Friday, February 17, 2012

The circularity of Ricardian Equivalence

We were talking about Ricardian Equivalence in macro last night. I for one think that it's actually not bad as a starting point for thinking about public debt. It's like any argument dependent on rational behavior. Rational behavior is an excellent starting point, you just have to remember that's not the end of the discussion.

Anyway - a brief thought I had was that there's a bit of circularity to the attempts to use Ricardian Equivalence to refute Keynesian claims about stimulus.

So people that do this set out to demonstrate that national income can't increase from deficit spending.

- To do this, they say "people will know they have to pay taxes in the future, so they reduce their spending, which cancels out any deficit spending"

- What they leave unsaid is "people will know they have to pay taxes in the future out of the same national income as in the counterfactual, so they reduce their spending, which cancels out any deficit spending".

- That bolded, red, unstated assumption is critical, of course!!! After all, if for some reason deficit spending increased national income relative to the counterfactual, taxpayers may not have to reduce their spending in order to prepare to pay taxes in the future, and the deficit spending wouldn't be canceled out.

So the argument - because of its unstated assumptions - is really rather circular. For Ricardian Equivalence to say what some people want it to say, you have to assume your conclusion - that the deficit spending won't increase national income.

Surprise, surprise! In a world where you assume deficit spending doesn't work, you tend to also draw the conclusion that it doesn't work.

This isn't to say, of course, that Ricardian Equivalence is useless. Use it as a framework for thinking about the public's responsiveness to public finance decisions. But don't assume it has broader macroeconomic implications unless you bring something else to the table theoretically.


  1. Hi Daniel,

    This is a confusion between circularity and consistency.

    Ricardian equivalence is consistent, because if people are rational and expect no change in national income from deficit, then deficit do not change national income. You call it circularity, I call it consistency. A lot of intertemporal theories must be what you call circular (think of game theory).

    Let's see if your argument is consistent.

    Rational people think that if they behave like keynesian, national income will increase (thanks to the keynesian multiplier), which enables them to consume more immediatly, which in returns really creates the growth in national income. Is this consistent ? Absolutely not, because if individuals really anticipate strong multiplier effect when the government runs a deficit, then they anticipate also a strong multiplier effect when the governement will reimburse the debt, but this time the effect will be negative. Which brings us back to the ricardian equivalence !

    Ricardian equivalence is consistent (circular if you prefer), but not your point. This is why keynesian economists do not use your argument, but attack the rationality hypothesis (and immortality).

    Good luck for your thesis

  2. And also, if we follow your argument, then people do not need the state anymore to stimulate the economy.

    They will increase their consumption by their own, because they know from Keynes that they will be wealthier if they consume more, which enables them to consume more now...;)


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