77
The Greek state was forced to borrow
large sums in 2011 to avoid bankruptcy.
The civil unrest that followed made it
clear that there are limits to how much
a government can borrow and tax.See also: Economic man 52–53 ■ The tax burden 64–65 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■
Saving to spend 204–05 ■ Rational expectations 244–47
THE AGE OF REASON
savings that are equivalent to the
amount they would have been
taxed today in order to meet that
eventuality. Ricardo suggested that
people understand a government’s
budget constraints and continue to
spend in the same way regardless of
its decision to tax or borrow because
they know these will ultimately cost
them the same. This idea became
known as Ricardian equivalence.
Imagine a family with a
gambling father who resorts to
taking money from his sons. The
father tells his sons that he will let
them keep their money this month
because he has borrowed from his
friend Alex. The happy-go-lucky
younger son, Tom, spends his extra
cash. The wise older son, James,
realizes that next month, Alex’s loan
will have to be repaid with interest,
at which point his father will
probably ask him for money. James
hides away today’s extra cash,
knowing he will have to give it to
his father in a month. James has
recognized that his overall wealth
hasn’t changed so he has no
reason to alter his spending today.
Ricardo was theorizing, and
did not suggest that Ricardian
equivalence would ever be apparent
in the real world. He believed that
ordinary citizens suffer from the
same fiscal illusion as Tom in our
example, and will spend the money
on hand. However, some modern
economists argue that citizens
suffer no such illusions.
The modern debate
The idea reemerged in an article by
US economist Robert Barro (1944– )
in 1974, and modern analysis has
focused on examining the conditions
under which people spend
regardless of taxation or borrowing.
One assumption is that people are
rational decision makers and have
perfect foresight; they know that
spending now means taxes later.
However, this is unlikely to be the
case. Borrowing and lending must
also take place at identical interest
rates without transaction costs.
A further problem is that human
life is finite. If people are self-
interested, they are unlikely to care
about taxes that will be imposed
after they die. Barro suggested,
however, that parents care about
their children and often leave
bequests, partly so that their
children can pay any tax liabilities
that arise after the parents’ deaths.
In this way individuals factor into
their decision making the impact
of taxes that they expect to be
imposed even after they die.Government spending
Ricardian equivalence, which
is sometimes known as debt
neutrality, is a hot topic today
because of the high spending,
borrowing, and taxation of modern
governments. Ricardo’s insight
has been used by new classicaleconomists to argue against
Keynesian policies—government
spending to increase demand and
drive growth. They claim that if
people know that a government is
spending money to lift an economy
out of depression, their rational
expectations will ensure they
anticipate greater taxes in the
future so they will not blindly
respond to the increased amount
of money in the system now.
However, the practical evidence—
for or against—is inconclusive. ■New classical macroeconomics
US economists Robert Barro,
Robert Lucas, and Thomas
Sargent formed the school of
new classical macroeconomics
in the early 1970s. Its key
tenets are the assumption
of rational expectations
(pp.244–47) and market
clearing—the idea that prices
will spontaneously adjust to
a new position of equilibrium.
New classical theorists claim
that this applies in the labor
market: wage levels are setthrough the mutual adjustment
of supply (number of people
seeking work) and demand
(number of people needed).
Under this view everyone who
wants to work can, if they accept
the “going wage.” Therefore,
all unemployment is voluntary.
Rational expectations claims
that people look to the future as
well as the past when making
decisions so they cannot be
fooled by a government when
it chooses to borrow or tax.