What is the Ricardian Equivalence

Ricardian equivalence is an economic theory that suggests that when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged. This is due to the fact that the public saves its excess money to pay for expected future tax increases that will be used to pay off the debt. This theory was developed by David Ricardo in the 19th century but was revised by Harvard professor Robert Barro into a more elaborate version of the same concept.

BREAKING DOWN Ricardian Equivalence

Ricardian equivalence, also known as the Barro-Ricardo equivalence proposition, stipulates that a person's consumption is determined by the lifetime present value of his after-tax income. Therefore, the Ricardian equivalence says a government cannot stimulate consumer spending since people assume that whatever is gained now will be offset by higher taxes due in the future. Thus, the underlying idea behind Ricardo's theory is that no matter how a government chooses to increase spending, whether with debt financing or tax financing, the outcome is the same and demand remains unchanged.

Arguments Against the Ricardian Equivalence

The major arguments against Ricardo's theory are due to what are perceived as the unrealistic assumptions on which the theory is based. These assumptions include such things as the existence of perfect capital markets and the ability for individuals to borrow and save whenever they want – scenarios which are not realistic. Additionally, there is the assumption that individuals are willing to save for a future tax increase, even though they may not see it in their lifetime. The theory espoused by Ricardo goes against the more popular theories provided by Keynesian economics.

Real-World Proof of the Ricardian Equivalence

It has been established that the Ricardian equivalence suggests a government has the same effect on consumer spending regardless of its debt levels or tax burdens. As a government increases spending to stimulate the economy, it takes out more debt, and people put aside money in expectation of higher future taxes to offset the debt. Therefore, logic follows that if the Ricardian equivalence is true, then countries with high levels of debt should also have comparatively higher levels of household savings.

As an example, when looking at government debt to GDP in relation to household net financial assets to GDP for countries within the European Union (EU) during the 2008 financial crisis, there is evidence to support the validity of the Ricardian equivalence. Based on data from 2007, there is a strong correlation between government debt burdens and net financial assets accumulated for 12 of the 15 countries within the union.