209 Ricardian Equivalence
Learning Objectives
- Describe Ricardian equivalence and how government borrowing can affect private saving
Ricardian Equivalence: How Government Borrowing Affects Private Saving
Early Neoclassicals criticized Keynesian views about fiscal policy for ignoring the “crowding out” effect. Recall that crowding out is the idea that expansionary fiscal policy causes interest rates to rise which reduces business investment, limiting the effects of the fiscal expansion. The Keynesians ultimately acknowledged the crowding out effect, and the debate changed to how much crowding out occurs. Neoclassicals argue for complete crowding out, meaning that fiscal policy was completely ineffective since an increase in government spending would be completely offset by a decrease in private investment spending with no net effect on aggregate demand. Keynesians argue for incomplete crowding out; thus, fiscal policy would be weaker than originally thought, but still effective to a certain degree.
Robert Barro and other New Classical economists introduced another criticism of fiscal policy. If people have rational expectations, a change in government budgets may impact private saving. For example, whenever the government runs a budget deficit, people might reason: “Well, a higher budget deficit means that I’m just going to owe more taxes in the future to pay off all that government borrowing, so I’ll start saving now.” If the government runs budget surpluses, people might reason: “With these budget surpluses (or lower budget deficits), the country will be able to afford a tax cut sometime in the future. I won’t bother saving as much now.”
The theory that rational private households might shift their saving to offset government saving or borrowing is known as Ricardian equivalence because the idea has intellectual roots in the writings of the early nineteenth-century economist David Ricardo (1772–1823). If Ricardian equivalence holds completely true, then any increase in government expenditure that increases the budget deficit would lead to a corresponding decrease in consumption expenditure, as households save more in anticipation of their future tax liability. The net effect on aggregate demand then is zero and fiscal policy is entirely ineffective.
In practice, the private sector only sometimes and partially adjusts its savings behavior to offset government budget deficits and surpluses. Figure 1 shows the patterns of U.S. government budget deficits and surpluses and the rate of private saving—which includes saving by both households and firms—since 1980. The connection between the two is not at all obvious. In the mid-1980s, for example, government budget deficits were quite large, but there is no corresponding surge of private saving. However, when budget deficits turn to surpluses in the late 1990s, there is a simultaneous decline in private saving. When budget deficits get very large in 2008 and 2009, on the other hand, there is some sign