If you believe in Ricardian equivalence, you don't believe in recessions


The same rational, non-credit constrained individual that will save a tax rebate in anticipation of higher taxes in the future is the same rational, non-credit constrained individual that will save something extra in the good times so he can maintain his consumption level unchanged during recessions - as much a certainty in life as death and taxes.

If you believe that fiscal stimuli are pointless, then you don't believe in recessions as we know them.

12 comments:

  1. pushmedia1 Says:

    Real business cycles? I know the literature is kinda new so you may not have heard of 'em. :-)

  2. Anonymous Says:

    what a crock of ... !

  3. Gabriel Says:

    Huh... consumption IS smoother than income which IS smoother than investment.

    Also, you might very well be rational, but if you are credit constraint (wow, people with bad credit, who would have thought!) then you won't be able to smooth consumption and your current consumption will have some correlation with current income (in differences).

    So, yeah, what pushmedia1 said... this is standard, first year macro.

  4. datacharmer Says:

    Gabriel - I think you are missing the point here. My claim is not that people are irrational.

    What I'm saying is that you see very significant fluctuations in consumption during recessions - because of credit constraints or whatever - which should not be happening given that the number and depth of recessions across your life-time is pretty predictable, and your lifetime income expectation should not be affected very much by any particular recession.

    In other words, how is a tax rebate - income that you will eventually have to pay back (and when I say you I mean the private sector as a whole) different to an economic boom - income above average lifetime income which you will see decline during the inevitable recessions?

    How can you reconcile the fact that while consumption moves together with income in a recession (pretty much nil impact on lifetime personal income expectation) it won't move together with income if said income comes from a tax rebate? (again, nil impact on lifetime personal income expectation)

    In your words: 'if you are credit constraint (wow, people with bad credit, who would have thought!) then you won't be able to smooth consumption and your current consumption will have some correlation with current income (in differences).'

    So if you can't increase consumption to the desired (average lifetime) level during recessions because you are credit constrained, maybe a tax rebate during a recession that brings your income back to its average lifetime level could help you?

  5. Gabriel Says:

    In the data there's some strong evidence of consumption smoothing but it's not perfect. Two causes come to mind: 1) different preferences than what we assume when modeling the Permanent Income Hypothesis; and 2) credit constraints preventing people from having access to lifetime earnings in the present.

    Mankiw has a paper in the '80s showing that if you assume that a 3rd of the population is credit constrained (lives hand-to-mouth) then you match the data well.

    I don't see where "believing in recessions" comes into play and what it means.

    The problem with recessions is that they have a disproportionately high impact on those that are poor: they are more likely to be credit constrained and more likely to become unemployed.

    This is precisely what theory predicts. For most practical purposes we can take PIH/Ricardian Equivalence as the baseline and then maybe think about some deviations from that, but I don't see how recessions are a problem for current theory.

  6. Gabriel Says:

    P.S. As far as your point... I think you are saying that recessions and rebates are both shocks to transitory income so they both shouldn't move consumptions, but looks, recessions move consumption. Is that what you're saying?

    Here's a picture that suggests that rebates don't move consumption much and we can easily plot similar pictures showing that during recessions consumption falls a lot less than income:

    http://gabriel.mihalache.name/ei/images/66.png

  7. datacharmer Says:

    My point is that you can't claim that Ricardian equivalence renders fiscal policy impotent in a recession because people won't adjust their current consumption despite the increase in their current income, at the same time as you observe significant comovement between consumption and (falling) income as a result of the recession! It boils down to saying that lower income leads to lower consumption but higher income does not lead to higher consumption.

    And yes, there are other arguments against fiscal policy in a recession; I'm just talking about fiscal policy in principle, and only with relation to the Ricardian equivalence argument.

    And the image doesn't say much at all. First of all, the rebate was not exogenous, nor was it unexpected. Secondly, just because consumption remains on trend doesn't mean that it would have done so without the rebate. Thirdly, why would you expect the effect on consumption to demonstrate itself as a spike? A rational person that gets a bit of money back in a rebate will probably increase his consumption over a large number of future (and indeed past) periods, not in the same one he gets the rebate! To expect to see a spike in consumption in the same period as the spike in income is, well, irrational. Don't be a sloppy casual econometrician!

  8. Gabriel Says:

    But isn't that the purpose of the "fiscal stimulus", to increase private consumption spending?

    Either it does or it doesn't. And it didn't. This is what PIH/Ricardian Equiv. predicts.

    Also, I don't know why you say "significant comovement between consumption and (falling) income as a result of the recession". Significant? There is *some* comovement but a lot less than implied by, for example, a dumb/static Keynesian multiplier.

    Why do you disagree with the scenario I suggested already? Baseline = PIH, but there are some poor, credit constrained people who generate that comovement and are worst hit by recession.

    The best idea I can take from this is that if you want to do rebates, send them to poor/bad credit folk...

  9. Gabriel Says:

    P.S. And yes, you are right, my implicit assumption/forecast is that consumption will just follow a trend. I think it works well and I'm not aware of any alternative forecasts that would suggest that, absent the stimulus, consumption would have dropped 6 months ago.

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