The Ricardian equivalence proposition (also known as the Ricardo–de Viti–Barro equivalence theorem Robert J. Barro took the question up independently in the 1970s, in an attempt to give the proposition a firm theoretical foundation.
Ricardo–de Viti–Barro equivalence
In 1974, Robert J. Barro provided some theoretical foundation for Ricardo's hesitant speculation
(apparently in ignorance of Ricardo's earlier notion and de Viti's subsequent extensions).
- capital markets are perfect (i.e., all can borrow and lend at a single rate)
- the path of government expenditures is fixed
Under these conditions, if governments finance deficits by issuing bonds, the bequests that families grant to their children will be just large enough to offset the higher taxes that will be needed to pay off those bonds. Among his conclusions, Barro wrote:<blockquote>... in the case where the marginal net-wealth effect of government bonds is close to zero ... fiscal effects involving changes in the relative amounts of tax and debt finance for a given amount of public expenditure would have no effect on aggregate demand, interest rates, and capital formation.</blockquote>The model was an important contribution to the theory of new classical macroeconomics, built around the assumption of rational expectations.
In 1979, Barro defined the Ricardian equivalence theorem as follows: "... shifts between debt and tax finance for a given amount of public expenditure would have no first-order effect on the real interest rate, volume of private investment, etc." Barro noted that "the Ricardian equivalence proposition is presented in Ricardo". However, Ricardo himself was skeptical of this equivalence.
Martin Feldstein argued in 1976 that Barro ignored economic and population growth. He demonstrated that the creation of public debt depresses savings in a growing economy. In the same issue James M. Buchanan also criticized Barro's model, noting that "[t]his is an age-old question in public finance theory", one already mooted by Ricardo and elaborated upon by de Viti.
In a response to the comments of Feldstein and Buchanan, Barro recognized that uncertainty may play a role in affecting individual behaviour with respect to government finance. Nevertheless, he argued that "it is much less clear that this complication would imply systematic errors in a direction such that public debt issue raises aggregate demand."
In 1977, Gerald P. O'Driscoll commented that Ricardo, in expanding his treatment of this subject for an Encyclopædia Britannica article, changed so many features of it as to result in a Ricardian Nonequivalence Theorem; he elaborated all the reasons why the proposition would not hold.
In 1989, Barro offered a number of defenses against various other critiques.
Empirical results
Ricardian equivalence has been the subject of extensive empirical inquiry. Barro himself found some confirmation in post WW I years. and Lawrence Summers shows that the Ricardian equivalence hypothesis is refuted by their results. In the Ronald Reagan era, the US government had a historically large budget deficit due to the Reagan administration tax cuts and increases in military spending. During 1976–80, government revenue was 10.01 percent of potential GNP, and it declined to 8.86 percent during 1981–1985. The ratio of the US government's budget deficit to its potential GNP did not exceed 4 percent from World War II until 1981, and exceeded 4 percent after 1981. The ratio of an inflation- and cycle-adjusted deficit to the potential GNP was 2.56 percent during 1981–1986, and this ratio was the largest between 1958 and 1986. If the Ricardian equivalence hypothesis is true, the rational consumers of the economy, who expect the government to raise taxes, try to reduce their consumption and increase their saving. The reality
An argument for countercyclical fiscal policies
Ricardian equivalence has crucial importance in the fiscal policy considerations of new classical macroeconomics. When assessing Ricardian equivalence or any of the new classical doctrines, one should bear in mind the conditional character of these theses. Thus the equivalence theorem should not be separated from the assumptions on which it is based. In other words, Ricardian equivalence does not mean that any countercyclical efforts will fail, but outlines the necessary conditions for that failure and, naturally, for success at the same time. Governments do not have any potential to exert countercyclical efforts if the path of government expenditures is fixed and if agents form rational expectations. If these conditions hold, cuts in taxes imply a later pressure to raise taxes, since government has to fill the resource gap in the budget which is the result of the initial tax cut. So, rational agents will put the additional income from the tax cut into saving, and consumption does not rise. In this story, if these processes can be changed by the government, or, in any way, the additional income can be believed not to be withdrawn later, the initial tax cut will induce a rise in public consumption expenditures.
So countercyclical fiscal policy can be effective if any one of the conditions necessary for the equivalence does not hold. Controlling the real economy is possible perhaps even in a Keynesian style if government regains its potential to exert this control. Therefore, actually, new classical macroeconomics highlights the conditions under which fiscal policy can be effective and not the inefficiency of fiscal policy. Countercyclical aspirations need not to be abandoned, only the playing-field of economic policy got narrowed by new classical macroeconomics. Keynes urged active countercyclical efforts of fiscal policy and these efforts are not predestined to fail not even in the new classical theory, only the conditions necessary for the efficiency of countercyclical efforts were specified by new classical macroeconomics. Ricardian equivalence underlines the importance of fiscal reforms, since such reforms are needed in order to change the path of government expenditures. When implementing comprehensive fiscal reforms which make public sector more efficient governments do not exert countercyclical efforts of course, but form the necessary conditions for regaining countercyclical potential. In this respect, Ricardian equivalence clarifies the exact conditions necessary for countercyclical fiscal policies.
See also
- Public finance
- Government debt
- Policy-ineffectiveness proposition
- Say's law
- Fiscal policy