Ricardian Equivalence Makes Comeback

Commentary, Frontier Centre, Role of Government, Taxation, Worth A Look

Stimulus is supposed to be the key to recovery, and governments around the world are embracing it as never before.

But a long-forgotten theory dating back almost 200 years is increasingly weighing on the minds of policy makers: Ricardian equivalence.

Named after the writings of David Ricardo in the early 1820s, the theory suggests that stimulus spending is doomed to failure because taxpayers tend to save their stimulus dollars rather than spend them.

Their reluctance to spend, according to Ricardo, stems from a basic lack of faith in the government’s ability to manage stimulus, and a belief that they will eventually be hit by big tax increases to pay off bulging deficits.

Lately, discussion about Ricardian equivalence is spilling from its normal confines in academia to the offices of Bay Street and Wall Street economists. It even drew a mention last month by Bank of Canada Governor Mark Carney, who warned in a speech that “Ricardian effects on consumption” are among the risks to the global recovery.

The Ricardian chatter signals policy makers’ and economists’ nagging fear that fiscal stimulus will fall flat or even backfire, undermining the global recovery before it has a chance to blossom.

The risk is that despite the hundreds of billions being spent, “the money from Uncle Sam goes into the coffee can instead of being used to buy more coffee,” explains David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc. “People see today’s stimulus as tomorrow’s tax hike.”

Last year, U.S. taxpayers saved essentially all the money they got through a federal tax cut. And the recent spike in the U.S. personal savings rate is all Mr. Rosenberg needs to believe Mr. Ricardo had a point. In May, the total Obama administration stimulus was worth $163-billion (U.S.) at annual rates, while consumer spending increased only by $25-billion that month, at annual rates. At the same time, the personal savings rate jumped to a 16-year high of 6.9 per cent of disposable income, up from 5.6 per cent in April and 4.3 per cent in March.

The stimulus, Mr. Rosenberg argues, “does seem like such a complete waste of time” because for every new government dollar, consumer spending rises just 8 cents.

Canadian savings rates have risen, too, but there is not much concern that Ricardian equivalence will render stimulus obsolete here. Canada entered the recession with a strong government balance sheet, so it won’t have to use huge tax hikes or spending cuts to bring its budget into balance again in the long run, said economist Nicholas Rowe at Carleton University.

In addition, monetary policy has been far more effective in Canada than in the United States in injecting some life into the economy, so recovery here is not as dependent on fiscal stimulus as it is in the United States, he said.

Canadian recovery is, however, very dependent on American households spending their stimulus. So if Ricardian equivalence does play out south of the border, the impact could be more than theoretical.

Though updated and modernized by economist Robert Barro in 1974 (and also known as the Barro-Ricardo equivalence proposition), the Ricardo theory has never held much sway among economists. In fact, Ricardo ultimately rejected the idea.

But many economists have tried, over the centuries, to disprove the theory, and none have succeeded in doing so.

The idea behind the theory – that consumers will not spend their stimulus because they think they will need the money as a cushion against future rough times – is more widely accepted than the Ricardian theory. The hoarding concern is even greater these days, amid rising concern that government-financed pensions won’t be able to withstand the crisis and individual households will have to make up the shortfall.

Now, with President Barack Obama’s administration signalling its intention to eventually raise taxes to offset the mounting deficit, taxpayers are almost being encouraged to stash away their stimulus, argues Derek Holt, senior vice-president of economics at Scotia Capital Inc.

“Every theory has its day in the sun and, at this point in time, especially in the United States, it’s holding true,” Mr. Holt said.

And loud talk about the need for fiscal and monetary “exit strategies” at a time when recovery has not yet taken hold only serves to highlight the reasons why households should start saving more, and could encourage people to do so.

Even if the Ricardian connection between hoarding and the announcement of exit strategies is tenuous, it’s not worth taking the risk, adds Avery Shenfeld, chief economist at CIBC World Markets.

“There’s no point waking up a hibernating Barro by talking too much, too soon, about a budget tightening ahead,” he said.