Why Ricardian Equivalence Is Nonsense

By Marshall Auerback and Edward Harrison.

Marshall’s view

Ed has asked me to deal specifically with the issue of Ricardian equivalence, the theorem used by anti-government proponents to argue that fiscal deficits are counterproductive and that cutting deficits in the middle of a recession will actually be good for the economy.  It suggests that when a government tries to stimulate demand by increasing debt-financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt. The mainstream presumption, then, is that agents won’t spend extra income from a tax cut as they ‘know’ there will need to be a tax hike later to keep the budget balanced. The mainstream would also be concerned that the higher government deficit would somehow ‘crowd out’ private borrowing.

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It is largely based on several wrongheaded concepts, not the least of which is the idea that the government reduces national saving by running a budget deficit.  The basis of this claim is that such government spending causes interest rates to rise, and investment to fall.  In other words, too much government borrowing "crowds out" private investment. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.

This argument reflects a complete misunderstanding of government spending. Increases in the federal deficit tend to decrease, rather than increase, interest rates. In reality, fiscal policy actions are those which alter the non-government sector’s holdings of net financial assets.

This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves – in the U.S. the federal funds rate – is driven to zero (yes, zero!). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the Fed Funds rate falls within the Fed’s target band. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn’t just true of the Fed.

RE posits a government borrowing constraint, based on the notion that there is a finite pool of savings to draw on and "finance" economic activity.  It is predicated on the notion that governments have a constraint similar to a household budget constraint. Like a household, the rising debt cannot be sustained indefinitely and so spending must be curbed and brought in line with the financial reality. Of course, a closer look reveals how fallacious is the household analogy.

People say: “No household can continually spend more than its income, and neither can the federal government”. But there are big differences between a household and the federal government. You don’t have the ability to print money in your living room, do you? Well, the government does. So how it finances its own debt and spending is different from the way you do.

A government is the issuer of the currency. The household, on the other hand, is the user. Households are restricted by the need to somehow get money into their bank accounts, or their checks will bounce. The federal government, by contrast, doesn’t “have” or “not have” dollars. Extreme versions of the analogy – so-called Ricardian Equivalence – posit the notion that the households anticipate the future tax burdens and increase saving now which negates any stimulus effect coming from the budget deficits. It assumes (like most neo-classical models) perfect markets and that any household can borrow or save as much as they require at all times at a fixed rate which is the same for all households/individuals at any particular date. So totally equal access to finance for all.

Clearly this assumption does not hold across all individuals and time periods. As Bill Mitchell notes:

"Households have liquidity constraints and cannot borrow or invest whatever and whenever they desire. People who play around with these models show that if there are liquidity constraints then people are likely to spend more when there are tax cuts even if they know taxes will be higher in the future (assumed).

Second, the future time path of government spending is known and fixed. Households/individuals know this with perfect foresight. This assumption is clearly without any real-world correspondence. We do not have perfect foresight and we do not know what the government in 10 years time is going to spend to the last dollar (even if we knew what political flavour that government might be)."


Edward’s take

Edward here. I think Marshall has been strangely subdued in tone.  I will take the more aggressive tone here. Ricardian equivalence is bogus economics. it is the kind of nonsensical ivory tower rational expectations drivel which led us to the abyss. It’s the kind of rubbish on which the mathematical models which blew up the financial world are based. Total garbage. I hope I wasn’t too subtle with this last paragraph.

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If so, let me summarize here: Ricardian equivalence = baloney.

For you non-economists, here’s how Wikipedia sums Ricardian equivalence:

The Ricardian equivalence proposition (also known as the Barro-Ricardo equivalence theorem) is an economic theory that suggests consumers internalise the government’s budget constraint and thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy being the same.

What this definition implicitly assumes is rational expectations which is the underpinning for all neoclassical modelling and other equally flawed theories like the efficient market hypothesis and the life-cycle model of savings. In this ivory tower view, you and I are rational ‘agents’ who look to maximize our savings over our lifetimes. We understand that any increase in government deficits via tax cuts or stimulus will be met with future tax increases or spending cuts down the line. In this world, in anticipation of these future events, we all collectively save every penny of the money from stimulus or tax cuts producing no net gain to the economy in the short run.

Does this sound like you? Remember the Bush 2008 stimulus bill? Did your cousin get his stimulus check and rationally calculate that taxes would go higher in future and immediately save all of the money? Or did he save some, pay off some debt and buy an iPod? I think you know the answer.

Star Trek’s Mr. Spock may operate under rational expectations but real-world people are not perfectly rational. Moreover, in an uncertain world without perfect information about future events people are simply not going to deviate that much from their set spending patterns. If I spend $32,000 of every $33,000 I earn, it is absurd to assume that I will save every penny of an extra $1,000 I receive via a tax cut. While the voodoo economics behind recent Republican claims that stimulus is bad but tax cuts are good is bogus, it does not follow that tax cuts will be saved.

Let’s take this one step further as Paul Krugman did just a couple of days ago. In talking about Fed policy activism, he writes:

So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.

Well I don’t believe in full Ricardian equivalence any more than Krugman.

So let’s look at this helicopter drop idea.  Let’s say the Federal Reserve decided to credit every taxpayer’s checking account with $1,000 that it printed out of thin air. What would happen?  Would the increase in base money feed through the economy via consumption or would people save (via saving or net debt reduction)? I reckon people would save some, pay down their debt and spend some too. After all, isn’t that what they did when they got their stimulus checks in 2008? And this was deficit-inducing tax cuts not free money printed out of thin air. Ricardian equivalence would have us believe none of this money would have been spent.

My point? I haven’t really decided on that yet. A helicopter drop is not going to happen, if only for political reasons. And fiscal stimulus is dead – for good reason in my view. That leaves tax cuts – with the Republicans are angling for an extension of Bush’s cuts for the rich.  Except they use the now debunked claim that tax cuts pay for themselves to promote them – as if this wouldn’t run up the deficit too.

All of this reinforces Adair Turner’s idea that economists and policy makers abuse economic ideology for political purposes. At Project Syndicate, he writes:

I suspect that a greater danger lies… with the practical men and women employed in the policymaking functions of central banks, regulatory agencies, governments, and financial institutions’ risk-management departments tending to gravitate to simplified versions of the dominant beliefs of economists who are, in fact, very much alive.

Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system.

Thus, only 18 months before the crisis erupted, the April 2006 GFSR approvingly recorded “a growing recognition that the dispersion of credit risks to a broader and more diverse group of investors… has helped make the banking and wider financial system more resilient. The improved resilience may be seen in fewer bank failures and more consistent credit provision.” Market completion, in other words, was the key to a safer system.

So risk managers in banks applied the techniques of probability analysis to “value at risk” calculations, without asking whether samples of recent events really carried strong inferences for the probable distribution of future events. And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.

The Uses and Abuses of Economic Ideology

Economics is not a science. People can put together as many mathematical models as they want in order to convince themselves that they can control the economic forces which have buffeted societies since time immemorial. But reality will not change. Let’s not confuse the model with reality. These are simplified abstractions that can be useful tools if applied properly and taken in context. There is some truth to mild versions of the efficient market hypothesis and Ricardian equivalence. But, as we have witnessed over the past 3 years, people confuse the models with reality. These abstractions are dangerous as practitioners use extreme forms of them and the elegant simplicity of modelling them to take on risk.

My guess is that we have moved from the period where misapplication of economic theories and modelling brought down the financial sector to where misapplication of economic theories will lead to very poor political calculations. In a global economy moving quickly to stall speed, this is not a good thing.

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  1. dansecrest says

    Here’s another perspective: Federal government taxes are not used to fund government spending. Rather, taxes are used to add value to the national currency. Thus, the concept of Secrestian Equivalence. Other things being equal, increases in the fiscal deficit result in depreciation of the currency. Of course, other things are not equal (witness Japan with the biggest government debt, and the strongest currency). Another way of looking at this is that increases in the fiscal deficit bring down interest rates, thereby decreasing the value of the currency as a place to invest funds. So how to account for the strong U.S. dollar and the strong Japanese yen? Japan has a big trade surplus, so that offsets the effects of its fiscal deficit and low interest rates. The large size of the U.S. deficit has indeed led to a decline in the value of the U.S. dollar. However, the strength of the U.S. as the world’s sole superpower, combined with weakness in other areas of the world (Europe) and the lack of convertibility of the Chinese currency, have stemmed the depreciation of the U.S. dollar.Your thoughts?

    1. Marshall Auerback says

      It’s simpler than that: private portfolio preference shifts drive currency
      values. They are the toughest thing to predict.

      In a message dated 7/16/2010 14:49:01 Mountain Daylight Time,

      1. Traderscrucible says

        Your is mostly but not entirely true. There is a very large MMT component to currency values.

        I’ve sent the charts to Mosler to demonstrate this. I’ve got the data.

  2. Scott Fullwiler says

    Another point I’ve been thinking about recently: Ricardian equivalence (RE) and the intertemporal govt budget constraint (IGBC) are inconsistent. RE says individuals will save taxes to pay off debt later. But the IGBC says that govt’s DON”T actually pay off debt, only that they need to ensure that the debt ratio levels off at some point (and it doesn’t even need to return to the current level). So, whereas RE says a govt will have to raise taxes in the future to pay for current deficits, $ for $, the IGBC says the govt doesn’t have to do this–and, by the way (to add to the confusion), a govt that follows the IGBC is said to be running a “Ricardian” fiscal policy. Thoughts?

    1. Scott Fullwiler says

      My point being that, if it’s not necessary for the govt to tax later, $ for $ (or even FV of the original tax), why would it be rational for the household to behave as if the govt will definitely do this? Seems to be an inconsistency even within the NC paradigm.

    2. Edward Harrison says

      Of course the implicit assumption here is that taxes fund spending, right. The assumption is that the government will need to raise taxes at some future date to fund the spending not covered today.

      1. Scott Fullwiler says

        Right Ed, for RE, but that’s not the case for the IGBC. For the IGBC, you just need to keep the debt ratio from growing in an unbounded fashion, which means that you don’t have to raise taxes, at least not to cover all the spending, in the future.

  3. Max says

    Of course there are other reasons you may not want a deficit. Increased debt leads to increased risk.

    1. Edward Harrison says

      There are a lot of reasons why you might not want a deficit. I linked to anrgument for one. However, we are talking about Ricardian equivalence and the concept of rational expectations – which are false in their stronger variants.

      1. Marshall Auerback says

        The only reason why one wouldn’t want a government deficit is if we’ve got
        a huge resource constraint and rising inflation. In which case, a policy
        which constrains domestic demand makes sense. When modern monetary theorists
        argue that there is no financial constraint on federal government spending
        they are not, as if often erroneously claimed, saying that government
        should therefore not be concerned with the size of its deficit. We are not
        advocating unlimited deficits. Rather, the size of the deficit (surplus) will
        be market determined by the desired net saving of the non-government sector.

        This may not coincide with full employment and so it is the responsibility
        of the government to ensure that its taxation/spending are at the right
        level to ensure that this equality occurs at full employment. Accordingly, if
        the goals of the economy are full employment with price level stability
        then the task is to make sure that government spending is exactly at the level
        that is neither inflationary or deflationary.

        In a message dated 7/16/2010 17:14:38 Mountain Daylight Time,

        Edward Harrison wrote, in response to Max (unregistered):

        There are a lot of reasons why you might not want a deficit. I linked to
        anrgument for one. However, we are talking about Ricardian equivalence and
        the concept of rational expectations – which are false in their stronger

        Link to comment: http://disq.us/haxos

        1. Traderscrucible says

          I agree with this idea in theory, but as for right now and practical implementation, I don’t.

          For example, what if Brazil right now started issuing bonds only in Real and then didn’t manage their deficit? It would become a huge problem very rapidly.

          MMT provides a path out of the mess we’re in, but the path isn’t a transporter – it will take time.

          And then this idea about “full employment”, well lets just say it doesn’t go over big with Fed governors. It is one of part of the Dual Mandate, right?

          Also, I’d say the proper level of inflation is probably higher than zero even in a full MMT regime. Inflation is the way we say money from the past isn’t as valuable as money now, that something I did 10 years ago isn’t as valuable as something I do today. I don’t think that money should have some quality that physical objects in the real world doesn’t possess – indestructibility. Physical objects decay, and the valuable things you can buy with money decay. I think money should approximate the decay of value we experience in the real world. 2% is good for me – it is better than buying a car, about as good as an untended house, and a bit worse than farmland.

      2. Traderscrucible says

        I agree with your idea. You’ve laid out a few reasons – but I think the most compelling is that nobody beyond a few of us cranks believe in MMT. So, unless you have g-3 economy, any group of hedge funds can bring your bond market to its knees very quickly.

        And then when you look at the amount of debt that exists for many countries – because they have been captive to RE for many years- the amount is less than the top 20 funds have undermanagement. Just add 3:1 leverage (which isn’t much) and presto, you need to balance your budget or we drive yields through the roof.

        With the amount of debt the U.S. is issuing, combined with the demand for savings in U.S.D, the vigilantes are getting crushed. But if New Zealand were to try this experiment, they would be paying 20%.

    2. Marshall Auerback says

      Increased PRIVATE debt to leads to increased risk. Public debt is less
      prone to be a cause of financial instability. So you have to distinguish
      between kinds of debt. Making blanket statements like “increased debt leads to
      increased risk” tells us nothing and might be wrong in certain contexts.

      In a message dated 7/16/2010 17:08:29 Mountain Daylight Time,

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