Time To Bury The Ricardian Equivalence

There is a peculiar argument against stimulus called the Ricardian Equivalence. It argues that if individuals have rational expectations, then when the government gives the economy a boost during a recession by cutting taxes or deficit spending, individuals will know that this deficit will have to be paid off at a later date and therefore the extra money will merely increase savings. This increase in saving will cancel out any stimulating effect the deficit might have. In other words it doesn’t matter whether taxes are raised now or later, the effect will be the same. In 2010, the President of the European Central Bank, Jean-Claude Trichet and current head of the IMF, Christine Lagarde both mentioned the Ricardian Equivalence as a reason why they didn’t support a stimulus.

Now it should be obvious that this in no way describes reality for two main reasons. Firstly, most people don’t know or care about the government finances. If you were to stop 100 people on the street, 99 of them wouldn’t be able to tell you what the budget deficit is. Even though the deficit is constantly in the news, people know surprisingly little of the details, and frankly, most find it too depressing to care about. It is unfortunately common for economists to spend too long inside the economics bubble and presume that the rest of the world thinks the same as them. However, issues that are of great importance to economists, are of only marginal importance to the wider public. So how can people adjust their savings to cancel out the deficit when they don’t even know what it is?

I highly doubt there is a single person who has ever lived whose reaction to a budget deficit resembled the Ricardian Equivalence. The simple fact is that the vast majority of people don’t know how the economy or the government works. People don’t draw a connection between deficits and the need for either future taxes or future spending cuts. Most people believe that there is a third option called “cutting waste” which can balance the budget, reduce the taxes they pay and not harm government services whatsoever. Ask anyone on what the budget is spent on and they’ll tell it’s spent on “them” not “us” (everyone has their own view of who “them” are, which ranges from the poor, the lazy, foreigners, public servants or simply just people in other parts of the country).

A recent poll revealed not only that people hadn’t a slightest clue of what the deficit was, but also that they were off by miles. Last year the American budget deficit significantly reduced, a point a believer in Ricardian equivalence would argue would cause consumers to start spending. However, an opinion poll found that 70% of people believed that the deficit had increased. Even more embarrassing, only 10% correctly guessed the scale of the deficit, namely that it was “hundreds of billions” which was less than the number of people who thought it was “hundreds of millions”. There are numerous examples of people being completely off in how they think the government spends its money or the true state of the debt (despite its constantly being a news feature).

Another survey was done by Irish economist Brian Lucey and Michael Daly which measured Irish people’s knowledge of economics. Suffice to say, even though the questions were incredibly broadly based, the results are not encouraging. People were asked roughly what the level of the Irish budget deficit was and were given options of either

A)     Less than €1 billion

B)      €1-20 billion

C)      €40-60 billion

D)     More than €60 billion

Now even as someone studying an Economics MA I couldn’t tell you off the top of my head what exactly the deficit is, but anyone who has even briefly glanced at the newspapers would know the rough ball park estimate of it. In fact it wouldn’t be possible to design the question any easier to answer. To non-Irish readers the answer is €12 billion. However, even with such a broad and easy answer only 38% of respondents got the right answer. This means that two-thirds of Irish people are widely inaccurate in their estimate of the deficit (and the one third may not be that close either). Likewise only 40% of people correctly answered that the national debt is between €100-250 billion (an extremely broad range). How can consumers accurately respond to deficits when they are completely inaccurate in their estimates of it?

Secondly, even if people were aware of the government budget, they may not be able to do much about it. Most consumers at the moment are struggling immensely. With wage cuts, layoffs and the mortgage to pay, most consumers couldn’t afford to put money aside even if they wanted to. It is hard to believe that an unemployed man whose rent is due is going to refuse to pay it because he wants to save up for a future tax rise. A deficit may not even lead to higher taxes as the government could simply cut spending instead. If a consumer feels they will not be affected by the spending cut, then they will feel no need to increase savings.

There are of course numerous other reasons why the present generation may not care about future tax rises. People will have immigrated and emigrated, some will have died and others will be born etc. People in general are pretty bad at planning for the future. If they are not completely accurate about what the future will bring, then the Ricardian Equivalence crumbles. They might not be overly concerned at problems that future generations may have to face. Furthermore a deficit now may not lead to future tax rises, after all America has been running a deficit for almost 50 years without any problems before the Financial Crisis. So long as growth and/or inflation exceeds the interest rate on the debt, then the debt will be falling and there will be no need to plan for future tax rises.

I think even Neo-Classical economists don’t fully believe in the Ricardian Equivalence, which is saying something, as those guys will believe anything (see rational expectations and anything linked to it like the Efficient Market Hypothesis). Even David Ricardo, who the theory is named after, repudiated the theory writing: “But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly … It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1,000.” With no one left to defend it, I think it’s time to bury this dead theory.


Filed under Economics

6 responses to “Time To Bury The Ricardian Equivalence

  1. I find the concept somewhat bizarre. This was given serious attention by significant economists. That undermines the rationality of the enterprise, eh?

    • I’m still not sure if anyone takes the notion seriously. It just seems too daft. Mind you I have seen it mentioned in passing and it is worrying that the head of the IMF and ECB seemed to believe it.

  2. Neoclassicism/neoliberalism is the religion of the overlords, and so the heads of the IMF and ECB bow their heads and state that they believe such b.s. My guess is the head of the ECB is a true believer while Lagarde is not but knows what’s required of her.

  3. What i find bizzare is your assumption that a dismissal of the ricardian equivalence is perfectly justified, while a fundamentalist belief in the traditional economics 101 ‘Keynesian Multiplier’ effect remains steadfast. I agree that some of the posturing and adherence to the views of inflationary hawks such as Jean Claude-Trichet and Legarde has retarded a possible coordinated Eurozone solution to the crisis, yet incurring more debt to stimulate stagnant growth caused fundamentally by a debt-crisis is far from a silver bullet. What happens when we eventually have to stop borrowing , while the stimulus-driven growth tail off ? What will the multiplier effect even be? Nobody has a silver bullet and I do share your concern at the ridiculous adherence of many Eurozone leaders toward a simple ‘non-inflationary’ policy, yet if a genuine solution is to be found, such traditional keynesian theories need also to be examined and challenged .

    • Will the stimlus-driven growth*

    • Howya Eoghan. For reasons of space I usually only take one issue at a time so the Keynesian multiplier (which even the IMF, hardly a left wing institution, has admitted is large). Of course Keynesianism is not a silver bullet as it will lead to higher government debt, but it is still the best option.

      The stimulus is meant to be temporary until the private sector is done repairing its balance sheet and has regained confidence to take over and start investing again. The government has to spend because if it doesn’t no one will.

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