Saturday, March 7, 2009

Key Concept - Ricardian Equivalence

Ricardian Equivalence is an economic theory that postulates debt-financed government spending will leave demand unchanged. It 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 will be the same.

According to the theory, the public will save any excess money received to pay for the inevitable future tax increases. In an extreme case, current generations will save the money and bequeath it to future generations to pay the bill.

The theory, developed by the 19th century political economist David Ricardo (who also was a pioneer in the description of comparative advantage), rests on several key assumptions:

1. A perfect capital market - all players can borrow or save as much as is required at a fixed rate which is the same for all persons at a given date
2. Fixed government spending path
3. Inter-generational concern - The increased taxes may not be paid by the current generation. Current individuals would need to have concern for their descendants.
4. Rational citizens

Obviously these are assumptions that are on shaky footing in our current world, which tends to cause the theory to lose some validity. Since the theory doesn't hold up completely, government stimulus plans can affect the economy, and may explain standard Keynesian theory where bond financed spending has a bigger effect than tax financed spending.

However, while perhaps not perfect, it certainly can explain some behavior that will temper the effectiveness of government stimulus programs. Many people use their stimulus checks to pay down debts, thus leaving more ability for payment of future tax increases.

It also brings up moral issues about financing current spending by writing debt to be paid by future generations that have no say in the process. Even if issuing debt does give an increase in demand for the economy, the recipient of the benefit and the payer of the debt should both be willing participants.

wikipedia, investopedia


Global Patriot said...

In times of plenty, additional sums of money, such as a tax refund or employee bonus, quickly enter the economy, must often on discretionary items.

In the current economic climate, where people are afraid of being laid off, or already have, paying down debt is far more common, thus mitigating the effects of increased funds on the manufacturing or service sector.

Daniel Plainview said...

It seems as if some people think it is a BAD thing that consumers are not spending. Is not that what put the economy into a pickle in the first place? Spending on houses, cars, etc. when one had no business doing such.

Saving is what the country needs to do, no?

Chief said...

I tend to think so. The Paradox of Thrift argues otherwise, however. I still contend that those that can afford it should continue to consume at a reasonable level, while ensuring they have sufficient resources to weather any foreseeable misfortune. Any entity that is spending more than it earns is not sustainable and should try to remedy the situation.