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Ricardian Equivalence

(A Case Study In How Not To Look At Economic Behavior)

There are assumptions about human nature built into the study of economics, assumptions that sometimes escape examination simply because they are built in so deeply. Take for example the notion of rational decision-making, in economics, a topic we’ve looked at in some in other places.

When describing people’s behavior, economists often employ a generalized model known as economic man– homo economicus. Who is economic man? To simplify a simplification, homo economics is rational (acting on all available information to the best of his or her ability) and wants to maximize utility (gain as much financially, or in terms of consumption, leisure or pleasure as possible. A notion rooted in the concept of utilitarianism.)

Clear enough, but maybe too simple. Take the debate over what is known as Ricardian Equivalence.

Ricardian Equivalence is the idea that deficit spending by the government will not expand the economy, because consumers and business people will see the increasing deficits and will cut back on their own spending in expectation of higher taxes to pay for the government debt.

It was named for late 18th/early 19th century English economist David Ricardo, who first proposed it and then rejected it. It seems Ricardo was ahead of those who came after, and not for the last time.

Ricardo put it this way: “the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the (deficit) is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000”

Many consumers and business owners probably don’t even realize deficits inevitably lead to higher taxes, or if they do know it intellectually they but somehow feel it doesn’t apply to them. To suggest that consumers who might be swayed by the smell of a new car are rational enough actors to put off a purchase based on government fiscal policy seems, shall we say, unreasonable in the extreme.

This not to say business people and consumers are never aware of deficits and never take them into account. But for them to become aware something else has to happen. For example, excess expansion of the money supply could cause a sharp rise in prices, or could force a devaluation that in turn causes inflation. The ordinary men and women in the economy then become aware, and act according to their understanding. But they are not reacting to the deficits themselves, but to the results of the deficits. If the deficits are properly managed, they may well remain invisible.

And that seems like it should be the end of it – Ricardian Equivalence doesn’t work because people just don’t make decisions that way. But maybe that’s too obvious for some economists. The debate over Ricardian Equivalence has at times devolved quickly into questions such as whether families passing on government bonds represents a permanent form of wealth passed down through families and what impact an expanding populationwould have a long term effect on tax revenues.

Interesting, appealingly technical questions. But also possibly beside the point. And as the issue becomes tangled in a series of these technical debates, observations of consumer decision making are ignored aside. Ricardian Equivalence becomes another in a series of similar macro-economic debates about deficit spending.

Which is not to say there is nothing to think about. For example, the question of whether the government deficit spending is really creating growth or simply moving it from one place (or one time) to another.

By going into debt to finance fiscal stimulus, the government is after all borrowing investment money to spend it on expanding the economy – money that could stimulate economic growth if it was spent by any borrower, not just the government. This suggests crowding out, the possibility that government deficits take away from the private sector investment by soaking up saved money. Many economists think some crowding out is inevitable. Others say if the economy is slack, the government is not taking investment from any business, because that investment would not have been made due to the poor economic climate.

Interesting question, and actually not all that easily answered. In Keynesian terms we could consider government deficit spending as a way to force savings back into action in the economy. Keynes wrote that depressions start because savings slow the spiral of activity, by reducing the amount of consumption and investment. This is the famous paradox of savings, that in a time of a slow economy what is good for the individual may be bad for the nation.

Keynes seemed to regard this as an issue of timing – fiscal policy being used to in essence borrow economic activity from the future, a time (one hopes) when growth is plentiful, or even excessive. This in turn suggests the possibility that depending on the interest rate, a deficit could be paid off at a time when economic growth makes the taxes less of a burden than they would have been when the money was borrowed. Of course that could also work the other way - the economy could decline, making future taxes more of a burden.

Another possibility regarding crowding out is that government deficits probably have some kind of impacts on private investment, but that in most cases the rise in interest rates that might result from crowding out would be overwhelmed by the direct conscious result of central bank policies controlling interest rates.

But one thing that is clear is that few, if any, people make day to day consumption decisions because of their expectations about future tax rates. And economists are missing something if they think otherwise.

Of course all economic decisions are the result of learned behaviors, because economics is a social contruct. So maybe people could be educated to make consumer decisions based on expected future taxes. But probably not.

Besides, if consumers really started behaving rationally, what would the marketing industry do for a living?

analysis/economics/ricardian_equivalence.txt · Last modified: 2013/05/19 18:46 by ram