“Ricardian Equivalence” is the strong proposition that debt financed government spending is “equivalent” to tax financed spending if taxpayers increase their savings in anticipation of higher future taxes. This notion was proposed by David Ricardo (although Hakes and McCormick (1996) show Adam Smith mentioned it earlier), and rediscovered by Robert Barro in 1976. Barro believed this proposition relevant for modern US policymaking, an idea that would have seemed absurd if not for the prominence and intelligence of its promoter. This issue highlights the important, if under-appreciated, point: that an economic model’s relevance for the real world is situation-dependent. This paper will explain how conditions in which one would expect savings to be affected by deficit spending are much closer to those in Ricardo’s time, than those that currently exist in the US.
This paper also pursues another methodological point: how theoretical advances can be spawned in reaction to dissatisfaction with existing theories. Before focusing on models based on rationality and market clearing, Barro had worked with Herschel Grossman on disequilibrium models based in inflexible prices. His subsequent embrace of rational expectations methodology was likely a reaction to frustration with those models. Similarly, as a graduate student at the University of Rochester, Richard Thaler found models he was taught, based on hyper-rational agents, produced implications profoundly at odds with his real world observations. This inspired Thaler to aggressively pursue alternatives derived from findings from Psychology. Thus, prominence of Ricardian Equivalence and Rational Expectations methods in the 1980s likely spurred on the development of Behavioral Economics.