Wednesday, September 21, 2005

Once the money's spent, what's to worry? 

I'm travelling more lately, and one of the advantages of this is getting time to read things I can't seem to get to read when I'm home or at the office. On a plane to New England last weekend I read the latest copy of the Minneapolis Fed's publication The Region, which is one of my favorite Fed publications (I read many.) This month's issue features an interview with Robert Barro, and the first item discussed is Ricardian equivalence. Barro argues that people confuse the argument for the equivalence of taxing and incurring debt with an argument that the size of government doesn't matter.

...a central part of the proposition is that the amount of public expenditure�today and tomorrow�is being held constant. It's never part of Ricardian equivalence that the level of government expenditure doesn't matter. As [University of Chicago economist] Milton Friedman put it, the costs or benefits of government outlays depend on the amount and nature of what the government spends�there is no free lunch about paying for that spending. So whether you pay for it now or later is secondary.

As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow, which is basically what a fiscal deficit is. The difference between taxes today and taxes tomorrow is analogous to the difference between paying for spending with an income tax or a sales tax. The method of public finance is an important question, but it is less important than the question of how big the government is and what activities it should carry out. Taxing now versus taxing later is an issue about optimal taxation, that is, a public-finance topic.

So what does this say about the spending arguments arising from the cleanup of Hurricane Katrina? The story -- I seem to recall this being in some form as an exam question for Barro's macro text, but I can't find my copy of the book right now -- is to imagine how people would react to having the barn on their farm blown up. They would want to replace it and begin to save immediately. They would also most likely work harder as they attempted to generate the capital they need for replacement. Now suppose the bank comes and offers a loan to rebuild the barn. Does this change the farmer's behavior? It really shouldn't. The decision of when to work and when to save depends on the productivity of the farmer with and without the barn -- the wage you can receive, the interest rate at which you can save up. You borrow so that you can smooth out your consumption of goods, just as students and their parents borrow for college. That's the public-finance question Barro refers to (in older times, economists referred to this as Ramsey taxation.)

So too with Katrina. The behavior of the economy, expressed in terms of prices, wages and interest rates, is changed at the moment the of the hurricane and flood, not by the decision to shift the financing from the private sector to the public, or from local government to federal. Now, Ricardian equivalence does have some gaps, as even Barro recognizes, but he says these are second-order effects.

Discussion of deficits and needing to raise taxes to pay for them, in this view, is rubbish. The discussion needs to focus on how much government spends, not how it pays for its spending.