Economics: Truer than it seems
By Scott Sumner
One thing that economists and non-economists have in common is that they underestimate the power of economic theory. More specifically, they aren’t able to accurately connect the predictions of economic theory with the behavior that they (wrongly) think they observe in the people around them. There are many examples of this. For instance, most people (economists and non-economists) underestimate elasticities. They underestimate how strongly people respond to changing incentives, such as tax changes, wage changes, price changes or interest rate changes.
Economists and non-economists also underestimate just how rational people really are, at least in aggregate. How much they understand about the world. And how efficiently markets aggregate information. And they do so because people don’t seem very smart, or very rational. As always in economics, appearances can be deceiving.
A good example is Ricardian equivalence (RE.) I thought of this when reading an excellent post by David Glasner. In the comment section of the post a commenter who identified him or herself as a non-economist was dismissive of the whole idea (that government borrowing leads people to save more, in anticipation of the tax burden of future deficits.) This particular individual didn’t really understand the subject, but even economists who do understand RE tend to be dismissive.
I’m agnostic on the validity of RE, and certainly don’t wish to defend it in this post. Instead, here I’d like to focus on the fact that people dismiss the idea for the wrong reason. They don’t find it plausible that people would save more if the budget deficit increased, and indeed they are even skeptical that the public would be aware of the fact that the deficit increased.
If I ask my students whether they find RE to be plausible, they almost all answer “no.”
But suppose I ask them a different set of questions:
1. Do you expect to get back all the Social Security that you have been promised?
Almost all say they expect less than what has been promised.
2. Then I ask whether that perception affects their willingness to save money for retirement, outside of Social Security.
Almost all say they are more likely to save for their retirement because of the perception that Social Security is on the road to bankruptcy.
But if you put these two answers together then you have Ricardian Equivalence! To see why, let’s first ask where the perception of Social Security bankruptcy is coming from. Most likely it is the media, which harps on the debt crisis to the point where Paul Krugman wants to pull his hair out. (BTW, like Krugman, I believe the debt problem is less severe than the Very Serious People in the media suggest.) But what Krugman and I believe is not important. What is important is that the American public is well aware of the US debt problem, and also aware than many experts think that it will eventually lead to cuts in Social Security. And that perception does lead Americans to save more, just in case.
Do American save more or less than the extra amount predicted by Ricardian Equivalence? There is absolutely no way to answer that question, because it involves not one but two great unknowns:
1. How bad is the debt situation? (No one knows, not even Larry Kotlikoff.)
2. How much does worry about the debt impact American saving?
I believe most Americans overestimate the problems with Social Security. That suggests a sort of super RE, even more saving than predicted. But I also believe Americans might save less extra money than would be rational, based solely on the prediction of RE. There are other factors such as borrowing constraints. And then there are marginal effects to consider—if the debt problem gets worse, how do Americans respond at the margin to increasingly hysterical media portrayals of the debt situation.
We can’t answer these questions. In that case, we have no reason to assume non-RE, and rationality is probably the best baseline assumption to work with, unless we have empirical evidence suggesting that deficits raise interest rates. And most of the empirical work I saw when this was a hot issue suggested that deficits don’t impact interest rates, just as RE predicts.
What’s true of RE is also true of efficient markets, rational expectations, the supply-side effects of high MTRs and lots of other areas of economics. People respond more strongly to incentives than you’d think. They are more rational than you’d think.
Common sense is almost useless in the field of economics. Never dismiss an economic theory because the assumptions about human behavior don’t sound plausible.
After all, quantum mechanics doesn’t sound plausible either—but it’s true.