Robert Barro Macroeconomics A Modern Approach Pdf
Silvana Fleischacker
Barro broke with tradition in 1974 with a powerful critique of Keynesian thought. Deficit spending won't stimulate an economy, he argued, since rational households will simply save more in anticipation of higher future taxes. "There will be no net-wealth effect," he wrote, "and, hence, no effect on aggregate demand or on interest rates of a marginal change in government debt." David Ricardo had hinted at this in 1820, but Barro's rigorous case rocked contemporary macroeconomic thought and added to the theoretical revolution known as rational expectations.
With Gary Becker, Barro then developed a landmark economic model of fertility that incorporated intergenerational decision-making. Barro's research on economic growth, currency areas and other topics has been equally important, breaking new ground and often challenging conventional wisdom. His articles are among the most often cited in economics.
Region: The Ricardian equivalence hypothesis, which you brought to prominence in 1974, might be taken to suggest that deficit spending isn't inherently harmful since rational people, expecting to pay higher taxes in the future to pay off government debt, will save more, so private savings will balance out the public deficit.
Barro: Let me say first that I think the Ricardian equivalence idea is basically right as a first-order proposition. However, people get confused as to exactly what it says. Before I say what that is, I should mention that, although the proposition is not mainstream in the sense of being fully accepted by most economists, the idea has had tremendous influence on the way economists think about this issue.
Analysis often begins with Ricardian equivalence as a first-order proposition and then goes on to investigate why there are deviations from precise equivalence. Thus, like the Modigliani-Miller theorem on corporate finance, Ricardian equivalence has become a common starting point for the way people think about budget deficits. This situation is vastly different from what it was before the mid 1970s.
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.
This view moves the analysis away from pure Ricardian equivalence to the optimal tax perspective, which brings in the principle of tax smoothing. The idea is that, unless something special is going on in different periods, optimal public finance dictates having tax rates, for example, on consumption or wage income, that are similar from one year to another. You do not want erratic movements in tax rates, because these patterns are highly distorting. From that standpoint, it is not desirable to have a very low tax rate today, financed by a fiscal deficit, followed by much higher tax rates in the future. This tax-smoothing result deviates from Ricardian equivalence, but in a
second-order way, in the same sense that the choice between an income tax and a sales tax is second order but nevertheless significant.
Well, before I wrote anything, I sat down for a lunch with Fischer Black (famous, of course, for the Black-Scholes options-pricing formula). I took about 20 minutes to go through the whole analysis I had worked out. Fischer said nothing, but listened intently. When I finished, he uttered only one sentence: "Sounds right to me."
Region: I'd like to follow that with an empirical question, if I might. By some measures, U.S. personal savings rates are quite low. What does this say about people's anticipation of having to pay higher taxes in the future?
Barro: National savings rates are not constant over time in the United States, and they are not the same across countries. A lot of variables influence national saving rates. However, economists have not demonstrated empirically for the U.S. or across countries that there is a regular relation between fiscal deficits or the size of the public debt and the level of the national saving rate. The idea that fiscal deficits drive down national saving is often claimed, but it is mainly proof by repetition. No one has actually shown convincingly that the U.S. national saving rate relates in a systematic way to the size of the fiscal deficit or the stock of public debt, both measured in relation to GDP.
I have been thinking about one interesting fact which may relate to the U.S. national saving rate. If you look particularly since the beginning of the 1990s, there has been a tremendous decline in the price of investment goods relative to consumer goods. Some of that is due to computers and some to other improvements in durable equipment. So if you look at the ratio of nominal investment to nominal GDP, currently that ratio, 17 percent, is a little above its average value since 1954; in particular, it rebounded significantly in the recovery since 2003 from the low ratio during the 2001 recession. Anyway, the current investment-GDP ratio is basically normal.
However, because of the relative price changes, the U.S. economy is getting a lot more in terms of real capital goods with a normal ratio of nominal investment to nominal GDP. In this sense, the saving needed to provide for a given amount of real investment is much less than it used to be. My conjecture is that this development might have something to do with the decline in the national saving rate, but I am unsure whether this view is correct. In any event, the decline in the prices of investment goods compared to consumer goods has been pronounced, and this change is important for economic growth.
The expansion of Medicare, in terms of coverage for prescription drugs, is one important aspect of the lack of discipline, and this "generosity" will have long-term adverse consequences for the federal budget. So, although I am not particularly concerned about the current fiscal deficit, I am worried about the growth of federal outlays under Bush.
The presidents who were good on federal spending discipline were, first of all, Reagan, who began in a very different environment, where spending had been rising relative to GDP since the 1950s. Clinton was surprisingly good on spending restraint, though I think much of this discipline came through Treasury Secretary Rubin and reflected fears of fiscal deficits and rising public debt.
Of course, the legacy of deficits and debt came from Reagan and the first President Bush; that is, they involved what economists now call "strategic budget deficits." I think this Reagan-Bush strategy actually worked to promote discipline on the federal spending side in the 1990s. Of course, it would have been different if Clinton had actually managed to pass Hillary Clinton's overly generous health insurance program during his first term.
Anyway, I agree that the longer-term expenditure problems related to Social Security and Medicare are significant. But there is also a broader, short-run problem with regard to federal spending across the board. President Bush really should try vetoing a spending bill sometime.
Region: I understand you've made some headway on the equity premium puzzle, the unexplained gap between average returns on stocks and bonds that Rajnish Mehra and Ed Prescott pointed out 20 years ago. Your explanation for the gap, I believe, involves rare events, a suggestion made by [University of Iowa economist] T. A. Rietz in 1988 that was immediately dismissed by Mehra and Prescott.*
Barro: It is certainly fair to say that this insight was in the 1988 paper by Rietz, which I think came out of his Ph.D. thesis. Mehra and Prescott were extremely critical of the Rietz analysis, and I think they managed to convince most people that low-probability disasters were not the key to the equity premium puzzle. But, although I highly value the insights in their original 1985 paper (which Mehra and Prescott like to point out was actually written in 1979), I think the arguments in their 1988 comment on Rietz were incorrect.
Barro: Well, "rare events" in this context are low probability, large disaster events. As a U.S. example, you think immediately about the Great Depression. However, war has been historically more important for most countries. I have in mind particularly the economic devastation of World Wars I and II for many countries, including much of Western Europe and Japan. From a U.S. perspective, one thinks about the world wars as times of good economic performance, but that outcome is unusual from a global perspective. For the U.S., one has to go back to the devastation of the Civil War in the South to find something comparable.
Suppose that you have potential events with, say, a 1 percent annual probability, where you lose half of your capital stock and GDP. This possibility seems to be enough to get something like the observed equity premium. Moreover, this mechanism has implications for a lot of other variables, not just for the excess of the average return on stocks over the return on government bills. For example, it can explain the very low "risk-free" rate and low expected real interest rates during most U.S. wars back to the Civil War. It can also explain some of the evolution of price-earnings ratios for the U.S. stock market. I am exploring these implications of the model and, by the time this interview comes out in The Region, I will have discussed it at the macroeconomics workshop in Minneapolis [the August 2005 Minnesota Workshop in Macroeconomic Theory, organized by the Minneapolis Fed and the University of Minnesota].
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