The Ricardian equivalence proposition (also known as the Barro–Ricardo equivalence theorem) is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their level of spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same.
Introduction
In its simplest terms: governments can raise money either through taxes or by issuing bonds. Since bonds are loans, they must eventually be repaid—presumably by raising taxes in the future. The choice is therefore "tax now or tax later."
Suppose that the government finances some extra spending through deficits; i.e. it chooses to tax later. This action might suggest to taxpayers that they will have to pay higher tax in future. Taxpayers would put aside savings to pay the future tax rise; i.e. they would willingly buy the bonds issued by the government, and would reduce their current consumption to do so. The effect on aggregate demand would be the same as if the government had chosen to tax now.
David Ricardo was the first to propose this possibility in the early nineteenth century; however, he was unconvinced of it. Antonio De Viti De Marco elaborated on Ricardian equivalence starting in the 1890s. Robert J. Barro took the question up independently in the 1970s, in an attempt to give the proposition a firm theoretical foundation. The proposition remains controversial.
Original Argument
In "Essay on the Funding System" (1820) Ricardo studied whether it makes a difference to finance a war with £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that
In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "Fiscal Illusion", which distorts their decisions.
Criticisms
Ricardian equivalence requires assumptions that have been seriously challenged. The perfect capital market hypothesis is often held up for particular criticism because liquidity constfaints invalidate the assumed lifetime income hyupothesis. International capital markets also complicate the picture.
In 1976, Martin Feldstein argued that Barro ignored economic and population growth. He demonstrated that the creation of public debt depresses savings in a growing economy.
In that same year, James M. Buchanan also faulted 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 particular, he criticized Barro for:
In 1977, Gerald O’Driscoll opined 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.
In 2009, Paul Krugman ignited a debate among notable blogging economists and financial journalists when he grouped Barro with "first-rate economists [who] keep making truly boneheaded arguments against [organizing Keynesian stimulus]".
From: http://en.wikipedia.org/wiki/Ricardian_equivalence
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Comments From the Blog Author
The above discussion demonstrates the permanent and essential stupidity of the fake "science" of "economics." It is obvious, incontrovertibly, inevitably obvious that it is better not to borrow the money unless the government has to pay later because an emergency such as general war has erupted.
Government owes its citizenry enough economic stability and credit such that it can borrow to win a war for its own survival. To prove my point, let us look at the low countries of Europe in 1940.
Belgium, Luxembourg, the Netherlands and Denmark had state socialism at that time. Their governments borrowed long term to pay for short term optional expenses. When the German army appeared at their borders, they caved, sometimes in a matter of hours. Ricardian "equivalence" does not imagine such a situation.
In comparison, look at the United States. In the Coolidge administration of the 1920s, the USA bought all the gold it could get from anywhere in the world and established a huge reserve of this metal to back its currency. It also paid down 40% of the nation debt during the booming 1920s.
America just started an unsound Social Security system in the late 1930s and, fortunately, had no federal medical assistance plan. Not only did the financial responsibility of Coolidge allow America to get through the Great Depression, it also formed a sound basis for the nation borrowing $1 trillion (in 1942 dollars!) from its citizens to win World War II. Obviously there is no genuine "equivalence" here. A nation owes its citizens a good enough credit rating to win the next war, whenever that may be.
Introduction
In its simplest terms: governments can raise money either through taxes or by issuing bonds. Since bonds are loans, they must eventually be repaid—presumably by raising taxes in the future. The choice is therefore "tax now or tax later."
Suppose that the government finances some extra spending through deficits; i.e. it chooses to tax later. This action might suggest to taxpayers that they will have to pay higher tax in future. Taxpayers would put aside savings to pay the future tax rise; i.e. they would willingly buy the bonds issued by the government, and would reduce their current consumption to do so. The effect on aggregate demand would be the same as if the government had chosen to tax now.
David Ricardo was the first to propose this possibility in the early nineteenth century; however, he was unconvinced of it. Antonio De Viti De Marco elaborated on Ricardian equivalence starting in the 1890s. Robert J. Barro took the question up independently in the 1970s, in an attempt to give the proposition a firm theoretical foundation. The proposition remains controversial.
Original Argument
In "Essay on the Funding System" (1820) Ricardo studied whether it makes a difference to finance a war with £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that
- In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value.
- But 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 war 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.
In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "Fiscal Illusion", which distorts their decisions.
Criticisms
Ricardian equivalence requires assumptions that have been seriously challenged. The perfect capital market hypothesis is often held up for particular criticism because liquidity constfaints invalidate the assumed lifetime income hyupothesis. International capital markets also complicate the picture.
In 1976, Martin Feldstein argued that Barro ignored economic and population growth. He demonstrated that the creation of public debt depresses savings in a growing economy.
In that same year, James M. Buchanan also faulted 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 particular, he criticized Barro for:
- failing to compare the differential impacts of taxation and debt issue;
- "superimposing" an issue of public debt without offsetting or compensating changes;
- erring in assuming the equivalence of the "helicopter drop" to currently old households and the sale of bonds on a competitive capital market, with the proceeds of this sale used to effect a lump-sum transfer to generation 1 household;
- not providing empirical evidence about the full discount of future taxes;
- not considering that, under his hypothesis, there should be roughly indifferent public reactions to a fully funded and to an unfunded pension system;
- not considering the political consequences of the equivalence.
In 1977, Gerald O’Driscoll opined 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.
In 2009, Paul Krugman ignited a debate among notable blogging economists and financial journalists when he grouped Barro with "first-rate economists [who] keep making truly boneheaded arguments against [organizing Keynesian stimulus]".
From: http://en.wikipedia.org/wiki/Ricardian_equivalence
= = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = =
Comments From the Blog Author
The above discussion demonstrates the permanent and essential stupidity of the fake "science" of "economics." It is obvious, incontrovertibly, inevitably obvious that it is better not to borrow the money unless the government has to pay later because an emergency such as general war has erupted.
Government owes its citizenry enough economic stability and credit such that it can borrow to win a war for its own survival. To prove my point, let us look at the low countries of Europe in 1940.
Belgium, Luxembourg, the Netherlands and Denmark had state socialism at that time. Their governments borrowed long term to pay for short term optional expenses. When the German army appeared at their borders, they caved, sometimes in a matter of hours. Ricardian "equivalence" does not imagine such a situation.
In comparison, look at the United States. In the Coolidge administration of the 1920s, the USA bought all the gold it could get from anywhere in the world and established a huge reserve of this metal to back its currency. It also paid down 40% of the nation debt during the booming 1920s.
America just started an unsound Social Security system in the late 1930s and, fortunately, had no federal medical assistance plan. Not only did the financial responsibility of Coolidge allow America to get through the Great Depression, it also formed a sound basis for the nation borrowing $1 trillion (in 1942 dollars!) from its citizens to win World War II. Obviously there is no genuine "equivalence" here. A nation owes its citizens a good enough credit rating to win the next war, whenever that may be.
There is no sound reason to borrow now in order to pay later unless the survival of the nation state itself is in serious question. This kind of crisis tends to arrive about once every 65 to 80 years. For all of the rest of the time, a government needs to build and maintain an excellent credit rating by not borrowing at all.
Unless you think the political leaders of the low countries were humanitarian in acting like spendthrifts in order to look good politically even if it enslaved their own people to do so? For this is the civility and humanity inherent in most economic theory.
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