I learned this from Andy Abel and Olivier Blanchard before my eyes first opened: increases in government purchases are ineffective only if (a) "Ricardian Equivalence" holds and (b) what the government buys (and distributes to households) is exactly what households would buy for themselves. RE by itself doesn't do it.
A Note On The Ricardian Equivalence Argument Against Stimulus (Slightly Wonkish): There have been a lot of shockingly bad performances among macroeconomists in this crisis; but if I had to pick the one that is most startling, it is the way freshwater economists have demonstrated that they don’t understand one of their own doctrines, that of Ricardian equivalence. Ricardian equivalence says… a temporary tax cut won’t stimulate spending, because people will figure that whatever they gain now will be offset by higher taxes later. It is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability. But… it does NOT imply that government spending on, say, infrastructure will be met by offsetting declines in private spending. In other words, Robert Lucas was betraying a complete misunderstanding of his own doctrine when he said this:
If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.
But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.
This remark was followed, by the way, by a smear against Christy Romer:
Christina Romer — here’s what I think happened. It’s her first day on the job and somebody says, you’ve got to come up with a solution to this — in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.
So she scrambled and came up with these multipliers and now they’re kind of — I don’t know. So I don’t think anyone really believes. These models have never been discussed or debated in a way that that say — Ellen McGrattan was talking about the way economists use models this morning. These are kind of schlock economics.
Maybe there is some multiplier out there that we could measure well but that’s not what that paper does. I think it’s a very naked rationalization for policies that were already, you know, decided on for other reasons.
I’ve tried to explain why Lucas and those with similar views are all wrong several times, for example here. But it just occurred to me that there may be an even more intuitive way to see just how wrong this is: think about what happens when a family buys a house with a 30-year mortgage.
Suppose that the family takes out a $100,000 home loan (I know, it’s hard to find houses that cheap, but I just want a round number). If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.
But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.
Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge; in this case the household really does know that today’s spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.
How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.