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This episode of Economics Explored explores the theory of Ricardian equivalence, a proposition that fiscal policy measures like tax cuts or stimulus payments may not effectively boost the economy if households anticipate higher future taxes to pay off government debt. Host Gene Tunny explains the concept originating from David Ricardo and popularized by Robert Barro, involving ultra-rational consumer optimization over infinite time horizons. While an elegant theoretical model, Ricardian equivalence relies on unrealistic assumptions and fails empirical tests. Evidence shows households do increase spending after rebates or transfers, although not always by as much as policy makers would like. Ultimately, while the merits of discretionary fiscal policy are debatable, Ricardian equivalence is too extreme a hypothesis. Households do not behave as ultra-rational dynamic optimizing models predict.

Please get in touch with us with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. 

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcast and Spotify.

Takeaways

Five takeaways from this episode are:

1. Ricardian equivalence is an elegant theoretical model but relies on unrealistic assumptions about rational consumer behavior.

2. Empirical evidence overwhelmingly finds that households do increase spending after tax rebates or fiscal stimulus, contrary to Ricardian equivalence predictions.

3. Related concepts like Friedman’s permanent income hypothesis are more nuanced but also face limitations in fully explaining consumer decisions.

4. While fiscal policy faces challenges, Ricardian equivalence is not a compelling argument against its effectiveness due to failures of the underlying theory.

5. Examining economic models against real-world evidence is important for evaluating their validity and implications for policy.

Timestamps

• Introduction. (0:00)
• David Ricardo’s economic theories and their relevance today. (5:30)
• Ricardian equivalence in macroeconomics. (11:02)
• Consumption function and fiscal policy. (17:48)
• Rational economic models and their implications. (23:18)
• Ricardian equivalence theory and its limitations. (26:41)
• Ricardian equivalence theory and its empirical support. (33:59)
• Consumer spending after receiving tax rebates. (39:10)
• Ricardian equivalence in economics. (43:55)

Links

Previous episode in which Ricardian Equivalence was mentioned:

https://economicsexplored.com/2024/01/11/the-limits-of-fiscal-policy-insights-from-tony-makin-alex-robson-others-ep222

Robert Barro’s 1974 article “Are Government Bonds Net Wealth?”

https://eml.berkeley.edu/~saez/course131/Barro74JPE.pdf

James M. Buchanan on “Barro on the Ricardian Equivalence Theorem”

https://www.journals.uchicago.edu/doi/abs/10.1086/260436

Geoffrey Brennan and James M. Buchanan on “The Logic of the Ricardian Equivalence Theorem”

https://www.jstor.org/stable/40911555

John J. Seater on “Ricardian Equivalence”

https://www.jstor.org/stable/2728152

T. D. Stanley on “New Wine in Old Bottles: A Meta-Analysis of Ricardian Equivalence”

https://www.jstor.org/stable/1060788

Economist 2008 column “Ricardian equivalence is dead”

https://www.economist.com/free-exchange/2008/05/19/ricardian-equivalence-is-dead

Anrdrew Leigh’s paper “How Much Did the 2009 Australian Fiscal Stimulus Boost Demand? Evidence from Household-Reported Spending Effects”

http://andrewleigh.org/pdf/FiscalStimulus.pdf

Matthew D. Shapiro & Joel B. Slemrod’s study “Did the 2008 Tax Rebates Stimulate Spending?”

https://www.nber.org/papers/w14753

Claudia R. Sahm, Matthew D. Shapiro and Joel Slemrod’s analysis “Check in the Mail or More in the Paycheck: Does the Effectiveness of Fiscal Stimulus Depend on How It Is Delivered?” 

https://www.aeaweb.org/articles?id=10.1257/pol.4.3.216

Ikuo Saito’s paper “Fading Ricardian Equivalence in Ageing Japan”

https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Fading-Ricardian-Equivalence-in-Ageing-Japan-44302

Transcript: Revisiting Ricardo: The Rise and Fall of Ricardian Equivalence

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:03

His argument was that all you’ve got to think about whether that be increase in income in the current period is a permanent increase or not. Because if it’s only a temporary increase, it doesn’t increase what they can spend sustainably over the long term buy much at all. Welcome to the economics explored podcast, a frank and fearless exploration of important economic issues. I’m your host gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show. Thanks for tuning into the show. This week. I’d like to discuss what economists call Ricardian equivalence. You may recall that this concept was mentioned in the episode on the limits of fiscal policy earlier this year, and I’m going to be exploring it more this episode with my colleague, Arturo Arturo Espinosa, welcome to the programme. Thanks,

Arturo Espinoza Bocangel  01:21

Ian. I’m glad to be here. Excellent. So

Gene Tunny  01:24

yes, looking forward to chatting with you about Ricardian equivalence. Now this came up in a conversation I had with Tony maker. Well, I was replaying a previous conversation with Tony Mike and Tony is sadly, no longer with us. But in the conversation I had with Tony this, this idea of Ricardian equivalence came up. It’s one of those objections to fiscal policy as a way of influencing the business cycle as a macro economic stabilisation tool. And it’s a rather elaborate theoretical objection to fiscal policy. And result, it’s all very elegant. And I thought it’d be nice to go over it and explore it, because it does raise some important issues about how we think about the economy, how we model the economy. So if you’re happy to do that, I think that would be good. And if you’ve heard of this concept before, have you Arturo.

Arturo Espinoza Bocangel  02:30

Jaya during my time, so the students at uni, but I don’t remember very clear. So this is a good opportunity to refresh my memories.

Gene Tunny  02:43

Oh, good. Well, yeah. So hopefully, I can give a clear explanation. That yeah, so in we’ve been doing some, some reading. So to get across it, and to remind ourselves what it is because I must say it’s a proposition that was very popular when I was studying economics in the early 90s, early to mid 90s, when I started, because there was still some belief in this as an idea. This is a concept. But I think since then, we’ve probably figured out that maybe there’s really no, you know, not a lot of evidence to support it. So that’s something we’ll we’ll go over. The idea is that a fiscal stimulus, if it’s in the form of a tax cut, or a transfer to to households, if it’s a matter of cutting taxes, giving money to to households, the idea is that those households, or businesses, they will realise that in the future, the government has to, you know, pay, if they if the government’s borrowed money to finance this, then those households will have to pay higher taxes and otherwise, so that’s, that’s the idea. And that, and that, therefore, in the current period, they won’t spend that tax cut or that transfer that stimulus money, they will save it instead. So there’s that. That idea. And so it’s an argument as to why fiscal policy discretionary fiscal policy or fiscal stimulus may not be effective, because Okay, people will realise that the government is just borrowing this money, they’re taking on more debt, where the taxpayers we ultimately have to pay back that debt. And so we’re not any wealthier. That’s essentially the idea. And it’s, it’s based on households been forward looking about having this view into the future that we know we’re gonna have to eventually pay it back or our descendants will have to pay it back, our children, our grandchildren, and we have a we’re eltra not altruistic we what’s the word we we value the lives of our children out, we love our children, we, we, we want to, we want what’s best for them. So we’re not going to take on all this debt now and have, you know, live beyond our means so to speak and burden the future. So that’s, that’s the idea. Broadly speaking, I will try and define that more precisely, but that’s how I think of Ricardian equivalence is. Am I on the right track there,

Arturo Espinoza Bocangel  05:26

Arturo? Yes. That inclination was very clear again. Okay, good. Good. So

Gene Tunny  05:31

there are two things here. One is, is Ricardian so it’s named after David Ricardo, the famous economist. And then we’ll go into what’s equivalent. A bit later, we might talk about Ricardo to begin with. So David Ricardo, so his dates 18th 18th of April 1772 to 11th of September 18 23. So he lived. He lived through the age of wonder, whatever you however you want to describe it. So he was born just two years after Captain Cook discovered Australia for ice and, and he died in 1823. So he lived through the Napoleonic Wars. He was a British political economist, they call them in those days politician and Member of Parliament of Great Britain and Ireland’s This is from Wikipedia. recognised as one of the most influential economists, one of the most influential classical economists alongside figures such as Thomas Malthus, Adam Smith, and James Mills, so very esteemed company. Now, one of the one of my favourite descriptions of Ricardo comes from John Kenneth Galbraith, who was the American economist, professor at Harvard. He was an advisor to Jack Kennedy, he was Kennedy’s Ambassador to India. And Galbraith wrote this great book, The Age of uncertainty on, you know, history of economics, economic history, essentially. And this is quite a great description. Ricardo is Smith’s only serious contender for the title of founding father of economics. With him the great ethnic rivals of the Scotch arrive. Ricardo was Jewish. He was a stockbroker, a member of parliament, a man of superb clarity of mind and terrible obscurity of for this. That’s classic Galbraith. I mean, I don’t think anyone could write as well as Galbraith. He was it was a brilliant writer. So yeah, I mean, any, any economist relative to Galbraith? Probably, maybe we could be accused of obscurity of pros. Okay, so Ricardo, very famous, he wrote, was it Principles of Political Economy? I should know that off the top of my head, but he wrote a, he wrote several important works on in economics and his main claim to fame is the theory of international trade, isn’t it? It’s comparative advantage. And so this is this proposition that, like, we can talk about this in another episode, but essentially, David Ricardo demonstrated conclusively in a logical sense, why free trade is can benefit both parties. Why? Why countries can gain from trade from specialising in? Yes. Yep, and trading so of course, so specialising according to the comparative advantage of the country. And yeah, that’s something that you know, that’s a very, there’s a subtle definition of what comparative advantage is that we might go into in another in another episode, but it’s a very important theory in economics. Yeah,

Arturo Espinoza Bocangel  08:45

of course, I like to add some important information about this Ricardian model, tre, international trade causes in most of the International Trade courts around the world. The first model that is used in order to explain the patterns of trade is Ricardian model. It’s what that as you mentioned, basically is playing that country is specialised in in producing and exporting food that has a comparative advantage relative to other countries.

Gene Tunny  09:19

And is that based on the factor endowments what? What are the Allen’s please?

Arturo Espinoza Bocangel  09:25

The main reason is the level of productivity

Gene Tunny  09:30

level of productivity except Brian okay, we might go into that in another episode, but I guess the, like Australia, for example. I mean, a lot of people criticise Australia and say Australia is not a very complex economy. You’re just digging stuff out of the ground and exporting it or growing weed and exporting that. But I mean, we’re very good at that. Right? We’re very good at mining. We’re very productive in mining, and we’ve got great, great minerals, lots of valuable iron ore and and and coal coking coal in particular, which is very valuable. And so yeah, it makes sense for us to co produce and export that stuff. So yeah, we might well have to go into that Ricardian model of trade in, in the future. So the main point is that your Ricardo was a really big deal in economics. He essentially made the case for free trade. He argued against what was called mercantilism, which is the idea that countries become wealthy by exporting by having a trade surplus and bringing gold into the country accumulating gold in the reserves of gold. So that’s, he argued against that. He said, Well, that’s not necessarily the way to think about economic prosperity. So not exactly what we’re gonna talk about today. But it’s important to know Ricardo was very important in in that in international trade theory. Now, why is this relevant? What did Ricardo have to say about fiscal policy? Well, I mean, he wasn’t really a theorist of of, Oh, it wasn’t a macro. Well, I he’s a classical economist. So I suppose they did deal with that we’re thinking about the economy as a whole. But he’s not a macro economist, as we’d probably think of one today. But nonetheless, he did it, he did have this, he ran a thought experiment, you could call it or maybe you could say it was a bit of a thought bubble, but But he had this idea that of this equivalence between taxation and debt financing. So the Ricardian equivalence relates to the idea that if you think about this, in a particular type of framework, and you think about how these households eventually have to pay back the debt, so if you’ve got a choice between financing, spending, or financing, a particular like a surge in spending, because it’s a pandemic, for example, or a war, and it’s a choice between increasing taxes, or increasing, or borrowing the money in terms of how what happens to households, and you know, how they change their consumption, spending their behaviour, in this really theoretical framework, and under certain strong assumptions, which we’ll talk about soon, it could be the case that they just behave the same way that Yep, they might have to pay if they pay more taxes, and that lowers their disposable income, and then that may force them to, you know, that maybe they will cut back their consumption spending, they won’t spend as much. But then if the government goes and borrows money, then it may be that the households do the same thing, because they realise that, oh, hang on, we’ve got to pay for this in the future, eventually. So it’s as if let’s act now let’s spend less now let’s save more in anticipation of those higher taxes later on, because we have to pay the debt. So it’s this idea of this equivalence between taxation and debt finance, and I guess, this is where we start thinking, Well, hang on. That’s, that may not actually be what happens in reality. And indeed, Ricardo himself thought this was I think he thought he, he thought this was implausible, really, or he didn’t put a lot of he didn’t really, you know, make a huge thing about this is just a, you know, an idea he had just a speculation of his so I think that’s, it’s it’s certainly an interesting speculation to think about, like, how do households react to what the government does? And, you know, to what extent are they forward looking? To what extent are they Ultra rational, where this where this Ricardian equivalence thing, where it came from, or what where it was brought back into economics, or how it was brought back in economics was there was this school of thought that emerged in the late 60s and then in the 70s, called the New classical school of macro economics, which was trying to make macro economics more rigorous built, create micro economic foundations for it, because there was this view that what Keynes was talking about in the 30s. Okay, he, he didn’t really have really strong micro economic foundations or there was an optimising behaviour in it. There were a lot of us assumptions about how these macroeconomic aggregates such as consumption and income, were related to each other. But you weren’t really thinking about, well, how would rational households behave? So they, they had there was this idea that we want to have a more rigorous economics, that macro economics and it’s based on optimising models and, and one of the driving forces is the mathematization of economics in the post war period, from after Paul Samuelson foundations of economic analysis famous textbook in the in the 40s, where he brought mathematics to a lot of economics. And then the idea is let’s bring that to macro economics as well. Let’s have these really elegant optimization models and you know, Ricardian equivalence is is one of those types of models. Okay, how am I going to Euro? Very good. Okay. Okay. It’s a, it is a tricky sort of area to tricky concept to explain, I think. And having begun this conversation, I’m thinking okay, I’ll have to, maybe I’ll go and refresh my knowledge afterwards. But I hope that I am imparting enough of the substance of it. Okay, so who’s the big name associated with this proposition? Is Robert Barro, isn’t it? So? Okay, so Robert Barrow is one of the most famous economists of, say, the last 50 years or so. He’s probably the most famous economist out there at the moment who hasn’t won a Nobel Prize? I mean, who knows? It may be coming. But he hasn’t won one yet. At least as far as I’m aware, he hasn’t won the Nobel Prizes. He I probably would have put that down in the show in the notes. If he had. Okay, if he has I’ll, I’ll definitely double check that but I’m pretty sure he hasn’t Paul Lucas. Sorry, not Paul Lucas. Robert Lucas. won the Nobel Prize for new classical economics Thomas saj. And I’m pretty sure Robert Barro hasn’t won it. He’s currently the Paul M. Warburg professor of economics at Harvard. And he’s, you know, as a visiting scholar at American Enterprise Institute, research associate of National Bureau of Economic Research, PhD in, in economics from Harvard and a Bachelor of Science in physics from Caltech. I think it was a student of Richard Feynman, I think I read that. And he went into economics was he, he realised that, you know, physics was something he might not, you know, rise to the top in. He thought our economics is probably a better bit. Physics is too crowded. There are too many, you know, really, really smart people in physics. And they thought, Well, why not? Economics? That could be something different. But yeah, Barrow, right, this very famous article in the 1980s 1974, published in the the house journal of the University of Chicago economic School, which is the Journal of Political Economy, and his article is our government bonds, net wealth, and extremely clever paper, I’ll put a link in the show notes. But yeah, the basic idea there is that, if you think about it, in a particular type of model that was popular in the post war period, a particular way of thinking about macro economics, and less government bonds were was seen as something that made the community wealthier on their own, then they shouldn’t have a significant or they shouldn’t have an impact on consumption spending, because they shouldn’t make the community feel any wealthier, at least, that’s the that’s the idea. And his argument was that, well, if households realise that they actually are the ones who have to service that debt and pay back the debt, eventually as taxpayers, then they’re not any wealthier. So they’re not going to, you know, lift their level of consumption spending, if the government gives them a tax cut or transfers some money to them. So that’s the that’s the basic idea. Now, an a related concept, and I have been struggling to think about how to bring this into the conversation because it is related to it in a way that comes at this issue from in a different way. There’s the there’s Milton Friedman’s idea of the permanent income hypothesis. And, like one way of looking at fiscal policy if you’re thinking about a tax cut or a stimulus check, for example, Apple. And this is another way of thinking about this same question using a different model or a different, slightly different theoretical framework. And this was an objection to some of the the temporary, you know, bonuses or the temporary tax cuts or stimulus money that we’ve seen in different crises, like Milton Friedman argue that your consumption spending is related to your permanent income, which is essentially what you could, what you could spend out of your, out of your wealth sustainably over the long term. So if I’m getting that, right, so. So Keynes is consumption function related, corroding, current income to cut related your consumption spending to your current income. So if your B income is, say, say it’s, you know, $5,000 or something, and there’s an increase in your income of $1,000. And then Keynes would have this coefficient, the marginal propensity to consume and say, That’s point eight, then there’s this mechanical relationship of income goes up by 1000 times point eight, then your spending will go up. $800. So that’s the, that’s the Keynesian consumption function. And Friedman objected to that, because his argument was that, well, you’ve got to, you’ve got to think about whether that increase in income in the current period is a permanent increase or not. Because if it’s only a temporary increase, but doesn’t increase what they consider spend sustainably over the long term, by much at all, and his argument is that households would try to smooth out their consumption. Over time, there’s this idea that we’re better off if we have a more steady, sustainable standard of living, rather than having some periods where we’re spending more and living, living really well than other periods where we’re not living great at all. We’re on hard times, we’d be better off in his optimising model and his rational optimising model, we’d be better off saving those temporary windfalls and income, and you’re saving them up for times where we had less income, and so smoothing our consumption in that way. And so that’s an argument against fiscal stimulus, because you could, it could be the case that people get their tax cut, or their stimulus check. And they realise, well, hang on, it’s not really making us is not really lifting our permanent income, which is not going to make us you know, make us huge impact on our on our, you know, average income over the next five or 10 years. So why should we spend it baby, let’s say that, and we can use it to help smooth out income, it can cover those difficult periods. So that’s another example of an optimising model. And it’s a similar type of philosophy to Ricardian equivalence, but it’s not. It’s not quite the same thing because Barrows proposition is stronger than that. And because in Friedman’s model, it’s possible that if if the government’s transfer enough money to households, then they might think that Well, yeah, we are wealthier. It is, it will, this level of additional money will allow us to spend much more sustainably into the future. But Barrow goes further than Friedman, because in Barrows model, those households would realise that they would eventually have to pay back that money through the tax system. So that ultimately not any wealthier. So there’s, there’s probably a higher level of rationality in Barrows model, then, then Friedman’s model that Fred’s Friedman’s model gets you sort of the, you know, partly the way there because you’re starting to think about the future and households are starting to think rationally. What’s coming up in the future? Does that make sense? Or am I complicating things?

Arturo Espinoza Bocangel  24:31

I think I’m Porton assumption for the neoclassical economists here. Yeah. Individuals are acting as a rational. Yeah,

Gene Tunny  24:41

they’re rational and forward looking. Yeah. And so in Friedman’s model, then Friedman gets us a lot of the way there with this permanent income model. And then Barrow basically goes even further and says that households are so smart that they realise that any money that the government is is giving you temporary? Well, that it’s actually giving you through a tax cut or through a stimulus check. You’re gonna have to pay that back later. So you’re not any wealthier overall. And so there’s there’s there’s no increase in permanent income in in that situation. And yeah, there’d be no change. Whereas in the Friedman model, there’s a possibility maybe there is a small, a small impact on consumption if I think about that. Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny  26:06

Now back to the show. Yeah, these ultra rational models, Friedman sort of started the this is an idea and then the new classical economists took it to the limit. Okay, so that was that was Barrow a very, very famous paper and generated a huge literature, people arguing about this theoretically. And then there was a lot of empirical work which we might go into. One point I should make at the moment is that when Barrow first wrote this paper, it wasn’t called Ricardian equivalence Barrow, himself didn’t realise that, that he was almost channelling Ricardo in a way. But this was pointed out by James Buchanan, who was a Nobel Prize winner for his work in public choice theory, what was called public what’s called Public Choice Theory. And he was at Virginia Polytechnic Institute at the time, I think that’s now George Mason University. Or I could have that wrong. But anyway, James Buchanan. He wrote a famous article in 1976, which pointed out that essentially what what Robert Barrow had done was rediscovered this proposition of David Ricardo and I might read this abstract because it’s very, it’s quite, quite succinct. So James Buchanan wrote his public debt issue equivalent to taxation. This is an age old question in public finance theory. David Ricardo presented the case for the affirmative. Professor Robert J. Barrow re examines this question in his recent paper, without however making reference to Ricardo or other earlier contributors, although his discussion has carefully qualified to allow for exceptions under specified conditions, the thrust of Barrows arguments supports the Ricardian theorem to the effect that taxation and public debt issue exert basically equivalent effects. So I think, yeah, my it’s interesting be cannon makes the point that David Ricardo presented the case for the affirmative, because my understanding was that even though Ricardo did make that, or he did make the case, he didn’t think that it was something that was realistic, in that it didn’t apply in reality, I think might have been Galbraith or someone like that, who made that point that even though no Ricardo wrote about this in the funding system, he himself thought it was a bit of a theoretical curiosity. Okay, and one thing you found so this is another article by Buchanan you dug this up before, Arturo? Because you didn’t I think this goes to this is related this point I was making about how this is a very elegant theoretical model is based on optimising behaviour forward looking rational. Now, let’s make the most elegant mathematically. What’s the word? Elegant, I suppose or logical model where you’ve got people maximising their their utility, what economists call utility, their satisfaction, and they recognise that they’re there ultimately, they ultimately have to pay the debt. So yeah, Buchanan and Jeffrey Brennan. So Jeffrey Brennan’s an Australian, he was at ASU and his son Michael Brennan actually runs the ball. He did run the Productivity Commission here. Now he’s running the e 61. Institute. Interesting. Yeah, yeah. And he was a senior person in the treasury after I was there, but he is all very good. Jeffrey Brennan, I remember did a staring rendition of Rule Britannia at tattersalls Club at a dinner, I went to law school dinner I went to, but 20 years ago, it was a, it was a good thing. It was a great singer and a very intelligent man. Very good economist. Okay. Now, that all of course is completely irrelevant to the point, the logic of the Ricardian equivalence theorem by Jeffrey Brennan and James Buchanan, which was published in was it finance archive? I think it was, yeah, the German public finance journal. And they, they list these very well, you’d say they’re restrictive conditions, aren’t they for, for this whole this theoretical approach this model applying, and I might put them in the show notes. But essentially, they make some very strong assumptions about how, you know, well, one is that capital markets are perfect individuals may borrow and lend at the same rate as the government. And I think what this is getting to is the fact that look, even if ourselves are rational and forward looking, they may not be able to act in such a way because they’re not able to easily borrow that you can’t borrow as much as you’d like to help smooth your consumption over time to. So it could be the case that if the government gives you a tax card, and or gives you a stimulus check, you may really need that money. In a in a theoretical, in an idealised world, you could have just been temporarily on hard times, and in that idealised world you could have borrowed against your future income, because you know, I’m gonna get out of this in the future. So rather than struggling now, and you know, me struggling to pay rent or buy the groceries, I’ll just borrow against my future income. But that doesn’t mean you can’t always do that in the real world. I mean, people do sort of, you know, some people try and do that through credit cards. But that’s a recipe for financial disaster in the long run. So it may be that, you know, fiscal, fiscal policy measures, such as a tax cut, or a stimulus check, has an impact because it helps alleviate a liquidity constraint. So there’s this concept of liquidity constraints. And that was one of the major objections to well, this whole new classical approach, and also to well to Friedman’s model, in a way, yes, definitely the Freedmen’s model, that, you know, one of the things that stops people from acting, as optimising over time rational households is the fact that you you may not be able to borrow the money that would be compatible with that optimization. So that’s that point. And then there’s some other points about how assumptions that that’d be Canada and Brandon, identify individuals are certain as to both current and future income and prospects. Which is, yeah, I mean, people, you know, so any theory about where people are optimising the future and making optimal decisions? Essentially, you have to assume that they know how the future is going to evolve. And it may be that they, they don’t. And so it could be that, you know, people’s, well, in the Ricardian model, it could be the case that, well, they see the government borrowing this money to give them a tax card or pay them a stimulus check. But in their own mind, they’re thinking, Well, I’m going to be wealthier in the future anyway, I’m going to be earning a higher income, so I don’t really care as much. Maybe I have to pay a little bit more tax, but but who cares? So they in that model? Yeah, there’s the Ricardian model essentially, assumes that they have this perfect foresight. Number five individuals, as current taxpayers and as potential future taxpayers behave in terms of infinite planning horizons, they act as a mortals Yep. So they either act as a mortals. Yeah. Okay. So what’s that, assuming that’s assuming that they care for their descendants? Basically, as if they’re just future versions of themselves at a later date in the future? It’s essentially you like your children, your grandchildren are essentially just you at a future date. And so that’s, that’s a very strong assumption. I mean, and it may be the case that, look, you know, one generation may be perfectly happy, running up a bill for future generations to buy. I mean, not that I’m saying that necessarily doing that, but, you know, it’s not necessarily the case that people are acting as a mortals I mean, just think about I mean, there are plenty without children, they may not have any connection. They may not feel any connection with sex with future generations. Right? So it’s a pretty, it’s a very strong assumption now that there were there were seven of those assumptions. I haven’t read them all out. But I’ll put them in the show notes. And you can check that out that the main point is that look, there’s there’s just very stringent conditions for this Ricardian equivalence to hold that, in reality, it’s probably not going to hold and therefore this objection to fiscal policy, this idea that households are going to just save any additional money the government gives them, it doesn’t seem to be, you know, supported when you think about it logically. Maybe in an elegant theoretical model, but not in reality with how people behave and what will go on to now as the evidence and my reading of the evidence is that it doesn’t support this hypothesis. Okay, any other points on the theory there, Arturo? No, I feel I’m gonna have to write this up. In an article just because I think that link, yeah, I want to explain how this model fits with these other models such as Friedman’s permanent income, because I think that’s a that’s an important question. Okay. What does the evidence say? Now, this is really interesting, because if you look at the earliest empirical studies after Barrows model came out, there were studies that were essentially finding support for it. But then later on, economists changed their mind as more evidence accumulated. Then when it first emerged, it was it was a popular proposition and there was a 1993 Journal of Economic Literature review paper Ricardian equivalence by John cedar, and he’s at North Carolina, North Carolina State University. So Journal of Economic Literature is the one of the leading journals published by the American Economic Association. The idea is to have authoritative literature reviews that summarise the current state of the economic literature on important questions. And his conclusion was that although tests of Ricardian equivalence do not quite give an unambiguous verdict on that propositions validity, I think it is reasonable to conclude that Ricardian equivalence is strongly supported by the data. Now, you know, I wasn’t a practising economist at that time, that was my first year at uni. And, but I do imagine that that would have been a controversial conclusion. And it’s definitely been reversed since then. So in 1998, there was a meta analysis. So this is a study of studies where you look at what Previous studies have found, ideally, if you can get hold of their data, you try and rerun all the, you know, try and pull all the data together, run a big regression that don’t always do that. But you’d at least look at each of the studies and try to work out well which is more authoritative, which has a better methodology, which is using better data, that sort of thing and come to a judgement as to where does the where does the weight of the evidence why and in the conclusion in that paper, is it by by a TD Stanley at Hendricks College in Arkansas, published in southern economic journal new wine in old bottles, the meta analysis of Ricardian equivalence and that concluded that a quantitative review or meta analysis of 28 empirical studies of the Ricardian equivalence theorem gives persuasive testament of its falsity, which is, you know, pretty much what I would I would have expected given that just how really outlandish the theoretical assumptions behind the model are when you think about it, and just think, just use common sense and and look at it if anything would have killed off the Ricardian equivalence theorem. It would have been evidence from the financial crisis and then the pandemic since then, the the free exchange column in The Economist may 19 2008. So this is prior to the the the financial crisis, but there was a looks like there was a tax rebate. There was a 2001 tax rebate in the US and then there was another one, maybe it was 2007. I’ll have to put that in the show notes. But they were looking at how consumers were spending their rebates. And this is the calmness in The Economist, so the authoritative magazine published in London, they wrote, I tend to be wary of the effectiveness of fiscal stimulus, though at least anecdotally, the current stimulus seems to be working theoretically, people should not increase consumption in response to a small temporary increase in income unless they face liquidity constraints. Or taxpayers might recognise that rebates increase the size of the budget deficit, if there is no corresponding decrease in government spending, that their future taxes will pay, okay? So they might recognise that rebates increase the deficit. And that means I’ll have to pay higher taxes in the future. But these factors suggest most of the rebate will be saved and not spent, perhaps consumers do consider these factors and plan on saving their rebates. But then what he does is he quotes evidence, or this colonists quotes evidence from Matthew Shapiro and Joel Slemrod. So well known us economists. Okay, so at the time of the rebate, when they got it in 2001, only 22% of respondents planned on spending it. Although they found little evidence, people factor government spending, ie future deficits into their decision. Okay, so that’s what they were thinking about at the time. But then, there’s a study by David Johnson, Jonathan Parker, and Nicholas Sulukule, that, that they actually spent a significant amount of it or a non trivial amount of it, they found that the average household spent 20 to 40% of their rebate within three months of receiving it. And two thirds of the rebate was spent within a quarter of receipt, lower income groups spend a large fraction of their rebate, I’ll put a link to that in the show notes as there’s a bit going on there. There’s quite a few different points there. The basic point is that people do spend more of a rebate, a tax rebate, they get that you might then these models, you know whether it’s permanent income hypothesis of Friedman or in the extreme the barrow, Ricardian equivalence, people do spend more than you might, then these models would predict. And this was also concluded by Andrew Lee, who’s a federal MP here in Australia, who is a professor of economics today, I knew how much did the 2009 Australian fiscal stimulus, boost demand evidence from household reported spending effects, he used some survey evidence. And he looked at the $21 billion in household payments delivered in Australia between December oh eight and may 2009. So he’s talking about the Rudd stimulus money. So the Rudd Government stimulus packages and 40% of households. So this is what Andrew found 40% of households who said they received a payment reported having spent it and you know, that’s a higher rate than in, in the US. And Andrew speculated that it could have been because of the form of the of the assistance, it was a it was a stimulus check, rather than a rebate of tax. And so Andrew was saying there could be something psychological going on there, you know, individuals are more likely to, to spend bonuses, so to speak, rather than, than rebates. But yeah, so Andrew does, essentially concluded that there’s this marginal propensity to consume out of these rebates, or this, you know, the stimulus money, I mean, of point four, one 2.42. So, that was spending around, you know, that two out of every $5 that they got so so they get this money, and they do actually spend a portion of it, it’s not as if they just leave it in the bank and, you know, maintain just just been what they normally would wait to wait to actually use some of it to go and maybe at the time, people were saying they were going to buy a flat screen TVs, that was the popular thing at the time to buy. But, yeah, definitely, there was more spending than then would have been expected. Right. I mean, the debate does go on. There have been some findings supportive of Ricardian equivalence, I should know there was a study by a former Treasury colleague of mine, Shane brittle, who, unfortunately is no longer with us. He was at University of Wollongong and I think he, this was a study published in the Australian Economic Review. He found some Ricardian impact but he couldn’t accept or he didn’t find in favour of full Ricardian equivalence. He did. He studied the macro data and his macro modelling suggested that over the long run changes in general government savings are offset by changes in private savings by almost a half minus point four, four. This implies that the behavioural response of households and corporations is not fully Ricardian. Well, I think that’s that’s right. So yeah, there’s definitely not full Ricardian equivalence. Could it be that maybe households there could be some Ricardian equivalence I don’t know, maybe, maybe, maybe households do realise that the eventually they might have to pay more in taxes. But maybe the reason that they’re saving part of it is this, this Friedman argument of permanent income, they realised that it hasn’t really allowed them to lift their consumption on a sustainable basis by much at all. And so therefore, let’s not spend too much of it. Now. Let’s save up the bulk of it. So look, whether what Shane’s found is regarding whether what whether he found some partial support for Ricardian equivalence, I think that’s that’s up for debate. My personal view is that it’s just such an extreme hypothesis. It’s yeah, it’d be it’d be hard to find any support for for it at all. This is not to say that discretionary fiscal policy is sensible. I think there are, there are plenty of arguments against fiscal stimulus discretionary fiscal policy that don’t require Ricardian equivalence what Tony makin was talking about with crowding out via interest rates via the exchange rate, all of the lags that that occur from when you recognise a shock in the economy to when the fiscal policy might actually impact. I think these are all valid reasons to question discretionary fiscal policy, but Ricardian equivalence probably isn’t one of those. Okay, Arturo, I think that’s that’s probably enough. I was going to talk about Japan, but I just don’t think Japan provides support for it either. There was initially a thought that maybe Japan’s The Ricardian case, because there was, you know, there was a lot of fiscal stimulus in the 90s. And it didn’t revive the economy. But, you know, Japan’s got Japan’s really, you know, it’s a bit of a special case. And I mean, we might go into it in another, another episode, but there are a lot of economic challenges there. And now they got the demographic challenge shrinking population. They had, you know, very, very high saving rate. Yeah, it’s a it’s a, it’s a different economy than ours in a way and, yeah, I mean, the conclusion is that it’s not really an example of Ricardian equivalence. And if it were, it’s becoming less Ricardian, there was a an IMF paper I’ll link to in the show notes that argues that it’s if it was recorded, and it’s becoming less so over time. But yeah, I think we might just leave that. Possibly I’ll do a bonus episode on Japan. But my feeling is that there’s just so much evidence against Ricardian equivalence, theoretically, it doesn’t. It’s just too strong. I mean, it’s very elegant model. It’s beautiful model. But the real world people just don’t behave as they do in elegant. optimising economic models. Maybe I have to follow this up with an article but hopefully I’ve got the main points across so anything you’d like to add?

Arturo Espinoza Bocangel  48:05

Well, in will basically, just to summarise so these recurrent colons, as you mentioned, was very formal model, I think is good for the students, academics, researchers, just to check that our current political evidence is can be cross check against the this model. So I think is supposed to want to explain these concepts, and also using data from different countries.

Gene Tunny  48:48

Yeah, yeah, exactly. Okay. So yeah, I think looking at different countries is important. Which is why and if you’re in the audience, you think it’d be good to look at Japan? Because, I mean, Japan was certainly one of the countries I was, when I first started studying economics. That was one of the countries I was interested in. Because it was just after the bubble burst. I mean, there was that. Well, what was it this square kilometre around the Imperial Palace was worth more than all the land in Manhattan or something, something along those lines, there was some crazy statistic about how much the Japanese property market was worth and Japan was just riding high in the late you know, in the 80s. And and they’re all these concerns are the Japan’s going to overtake the US and then they had the crash and the bubble burst and there’s all the talk about trying to revive it through fiscal policy through infrastructure spending, and it just didn’t just didn’t revive the economy and they had their last decade. But if you’re interested in hearing more about Japan, I can certainly cover that in a in a future episode and try to find someone who’s, you know, knowledgeable about Japan. If you know anyone, let me know. Okay, how to Thanks so much for your time. I really enjoyed chatting about Ricardian equivalence with you. Oh,

Arturo Espinoza Bocangel  50:04

thank you for having me again.

Gene Tunny  50:06

Very good rato thanks for listening to this episode of economics explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact at economics explore.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and later writing. Thanks for listening. I hope you can join me again next week.

50:55

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Credits

Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple Podcasts, Google Podcast, and other podcasting platforms.