Grand Cocktail of Fiscal Stimulus Debate Take 2: The Ricardian Equivalence

For complete beginners, the Ricardian equivalence is a hypothesis that says something along the following line. When the government spends more money without simultaneously raising tax, it must automatically be borrowing from the public (issuing more bonds). That borrowing will eventually have to be paid back to the public, and when that day comes, the government will either need to raise tax or cut spending or both. If the public is smart, they should see this coming and should not react to the initial increase in government spending, because they know that they will have to pay for it in the future. Tax now, or higher tax later (borrower must pay interest rate), the tax bill is the same in present value term. The conclusion is, fiscal stimulus cannot do anything to stimulate consumption.

The details for this is spelled out in Robert Barro's paper "Are Government Bonds Net Wealth?", probably in JPE some time in the 70's. I remember reading this some 10 years ago, thinking it's a very neat model but probably doesn't hold in reality. I've also been told that Ricardo himself didn't quite believe it, though I didn't get to read the original reference myself. In any case, the concept's gathering some momentum now, in the fiscal debate round two. Like in the first round, we're not even dealing with the assumptions of the original model (rationality, discount rate, agents' longevity etc), but rather the basic understanding of the model itself. What should we teach our undergrads when we can't have a consensus about anything these days?

Ricardian

• Robert Lucas [Mar 30: speaking at the Council for Foreign Relations]
  

Keynesian

• Brad Delong [April 5: Appeal for Help][April 6: Great Misunderstanding]
  
• Paul Krugman [April 6: One more time]