demand (for goats), to help their simple faith.

Philosophy of action. I can't think of anything very intelligent to say. Some mixture of rational choice, subjectivist/Bayesian probability, rules of thumb, habit, custom, adaptive learning, fashion, genetic hardwiring, maybe even alcohol (how many advanced economies are not alcohol-based?). I argued in my PhD thesis that people are rule-maximisers rather than act-maximisers (analogous to rule- vs act-utilitarianism), but it didn't get me very far. I missed that course as an undergrad, and my daughter seems to have taken my only book on the philosophy of action (can't even remember the author).

Econometricians do test different theories of savings. They seem to be able to explain at least some part of savings behaviour.

[Nick Rowe]

Don: On re-reading your comment, I now re-interpret your:

"My view is that infrastructure spending sends the signal that we are confident enough to invest in our future, thereby calming fears of the future."

If I see Warren Buffet (or anyone who I think knows more about the future than I do) investing in X, that's a signal to me that X is a good investment. So you are saying that the govt. is signaling in the same sort of way. OK. I think I get you now. It's putting its money (except it's really our money) where its mouth is, so it's not just 'cheap talk' when it says we will survive, and it wants us to reason like that. Good point. I missed it last night.

[Ken Houghton]

I saw T. Boone Pickens investing in alternative energy, and decided it was a good idea to do so. Remind me not to do that again.

"Conclusion: if we can think of government investment projects that are productive, and give the government future income or give us future income, and which earn a good rate of return, this sort of government spending is not only good microeconomics, it can be good macroeconomics as well, if what you want is to increase aggregate demand."

This is the argument that Laurence Ball, Greg Mankiw, and Doug Elmendorf made in 1998 (h/t Simon van Norden chez DeLong). I wonder what Mankiw is doing these days...

[Nick Rowe]

Thanks Ken: I hadn't heard it before, till I saw Kevin Quinn make it recently in comments. I think it's an important point.

Because fiscal policy hasn't been used for so long to influence AD, I think it's taking a lot of us a lot of time, not just remembering how it works, but re-thinking the over-simplifications in the old Keynesian cross model, where it didn't matter what G was spent on.

[LMS]

Re: “The government is just doing our shopping for us” (in Point 2)
I know economists like to simplify things and ignore messy details such as the cost of government doing your shopping. You might think that overhead cost of spending on infrastructure must be relatively modest. However I suspect the cost of government spending money on investment (productive or otherwise) is significant.
In order to get an order of magnitude estimate of such costs I took a look at the cost of what should be even easier – giving away money to students. In 2006-07 Canada Millennium Scholarship Foundation spent $22.5 million on administration to give away $342.6M in grants - that’s 7%. (This was better than what was in their budget for that year - $27M to give away $348.5M – that’s 8%.) If you think that this may not be a well-managed agency - a 2007 audit by the auditor general “found that the Canada Millennium Scholarship Foundation's bursary programs are well managed and that the Foundation has the necessary controls in place to ensure that eligibility for bursaries is assessed correctly and that payments are issued in the right amounts to the right people”. If that management costs 7-8%, just imagine what the overhead costs are for infrastructure spending.

I won’t even try to estimate the cost of collecting taxes (which includes the cost of those painful audits). But I bet it costs as much for the government to collect money as it does to give it away to students.

[Phillip Huggan]

"Has anyone serious proposed lifting the immigration target to from 250-300k to say 350-400k for a few years, with the express intent of creating increased consumption/demand for housing, furnishings etc"

I've seen an article suggesting Obama increase Mexican immigration (or was is illegals integration) to increase homeownership of vacant homes. In Canada there was a $600M Liberal proposal circa 2007 to increase the number of immigrants who find work that matches their credentials. I'd guess before upping immigration, you'd need to fund such programmes out of tax increases or deficit.