Monday, April 06, 2009

Horror at Central Bank ignorance

Both Paul and Brad are horrified that advocates of Ricardian equivalence do not understand the implications of their own model. Fair enough. Others may be horrified that macroeconomists, operating on the global stage to influence policy, do not understand how Government spending and taxation works. Here's Paul:
If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.
Nope. Government is a currency issuer. Non-Government is a currency user. Government spending creates money, Government taxation "uncreates" it. The Government never needs to tax in order to spend. If the Government spends an extra $100B a year forever, with no increase in taxes, it will inject an extra $100B/year into the private sector, which may trigger inflation, or it may not, depending on what the private sector does with that money. Right now, money is being saved, so it will not trigger inflation, although it may help support aggregate demand and employment. If the Government increases taxes by $100B/year, that will sterilize the impact of the spending, and thus reduce the money the private sector has available to save. In inflationary times, this will reduce inflation. In deflationary times, it will further reduce aggregate demand, and increase unemployment.

"Ricardian equivalence" is based on the gold standard notion that the Government needs to tax first in order to spend. This is non-operative in the fiat world we live in.

Advocates of Government spending should understand how Government spending works.


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