The Fallacy of Ricardian Equivalence

Stiglitz: Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense  [see “Quotes Critical of Economics” for more.] This post explains why.

NOTE: Many readers have pointed out that this modern fallacy is not actually due to Ricardo. As with comparative advantage, and with the Invisible Hand, modern theories which serve interests of the rich and powerful, are given respectability by being given a forged pedigree.

In this post, we will create a simple model that demonstrates some fundamental truths of Modern Monetary Theory.  This is a variant of “.Simple Model Explains Complex Keynesian Concepts“, We will show the following phenomena

1. A Market Economy naturally creates an equilibrium with high unemployment and under-employment, showing existence of under-employment equilibria
2. Government Deficit Spending increases aggregate demand, and moves the economy to full employment.
3. Deficit Spending, also massively improves social welfare, by providing food even to the unemployed, using the additional output created by the increased aggregate demand
4. Deficit Spending is not  “FINANCED” from any source. Government spending money which it does not have, creates welfare by injecting money into the economy. This money leads to increased output and is not inflationary. The government can continue this deficit spending forever, without worrying about sustainability or “paying back” the debt.
5. Government Deficit injects money into the system which is exactly equal to the PROFITS of the firms, plus the SAVINGS of the laborers. Since firms work for profits while households wish to save, neither can succeed UNLESS the government runs deficits. Thus deficit spending is crucial to a capitalist economy — without it there would be no profits for business, and without profits and savings the economy would collapse.

Consider a simple isolated village, which has 10 Farmers each of whom owns 1 Acre of Land. There are 40 laborers in the village. The production function is 1 Laborer plus 1 Acre will yield 100 units of corn. Going wage rate (determined by wages in nearby city) is $100 per laborer for full duration of period. For simplicity assume period is 100 days, and hiring a laborer for N days costs $N and produces N units of corn. When N is less than 100, the laborer is under-employed.

As per Keynesian assumptions, production decision are made first. At start of period, all farmers hire one full-time laborer for $100, assuming they will be able to sell their product. There are two key differences here from the neoclassical models.

1. The wages are determined by reference wage in nearby labor market, and NOT by marginal product. Wage bargain is in NOMINAL terms, not in real terms.
2. The future is uncertain. Farmers do not know what price they will get for corn at the end of the period, so it is impossible for them to compute the required marginal product. As we will see, the price can vary substantially, due to a number of different factors, none which can be known at time production decisions are made. This is why wage bargain CANNOT be made in real terms.

At the end of production period, all laborers have earned a wage of $100 and all Farmers have produced an output of 100 units of corn. We now consider several different scenarios regarding what may happen at the end of the period.

1. All of the corn – 1000 units – is placed on the market for sale. The ONLY buyers are the employed laborers. No one else has money. Total wages are $1000, so price of corn will be $1 per unit to clear the market. Each laborer will consume 100 units of corn. Note that PROFITS of the Farmers will be ZERO. Since there are no injections of money into the economy, it is impossible for Farmers to make profits in the aggregate.
2. Suppose Laborers want to save some of their income. Suppose they save $50 and spend $50. Now supply is 1000 units but $500 is available for purchase. Market clearing price will be $0.50, and each laborer will still consume 100 units of corn. Note the massive difference in real wage between cases A & B. In this case, the Farmers will make a LOSS. The Consumer Savings of $500 will offset by Farmer Losses of $500 and Aggregate savings plus profits will still be ZERO.
3. Suppose Farmers consume 20 units of the corn produced. Thus, only 80 units is available for marketing. Aggregate supply is 800 units of corn, and $1000 is available to purchase it, so market clearing price will be $1.25 per unit. Each employed laborer will be able to purchase 80 units of corn with his $100 of income.
4. Suppose Laborers wish to save half of their income. Then $500 will be available to purchase 800 units of corn. Market will clear at $0.625 per unit of corn. Each employed laborer will still get 80 units of corn. Laborer savings of $500 will be exactly offset by the Farmers loss of $500.

In all these scenarios, we note that Farmer Profit + Laborer Savings = ZERO = Government Injections.

Keynesian unemployment scenarios arise if the Farmers make losses and decide to produce less in the next period. A plausible scenario arises if we put a maximum bound on the consumption of corn. Suppose 20 units of corn is the maximum possible consumption for one person for one period. Suppose Farmers consume 20 units, and put the remaining 80 units for sale on the market

1. Total aggregate demand for corn is 200 units. With 800 units available for sale, price would decline to virtually zero in D&S equilibrium.
2. As a solution to excess production, farmers may decide to BURN 600 units of the overproduction. Now the supply is 200 and laborers have $1000 in wage income to purchase it. The price will be $5 per unit, and all laborers will get exactly 20 units of corn.
3. Continuing from F above, the next period, the farmers may decide to cut back production to only 400 units, noting that they ended up with excess production of 600 units which they had to destroy. Instead of full-time labor at $100, they might hire part-time labor at $40 in order to produce only 40 units of corn each. Now 30 laborers are unemployed, and 10 laborers are under-employed. The supply of corn in the market is 200, and $400 is available to purchase it. So the price of corn will be $2 per unit, and each employed laborer will purchase 20 units with his income of $40. Since the wage bill is $400 and the revenue from sales of corn is also $400, profits of farmers are ZERO, as expected, since there are no injections.

This last case is exactly the scenario where lack of effective aggregate demand leads to unemployment and under-employment. Now consider this same scenario as in G, but introduce a Government. The Government announce a social welfare plan. All unemployed laborers will receive $50 as social security payments from the government. Government will spend $50 each on the 30 unemployed laborers running a budget deficit of $1500. Now let us consider what happens

3. Anticipating greater demand, Farmers hire full-time laborers and pay them $100 each to produce Aggregate Supply of 1000 units of corn. They self-consume 200 units and bring 800 units to the market. Now there are $1000 of wage income plus $1500 of welfare payments available to purchase this corn. At the price of $3.125 per unit of corn, $2500 will purchase 800 units and clear the market. At this price, $100 will buy 32 units, while $50 will buy 16 units. So, the unemployed laborers can get 16 units and the employed can buy 32 units.

According to our assumptions of 20 units maximum consumption of corn, this is not a feasible outcome. So a different feasible scenario is as follows.

2. Employed laborers decide to save half of their income. Now $500 is available from the employed while $1500 is welfare so total of $2000 is available to purchase 800 units. Market clears at $2.50 per unit of corn. All laborers, employed and unemployed, consume 20 units of corn.

It is this last scenario which shows the magic of MMT. The government spends $1500 out of no-where – no taxes in present or future – no Ricardian equivalence. This deficit spending allows a private sector surplus of exactly the same amount, with $500 in savings of the employed laborers, and $1000 in profits of the farmers. As per Keynesian prescriptions, this spending generates additional aggregate demand which brings the economy to full employment. The surplus generated is enough to feed the unemployed workers – forever – That is, the government can continue to make this deficit spending forever, keeping the economy at full employment, without worrying about sustainability of the budget deficit.

Note that in standard MMT models, value of money is created by taxation. Here we are thinking of a village which is out of the government tax net. The value of money is created by the ability of villagers to go to nearby city and purchase city goods with the money.

A  BIGGER point in context of this model is the following. Human understanding of abstract concepts is based on translating these concepts to concrete forms. Models helps us to do that by simplifying reality, and enabling us to see the abstractions in action. Thus the MMT idea that Government Injections = Firm Profits + Household Savings is an abstraction until it is  illustrated via a concrete model, such as the one above, where it appear with much greater clarity. BUT the model by itself is not enough either, because it just shows one instance and not the general principle. UNDERSTANDING requires operating at BOTH levels at the same time — understanding the abstractions, and understanding the form that these take in concrete representations, like models. This point is brought out in the following 16 minute mini-discussion