## A Note on Determinants of Aggregate Demand…

Paul Krugman wrote:

A Note On The Ricardian Equivalence Argument Against Stimulus: I’ve tried to explain why Lucas and those with similar views are all wrong several times…. 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…. 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. Let me make two points: First, in their defense, I would note that if the government buys the same goods as the private sector would have bought anyway and hands them out, then the family would cut its spending right now by$100,000, because then it is both the case that (a) you are poorer because of the future tax liability, and (b) your marginal utility of consumption right now is low because the government is giving you all of this stuff. But since what the government buys (roads, bridges, weather stations, human capital for twelve year olds, etc.) tends to be quite different from what the private sector buys, this defense is extremely shaky and limited.

Second, I remember--long ago--Bob Barro telling a bunch of us that "RE is just a Modigliani-Miller result for the government's balance sheet". And he was right. However, there is nobody who says: "corporate capital structure is irrelevant". Instead, people say: "corporate capital structure is relevant because it can help the corporation (a) create assets that those with preferred habitats are willing to pay healthy premiums to hold, and (b) minimize the appropriate combination of future monitoring, agency, and reorganization costs." Nobody takes MM to be the end of analysis: it is the start.

Yet a lot of people--for reasons I have never understood--take RE to be the end of the analysis...