John Cochrane is blogging, something I take complete credit for since I introduced Cochrane’s ideas to HTML here.

He writes in a lengthy internally dependent style reminiscent of my own. Nonetheless I will try to excerpt the key points

We all agree that "Ricardian Equivalence" is how the economy would and should work, if there were no "frictions," or other problems. 

I am not so sure about that. From what comes later it is clear that Cochrane means something different by Ricardian Equivalence than I do.

When I use the term Ricardian Equivalence I mean that when the government borrows money the fact that future taxes will have to rise induces folks in the economy to save more money.

What’s absolutely key here – and I will show later – is that this means that ceteris paribus interest rates do not rise from an increase in government borrowing.

This claim I believe is false and I think many other people do as well.

Now, I’ll try to quote enough to show Cochrane’s meaning of the term.

So according to Paul, the prediction of a properly functioning economy is that people who take out a $100,000 mortgage consume $100,000 less in the first year; that they do not do so is proof stimulus works.
. . .

But what about the extra $100,000 of "spending"? Doesn’t the new house contribute to "aggregate demand?" What, in the classic view, goes down by $100,000?

. . .
The question is not the family’s spending, but where did the $100,000 come from, and what were they going to do with the money?

. . .
Most likely, someone was saving money, and put it in a bank. If this family didn’t take out the loan, another family would have (perhaps at an infinitesimally lower interest rate) done so, and the economy would have built a different house.

. . .
To me, this example illustrates beautifully how Krugman "got this wrong." He never asked where the $100,000 loan came from!  In his analysis of  government borrowing and spending, he does not ask, who lent the money to the government, and what were they planning to do with it otherwise.  People "with an economics training" are supposed to remember lesson one — follow the money and pay attention to budget constraints.

What Cochrane is invoking here is what I would call adding-up constraints. In this version of the world the government borrows money. This means that there are fewer savings available for non-government borrowers. Those fewer savings must be rationed and in a free market economy this is done with the price mechanism.

Interest rates in the economy rise so that fewer people want to borrow and so that more people want to save. Once, interest rates have adjusted the increase in private savings and the decrease in private borrowing exactly match the increase in public borrowing.

Thus, there is no increase in aggregate demand.

However, very importantly, in this mechanism interest rates rose to clear the market for loanable funds.

Now, what about government stimulus?

If the first mechanism is at work then certain types of stimulus will never be effective. For example, simply rebating taxes to families will have no effect. People know that this simply means more taxes later and so they save exactly the amount of the stimulus.

If the government buys stuff rather than rebating taxes then this can only work if the stuff the government buys is not a direct substitute for what people would have bought themselves. If it is then people will simply refrain from buying stuff and save instead.

If it is not then people will save some but not completely because otherwise they would have suffer extraordinarily in this year. They would rather spread the pain of paying for this government purchase over several years.

So, that’s what I think of as Ricardian Equivalence.

Now, what about adding up?

Remember that key in the adding up mechanism was that the interest rate cleared the market for loanable funds. However, real life baseline interest rates are controlled by the Federal Reserve.

Now, suppose the Federal Reserve holds interest rates constant even if the government is borrowing more money. This means that now the total amount of public plus private borrowing exceeds the amount of savings.

How does the market clear?

The market clears because the Fed prints money in order to fund the desired amount of borrowing.

Or, to more accurately represent the world we live in today: in the face of extra demand for borrowing banks turn excess reserves into required reserves by making creating more checking accounts which are in turn the basis of loans to consumers and businesses.

The answer to where does the money come from is that it is created out of thin air, either by the printing press or switching reserves from excess to required status.

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