Ricardian Equivalence: An Argument for Countercyclical Fiscal Policies

Ricardian equivalence has crucial importance in the fiscal policy considerations of new classical macroeconomics. When assessing Ricardian equivalence or any of the new classical doctrines, one should bear in mind the conditional character of of these theses. The equivalence theorem should not be separated from the assumptions on which it is based. In other words, Ricardian equivalence does not mean the failure of any countercyclical efforts, but underlines the necessary conditions for this failure and, naturally, for the success at the same time. Governments do not have any potential to exert countercyclical efforts if the path of government expenditures is fixed and if agents form rational expectations. If these conditions hold, cuts in taxes imply a later pressure to rise taxes, since government has to fill the resource gap in the budget which is the result of the initial tax cut. So, rational agents treasure up the additional income from the tax cut and consumption does not rise. In this story, public operations should stand in the focus of reasoning: if these processes can be changed by the government, or, in any way, the additional income can be believed not to be withdrawn later, the initial tax cut will induce a rise in consumption expenditures. So, any of the conditions necessary for the equivalence does not hold, countercyclical fiscal policy can be effective. Controlling the real economy is possible perhaps even in a Keynesian style if government regains its potential to exert this control. Therefore, actually, new classical macroeconomics highlights the conditions under which fiscal policy can be effective and not the inefficiency of fiscal policy. Countercyclical aspirations need not to be abandoned, only the playing-field of economic policy got narrowed by new classicals. Although Keynes urged active countercyclical efforts of fiscal policy, these efforts are not predestined to fail not even in the new classical theory, only the conditions necessary for the efficiency of countercyclical efforts were specified by new classicals. Ricardian equivalence underlines the importance of fiscal reforms, since such reforms are needed in order to change the path of government expenditures. When implementing comprehensive fiscal reforms which make public sector more efficient governments do not exert countercyclical efforts of course, but form the necessary conditions for regaining countercyclical potential. In this respect, Ricardian equivalence clarifies the exact conditions necessary for countercyclical fiscal policies.

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On the Classical Dichotomy

In new classical macroeconomics there is a short-run Phillips curve which can shift vertically according to the rational expectations being reviewed continuously. In the strict sense, money is not neutral in the short-run, that is, classical dichotomy does not hold, since agents tend to respond to changes in prices and in the quantity of money through changing their supply decisions. However, money should be neutral in the long run, and the classical dichotomy should be restored in the long-run, since there was no relationship between prices and real macroeconomic performance at the data level. This view has serious economic policy consequences. In the long-run, owing to the dichotomy, money is not assumed to be an effective instrument in controlling macroeconomic performance, while in the short-run there is a trade-off between prices and output (or unemployment), but, owing to rational expectations, government cannot exploit it in order to build a systematic countercyclical economic policy.

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Assessing New Classical Macroeconomics

Today new classical macroeconomics is often said to be irrelevant in terms of the conditions of national economies. Some of the new classical doctrines, i.e. first, the costless reduction of the rate of inflation by controlling public expectations, or, second, the inefficiency of monetary and fiscal policy, rarely work in practice. This fact leads some economists to think that new classical macroeconomics is only an incomplete theory that fails in terms of reality. However, as some recent researches highlight it, this attitude is only the consequence of a superficial and incomplete understanding. It is argued that, actually, new classical macroeconomics did not underline the inefficiency of economic policy but the conditions under which countercyclical economic policy can be effective. In other words, one should not forget the conditional character of the new classical doctrines. If prices are completely flexible and if public expectations are completely rational and if real economic shocks are white noises, monetary policy cannot affect unemployment or production and any intention to control the real economy only ends up in a change in the rate of inflation. However, and this is the point, if any of these conditions do not hold, monetary policy can be effective again. In terms of fiscal policy it is the Barro-Ricardo equivalence theorem that has crucial importance. As it is known, if processes of the public sector remain unchanged and agents form rational expectations, cuts in taxes imply a later pressure to rise taxes, since government has to fill the resource gap in the budget which is the result of the initial tax cut. So, rational agents will treasure up the additional income from the tax cut and consumption will not rise. In this story, public operations should stand in the focus of reasoning: if these processes can be changed, or, in any way, the additional income can be believed not be withdrawn later, the initial tax cut will induce a rise in consumption expenditures. So, any of the conditions necessary for the equivalence do not hold, countercyclical fiscal policy can be effective. Perhaps controlling the real economy is possible in a Keynesian style if government regains its potential to exert this control. Therefore, actually, new classical macroeconomics highlights the conditions under which economic policy can be effective and not the inefficiency of economic policy. Countercyclical aspirations need not to be abandoned, only the playing-field of economic policy has been narrowed by new classicals. Although Keynes urged active countercyclical efforts of fiscal policy, these efforts are not predestined to fail in the new classical theory either, only the conditions necessary for the efficiency of countercyclical efforts were specified by new classicals.

Pictorial (from left to right): Robert Lucas, Tom Sargent, Robert Barro and Neil Wallace.

On the Lucas-critique

Today, after the Lucas critique, the old-style Keynesian economics is often said to be dead. Today societies and politicians hardly accept the direct and unlimited success of countercyclical economic policy highlighted by John Maynard Keynes. For Keynes, fiscal policy has the hope of countercyclical success, though he himself also referred to some limits in the form of expectations (e.g. Ch. 12 of his General Theory). This was the problem that was examined by both Milton Friedman and Robert Lucas. However, deeply, the core idea of Keynesian countercyclical economic policy remained intact all along: there are situations in which government intervention may be successful in real terms. This is the consequence of the conditional character of the theory of new classical macroeconomics. However, the exact circumstances under which this countercyclical potential is available underwent serious modifications. Today, thanks to the new classicals, we have a deeper understanding of these limiting factors.

On the Neutrality of Money

Neutrality of money has been a central question for monetarism. The most important answers were elaborated within the framework of the Phillips curve. Milton Friedman, assuming adaptive expectations, distinguished a series of short-run Phillips curve and a long-run one, where the short-run curves were supposed to be the conventional, negatively sloped curves, while the long-run curve was actually a vertical line indicating the natural rate of uneployment. According to Friedman, money was not neutral in the short run, because economic agents, confused by the money illusion, always respond to changes in the money supply. If the monetary authority chooses to increase the stock of money and, hence, the price level, agents will be never able to distinguish real and nominal changes, so they will regard the increase in nominal wages as real modifications, so labour supply will also be boosted. However, this change is only temporary, since agents will soon realize the actual state of affairs. As the higher wages were accompanied by higher prices, no real changes in income occurred, that is, it was no need to increase the labour supply. In the end, the economy, after this short detour, will return to the starting point, or in other words, to the natural rate of unemployment.

New classical macroeconomics led by Robert E. Lucas also have had its own Phillips curve. However, things are far more complicated in these models, since rational expectations were presumed. For Lucas, the island models made up the general framework in which the mechanisms underlying the Phillips curve could be scrutinized. The purpose of the first Lucasian island model was to establish a framework to support the understanding of the nature of the relationship between inflation and real economic performance by assuming that this relation offers no trade-off exploitable by economic policy. Lucas’ intention was to prove that the Phillips curve exists without existing. It was a heritage that there is a trade-off between inflation and unemployment or real economic performance, so it is undoubted that there is a short run Phillips curve (or there are short run Phillips curves). Although there are fewer possible actions available for the monetary policy to conceit people in order to increase the labour supply, unexpected changes can always trigger real changes. But what is the ultimate purpose of the central bank when changing the money supply? For example and mostly: exerting countercyclical control. Doing so, monetary policy would increase the money supply in order to eliminate the negative effects of an unfavourable macreconomic shock. However, monetary policy is not able to utilize the trade-off between inflation and real economic performance, because there is no information available in advance about the shocks to eliminate. Under these conditions, the central bank is unable to plan a course of action, that is, a countercyclical monetary policy. Rational agents can be conceited only by unexpected changes, so a well-known economic policy is completely in vain. However, and this is the point, the central bank cannot outline unforseeable interventions, because it has no informational advantage over the agents. The central bank has no information about what to eliminiate through countercyclical actions. The trade-off between inflation and uneployment exists, but it cannot be utilized by the monetary policy for countercyclical purposes.

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On Abstraction and Homo Oeconomicus

It can be easily argued that abstraction is an elementary methodological tool in several social sciences. Social sciences have definite and different man concepts that highlight those aspects of man and his behaviour by idealization that are relevant for the given human science. Homo sociologicus is the man as sociology abstracts and idealizes it–depicting man as a social being. Moreover, we could talk about homo cyber sapiens (the man who can extend his biologically determined intelligence thanks to new technologies), or homo creativus (who is simply creative).

Abstraction (combined with Weberian idealization) plays a crucial role in economics. Breaking away from directly experienced reality was a common trend in 19th century sciences, and this was the effort which was fundamentally determined the way economics tried and still tries to approach social life. It is abstraction that we meet in the case of both Newton’s physics and the neoclassical economic theory, since the goal was to grasp the unchangeable and timeless essence of phenomena. For example, Newton created the concept of the material point by following this abstraction method so that he abstracted from the dimension and shape of any perceptible object, preserving only inertia and translational motion. Material point is the ultimate and common feature of all bodies. Neoclassical economists created the indefinitely abstract notion of homo oeconomicus by following the same procedure. Economists abstract from all individual and personal qualities in order to get to those characteristics that embody some essential features of economic activity. Eventually, it is the substance of the economic man that they try to grasp. Any characteristic beyond that only disturbs the functioning of this essential core.

Book of the Month

John Banville (2005): The Sea. London: Picador.

Hungarian Edition: John Banville (2016). A tenger. Budapest: Geopen.

A masterpiece. This was the first word that occured to me after reading John Banville’s award-winning novel, The Sea. It is similar to a glass of wine the real bouquet of which only reveals itself at second draught… or to a girl whose beauty only strikes roots in your mind at second sight. A girl whose tiny gestures you may walk past at first, but there is still something that makes you return to her time and again. Something that makes you unable to take your eyes off her face no matter how hard you try and that makes you turn her pages so as to discover the deeper levels of her intellectual depth and beauty.

I came across the Hungarian edition of Banville’s novel the other day when I was hanging about in a local bookshop on the corner to find something to read for the weekend. Standing in front of the shelf for world literature a small book caught my eyes. The sea – it was its title. It may sound funny but all of this was going on after a coffee with my best friend when we had had a light chat about escaping from our everyday lives to somewhere where the totality of life can be discovered again. Our idea naturally occurred was spending some years sailing on the sea. So it is no wonder that a book under such a title was so appealing to me on that day.

Banville seems to feel attracted by visual arts, especially painting, and it is somehow evident that he has learnt to write from the great impressionists. His novel is like a huge canvas on which the scenes of his story painted in vivid colours show up one by one. It is typical that I caught myself in the very act of re-reading and re-reading his paragraphs again and again. His sentences require careful reading, similarly to a situation when we want to memorize all the flavours of a delicious meal. I really felt tempted to remember his words so much that I narrowly missed learning the whole text by heart. The text itself is organized into major units that can be evaluated individually like the individual works of a painter. These units could easily be taken out of the totality of the text and could be read as individual short stories. This is the strength of this novel. The power of Banville lies in this ability of his: he can lay out a scene through dropping some closely knit sentences, while avoiding any unnecessary details. The story itself is about a man who tries to rake over the ashes of the past, but, to be honest, it is completely indifferent as to the merits of the novel. Banville can write masterpieces on whatever as a topic, I am sure. He can consistently avoid luxuriating in the abundance of adjectives or spending too much time describing minor details. Banville is the writer of the big pictures. He has become an impressionist of modern novels by giving full descriptions through only a few strokes of his brush, so it is his readers who must finish off his paintings. The touches he adds to a picture are far from being concrete, but they are still evident. This is the reason why we must re-read his sentences time and again. We need to dig deeper in his broad strokes of the brush to find the minor details all of which are hidden under the surface of vivid colours. It is weeks since I finished reading this book, but I cannot get that out of my mind even today…

John Banville received Man Booker Prize for The Sea in 2005 and he is widely believed to be expecting the Nobel Prize in literature. He is a giant. And his Sea is a must.

A Theoretical Economist on Vacation

Being on holiday now I am spending a couple of hours a day studying Sydsaeter and Hammond’s Mathematics for Economic Analysis (Prentice-Hall, 1995). I do my best to dig deeper in the theory and practice of mathematical analysis from multivariate optimization to matrix algebra. For an economist mathematics can never be enough so it is worthwhile for one to deepen his knowledge of maths. So I can discover the beauty of mathematical analysis again. It is fun.

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History of Economic Thought in Hungary

As for a theoretical economist or a methodologist the current state of the history of economic thought and its heritages in the country where he was educated is an important thing. It has been in my mind for a long time to write a post on this topic because Hungary is a special case, I am sure. It is worthwhile to consider the theoretical foundations which a methodologist must rely on when looking for his own way.

As far as I know there are two authors who had strong influences on the history of economic thought in Hungary: one is Marx and the other is Prof. Janos Kornai. Obviously these two sources cannot be taken as independent from one another. Hungary was closed behind the Iron Curtain for decades, so quoting Marx was an inevitable component of all the scientific publications, not only in economics but in all disciplines from political science to literature or aesthetics. Marx was a serious distorting factor for sure. While in Western Europe Marx, interpreted as having placed his system upon the never-proved axiom of the labour theory of value, has been regarded as an unsuccessful effort to renew economic thinking (for instance, the well-known Keynesian historian of the economic thought Phyllis Deane treated Marx in this way), in Hungary Marx is taken somehow as an intellectual complementary to Keynes and one of his predecessors. The Hungarian edition of Keynes’ General Theory was published in 1965, some 30 years later than the first English edition. During this 30-year-long period Hungarian professionals were totally imbued with Marxism. The most important contribution of Keynes was thought to be the idea of central planning, so for the Hungarian economists taking Marx as their intellectual foundation Keynes was not considered to be able to convey any new or important messages, not only in political but also in theoretical terms. In the years after 1965 one can hardly find any publications on Keynes, so the deep-structure of his system remained intact and unrevealed. Only a few historians of economic thought proved to have achieved an in-depth understanding of Keynes.

Kornai treated mainstream economics as a highly idealized system and, consequently, as a failure. Many contemporary economists are still under the impression of this age-old idea. They still tend to choose inadequate measures to judge mainstream theories: these measures are grounded upon the fundamental idea of directly comparing abstract theories to reality. This is nonsense and this act of theirs is a clear manifestation of a misunderstanding of the theoretical developments in modern economics and methodology. For them an abstract-idealized theory is necessarily a failure, since it cannot grab all the essential features of real macro-economic systems. They are not familiarized with the idea that abstract theories are usually directed at revealing only some of the mechanisms of real socio-economic systems. One at a time.

In contemporary methodology an idea has been striking root according to which mainstream economics should be regarded as a thesaurus of conditional theorems. In other words, the exact content of these theories should not be separated from the underlying simplifications and assumptions. This idea has become a commonplace in Western methodology by this day and age (for instance, see Frank Hindriks’ detailed analysis on the Miller-Modigliani theorems), and this is the idea which was chosen as the backbone of The Theory of New Classical Macroeconomics. Admittedly, I myself was influenced by Marxism in the very beginning. As an open-minded young researcher I was governed by my professors, and some of them have been strongly influenced by the sharp rejection of mainstream economics. This is the reason why I used John Weeks’ Critique as an intellectual basis in Chapter 1 of the monography… so this work on new classicals should be taken as a struggle to say good-bye to the old-school of the history of economic thought in Hungary. The whole publication is dedicated to one effort: how to break away from the narrowest interpretation of mainstream economics.

Economics: Debates around the Unread Literature

The difference between mainstream economics and some other approaches is rarely as clarified and explicit as in Hicks’ seminal book ‘Value and Capital’ (1939, Oxford, Clarendon Press). In the Itroduction (p. 7) he gave the following statement:

This is a work on Theoretical Economics, considered as the logical analysis of an economic system of private enterprise, without any inclusion of reference to institutional controls. I shall interpret this limitation pretty severely. For I consider the pure logical analysis of capitalism to be a task in itself, while the survey of economic institutions is best carried on by other methods, such as those of the economic historian (even when the institutions are contemporary institutions). It is only when both these tasks are accomplished that economics begins to near the end of its journey. But there is a good line for division of labour between them, and it is a line we do well to observe. It must be realized, indeed, that, as the price of this austerity, the purely theoretical economist becomes unable to say that any opportunities or dangers he diagnoses are or are not present in the actual world, at any particular date. He is bound to leave that to a separate investigation. But he will at least have helped that other investigator in showing him some things to look out for.

No further comments are needed, I think. Today, when contemporary economists have been making serious efforts to find the adequate place for theoretical economics and tend to regard it as spurious, so clear-cut a manifesto proves to be highly illuminating. Looking into the effects of social institutions on the behaviour performed by the agents is not on the agenda of mainstream econonomics, simply put. This is the essence of the division of labour between the possible scientific approaches to our socio-economic reality, as Max Weber suggested. Economists in the Hicksian sense are responsible for elaborating the rational core in order to take the consequences of rational utility-maximizing behaviour into account. It is out of question that investigating the effects of social institutions is equally important, but it is a job to be done by others… historians, sociologists, economic politicians and, of course, institutional economists. It is difficult to imagine how different the reception and the contemporary evaluation of mainstream economics would be if our profession felt tempted to recall such classical texts. I am afriad our current debates are about an enormous quantity of unread and forgotten works in theoretical economics. To be sure, mainstream economics is not something to give upon but it is a project the exact scope of which should be urgently reconsidered… This is a mission.