What Is Ricardian Equivalence?

Ricardian equivalence is an economic theory that argues that attempts to stimulate an economy by increasing debt-financed government spending are doomed to failure because demand remains unchanged. The theory argues that consumers will save any money they receive in order to pay for the future tax increases they expect to be levied in order to pay off the debt.

This theory was developed by David Ricardo in the early 19th century and later was elaborated upon by Harvard professor Robert Barro. For this reason, Ricardian equivalence is also known as the Barro-Ricardo equivalence proposition,

Understanding Ricardian Equivalence

The Ricardian equivalence argues that an individual or family's rate of consumption is determined by the lifetime present value of their after-tax income. The recipients of a government windfall perceive it as such. It's a bonus, not a long-term increase in income. They will resist spending it because they know it's unlikely to recur, and will even be clawed back in the form of higher taxes in the future.

Therefore, the government, cannot stimulate consumer spending.

Key Takeaways

  • Ricardian equivalence maintains that government spending to stimulate the economy is not effective.
  • That is, individuals who get extra money will save it in order to pay for the future tax increases they know must follow.
  • This theory has been widely discounted by economists who subscribe to the theories of Keynesian economics.

The underlying idea is that no matter how a government chooses to increase spending, whether through borrowing more or taxing less, the outcome is the same and demand remains unchanged.

Arguments Against the Ricardian Equivalence

Some economists argue that Ricardo's theory is based upon unrealistic assumptions. For instance, it assumes that people will save in anticipation of a hypothetical future tax increase. It also assumes that they will not find it necessary to use the windfall.

It even assumes that the capital markets, the economy in general, and even individual incomes all will remain static for the foreseeable future.

In any case, the theory espoused by Ricardo contradicts the widely accepted theories of Keynesian economics, which argued that the government can stabilize the economy by stimulating demand or suppressing it.

Real-World Proof of Ricardian Equivalence

The theory of Ricardian equivalence has been largely dismissed by many economists. However, there is some evidence that it has validity.

Many modern economists think that Ricardo's theory is based upon unrealistic assumptions.

In a study of the effects of the 2008 financial crisis on European Union nations, a strong correlation was found between government debt burdens and net financial assets accumulated in 12 of the 15 nations studied. In this case, Ricardian equivalence holds up. Countries with high levels of government debt have comparatively high levels of household savings.

In addition, a number of studies of spending patterns in the U.S. have found that private sector savings increase by about 30 cents for every additional $1 of government borrowing. This suggests that the Ricardian theory is at least partially correct.