Ricardian equivalence is the theory that a rise in government deficits will cause taxpayers to increase their savings because they know they will have to pay for it in a future tax increase. Ricardian Equivalence stems from economic models that made recessions impossible because they omitted hoarding which is the most common reason for a recession. The theory of Ricardian Equivalence was first promoted by Harvard economist Robert Barro in 1974 and he named it after the great 19th century English economist, David Ricardo, as part of his effort to promote the idea. Ricardo did mention the idea but he immediately rejected it at the same time. He never promoted it. Robert Barro first promoted the idea and it has become a kind of zombie theory ever since. It has been killed numerous times, but somehow continues to live on and infect new believers nonetheless.
There are several flaws in Barro’s theory, but the only way his theory could work would be if the money supply were fixed, there were no recession and the economy was already operating at full employment and people had low discount rates. Then Ricardian Equivalence would be approximately true. If everyone is already working as much as they want to work and the government tries to spend money to get people to do more work for the government, then total GDP cannot increase and the government merely shifts workers from private-sector work to doing government work. In this case there would be rough equivalence between government spending that is financed by immediate taxation or by borrowing.
For example, if the government immediately taxes people to pay for increased government spending, then households cannot spend that money on household goods and so there is just a shift from household spending to government spending. Equivalently, if the government borrows the money, then people’s savings must go to the government rather than going to private borrowers. Barro gave a flawed rational expectations story for Ricardian Equivalence in which taxpayers naturally see that the government will have to pay for the new spending with higher taxes and so they rationally increase savings (thereby reducing household consumption) so they will be able to pay for the higher taxes that they expect to have in the future. This doesn’t really change the story however that Ricardo assumes that government borrowing has exactly the same effect on output as an immediate tax hike. The only way that could be true is if there were a fixed money supply and no hoarding. But hoarding is the main reason for recessions, and if there is hoarding, then the government can borrow the hoardings without reducing household spending because there are more savings than borrowers know what to do with. During a typical recession, government borrowing reduces hoarding in the loanable funds market. In the labor market, hoarding also causes a problem: unemployment. When the government spends some of the hoarded money, it will help get people working again. It is that simple.
So I would agree with Barro’s theory in times when unemployment and hoarding are very low, but that is the standard Keynesian theory. In times like that, governments should use austerity to reduce inflationary pressures. But Barro argued that his theory is universal which is ridiculous. It is a special case which only becomes approximately true in rare circumstances.
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