David Ricardo, the British economist who died in 1823, gave the world two deep economic insights. The first, the concept of comparative advantage, became economic gospel, used ever since to justify specialization and trade. The second, the concept of Ricardian Equivalence, has become almost as universally accepted.
Ricardian Equivalence asserts that only the amount of government spending matters, not how it is financed. This is the same thing as saying government debt does not matter. The logic is that taxpayers aren’t stupid. They see the debt as future taxes and save exactly what they need to pay the tax at some future date.
Now, Reinhart and Rogoff, in their highly recommended book “This Time is Different: Eight Centuries of Financial Folly,” provide evidence that high debt levels cause slower economic growth. They report a threshold: When debt exceeds 80 percent of GDP, gross product growth slows two percent. Today, David E Sanger, in a New York Times piece says “two numbers stand out as particularly stunning:”
“The first is the projected deficit in the coming year, nearly 11 percent of the country’s entire economic output. That is not unprecedented: During the Civil War, World War I and World War II, the United States ran soaring deficits, but usually with the expectation that they would come back down once peace was restored and war spending abated.
But the second number, buried deeper in the budget’s projections, is the one that really commands attention: By President Obama’s own optimistic projections, American deficits will not return to what are widely considered sustainable levels over the next 10 years. In fact, in 2019 and 2020 — years after Mr. Obama has left the political scene, even if he serves two terms — they start rising again sharply, to more than 5 percent of gross domestic product. His budget draws a picture of a nation that like many American homeowners simply cannot get above water.
For Mr. Obama and his successors, the effect of those projections is clear: Unless miraculous growth, or miraculous political compromises, creates some unforeseen change over the next decade, there is virtually no room for new domestic initiatives for Mr. Obama or his successors. Beyond that lies the possibility that the United States could begin to suffer the same disease that has afflicted Japan over the past decade. As debt grew more rapidly than income, that country’s influence around the world eroded.
Or, as Mr. Obama’s chief economic adviser, Lawrence H. Summers, used to ask before he entered government a year ago, “How long can the world’s biggest borrower remain the world’s biggest power?””
These are clearly challenges to the concept of Ricardian Equivalence. So, why would Ricardian Equivalence not hold? I think the answer is that Ricardian Equivalence holds for relatively normal debt levels, but it falls apart at high debt levels. Why?
One reason may be that at very high debt levels it becomes clear that future generations will be paying a significant portion of the debt. To the extent that taxpayers value their own consumption over their decedents’ consumption, the motivation to save is reduced. Economists have long accepted a bequeath motive for savings. So, this argument is not particularly persuasive to me.
A more believable reason is the one implied by Reinhart and Rogoff and by Summers: High debt levels increase the probability of default or inflation, a slow form of default. This would explain both low savings levels and challenges from other governments.