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Abba Lerner and the nonsense called ‘Ricardian equivalence’

Summary:
According to Abba Lerner, the purpose of public debt is “to achieve a rate of interest which results in the most desirable level of investment.” He also maintained that an application of Functional Finance will have a tendency to balance the budget in the long run: There is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full employment, the government must always be borrowing more money and increasing the national debt … Full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase … Since one of the greatest deterrents to

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According to Abba Lerner, the purpose of public debt is “to achieve a rate of interest which results in the most desirable level of investment.” He also maintained that an application of Functional Finance will have a tendency to balance the budget in the long run:

There is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full employment, the government must always be borrowing more money and increasing the national debt …

Abba Lerner and the nonsense called ‘Ricardian equivalence’Full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase …

Since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself, the guarantee of permanent full employment will make private investment much more attractive, once investors have gotten over their suspicion of the new procedure. The greater private investment will diminish the need for deficit spending …

As the national debt increases it acts as a self-equilibrating force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow comes completely to an end. The greater the national debt the greater is the quantity of private wealth.

Abba Lerner

According to the Ricardian equivalence hypothesis, the public sector basically finances its expenditures through taxes or by issuing bonds, and bonds must sooner or later be repaid by raising taxes in the future.

If the public sector runs extra spending through deficits, taxpayers will according to the hypothesis anticipate that they will have to pay higher taxes in future — and therefore increase their savings and reduce their current consumption to be able to do so, the consequence being that aggregate demand would not be different to what would happen if taxes were raised today.

Describing the Ricardian Equivalence in 1989, Robert Barro writes (emphasis added):

The substitution of a budget deficit for current taxes (or any other rearrangement of the timing of taxes) has no impact on the aggregate demand for goods. In this sense, budget deficits and taxation have equivalent effects on the economy — hence the term, “Ricardian equivalence theorem.” To put the equivalence result another way, a decrease in the government’s saving (that is, a current budget deficit) leads to an offsetting increase in desired private saving, and hence to no change in desired national saving.

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

There is, of course, no reason for us to believe in that fairy-tale. Ricardo himself (!) didn’t believe in Ricardian equivalence. In ‘Essay on the Funding System’ (1820) he wrote:

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.

That the theory does not fit the facts we already knew. Studies that have empirically tried to test the theory have over and over again confirmed how out of line with reality Ricardian equivalence is. This only underlines that there is, of course, no reason for us to believe in that fairy-tale. Or, as Nobel laureate Joseph Stiglitz has it:

Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.

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Lars Pålsson Syll
Professor at Malmö University. Primary research interest - the philosophy, history and methodology of economics.

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