Ricardian Equivalence: or why Keynesianism doesn\’t work

There\’s an idea floating around out there that for all the pretty stuff in Keynesian macroeconomics it doesn\’t actually work. This isn\’t the clear and obvious point that while it says you should boost spending in a slump it also says you should cut it in a boom and we all know that politics just doesn\’t work that way. There\’s always a Polly saying that we should be spending all that lovely tax money on the children.

No, this is a microeconomic idea known as Ricardian Equivalence. In essence it says that if the government finances spending by borrowing, then households know that they\’ll have to cough up more tax in the future to pay for this spending. Thus they save more now to cover this future bill.

This entirely knocks out the effect of the increased government spending. Keynesian fiscal stimulus simply don\’t work: lovely theory destroyed by a cruel fact.

It has to be said that there aren\’t all that many people who believe this in  its pure form, I\’m not sure that I\’m one of them either.

The average household saved almost £300 a month in the three months to September – the biggest amount in any quarter in British economic history, according to the Office for National Statistics.

The ONS said that families saved 8.6p of every pound of disposable income they earned in the third quarter – the highest ever proportion. In total, households saved some £21.4 billion in those three months alone.

If you annualise that figure it\’s about £100 billion. The current fiscal stimulus from Darling is about £100 billion (the rest of his borrowing is a structural deficit).

This still doesn\’t show that the old Keynesian thing doesn\’t work for we\’ve not shown cause and effect. Followers of JMK could say that *because* families are saving government must make up the difference. And those followers of RE could say but because of the borrowing familes are saving which means that the stimulus doesn\’t work.

The feeling in my water is that as and when this \”Great Recession\” is all over we\’re going to see some really fascinating work come out about causes and effects. As revolutionary as Milton Friedman\’s stuff on the Great Depression and the money supply. I have a feeling that much of contemporary macroeconomics just isn\’t going to stand up to the scrutiny.

7 comments on “Ricardian Equivalence: or why Keynesianism doesn\’t work

  1. Ricardian equivalence is a mathematical fact – government borrowing must equal private sector saving (ignoring foreign governments). The question surely is at what level of economic activity does this occur?

  2. In complete laymans logic, surely the common folk is simply paying off their debt as fast as possible, because they are scared of losing their jobs.

    When spending is financed by taxation, the public will react immediately, but for borrowing, I don’t believe that most people are rational enough. Or perhaps, they would worry that they will be penalised for frugality anyway.

  3. On the plus side, we can solve the AGW warming problem: attach magnets to Keynes’ feet and head and put copper wire around his grave and his spinning will generate endless carbon-free electricity.

    Two flaws in this plan. First is that we’ll only draw power for a few months until the Gordon Brown is tossed out of office. Second is that Keynes was cremated.

  4. the legacy of people who thought they understood Keynes was a disaster…but not as bad as the legacy of people who thought they understood Marx…and maybe Gordon B and John B are even worse

  5. diogenes1960:

    Bad as might be the legacy of those who thought they understood Marx (or Keynes), worse, by far, are the legacies of those who actually did understand them!

  6. Damn, there goes my free lunch… 🙁

    (the only thing that is amazing about this is that so many apparently smart people believe in this financial perpetuum mobile invention…)

  7. In terms of Marginal Propensity to Save, 8.6% of disposable income is quite high. I’m at about 18% but I’m very risk averse.

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