Functional finance and Ricardian equivalence

25 May, 2021 at 08:30 | Posted in Economics | 6 Comments

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:

Finally, 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. There are a number of reasons for this.

dec3bb27f72875e4fb4d4b62daebb2fd161b36392c1a0626f00cfd2ece207d84First, 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.

Second, 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.

Third, as the national debt increases, and with it the sum of private wealth, there will be an increasingly yield from taxes on higher incomes and inheritances, even if the tax rates are unchanged. These higher tax payments do not represent reductions of spending by the taxpayers. Therefore the government does not have to use these proceeds to maintain the requisite rate of spending, and can devote them to paying the interest on the national debt.

Fourth, 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. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (possibly through a corporation in which he has shares), and who regards these obligations as part of his private fortune. The greater the private fortunes the less is the incentive to add to them by saving out of current income …

Fifth, if for any reason the government does not wish to see private property grow too much … it can check this by taxing the rich instead of borrowing from them, in its program of financing government spending to maintain full employment. The rich will not reduce their spending significantly, and thus the effects on the economy, apart from the smaller debt, will be the same as if Money had been borrowed from them.

Abba Lerner

Even if most of today’s mainstream economists do not understand Lerner, there once was one who certainly did:

I recently read an interesting article on deficit budgeting … His argument is impeccable.

John Maynard Keynes CW XXVII:320

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.

Robert Barro attempted to give the proposition a firm theoretical foundation in the 1970s.

So let us get the facts straight from the horse’s mouth.

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

Suppose now that households’ demands for goods depend on the expected present value of taxes—that is, each household subtracts its share of this present value from the expected present value of income to determine a net wealth position. Then fiscal policy would affect aggregate consumer demand only if it altered the expected present value of taxes. But the preceding argument was that the present value of taxes would not change as long as the present value of spending did not change. Therefore, 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.

Since desired national saving does not change, the real interest rate does not have to rise in a closed economy to maintain balance between desired national saving and investment demand. Hence, there is no effect on investment, and no burden of the public debt …

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 — mirabile dictu — didn’t believe in Ricardian equivalence. In “Essay on the Funding System” (1820) he wrote:

But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. 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.


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  1. While I agree with much of Lerner’s material and with MMT, I object to Lerner’s claim that ” the purpose of public debt is to achieve a rate of interest which results in the most desirable level of investment.” That assumes that bureaucrats in charge of the debt at the Treasury or wherever have a better idea as to what the “most desirable level of investment” is than market forces. Anyone making that sort of claim needs to back it up with some very good evidence as to why the market gets this wrong, and Lerner fails to do a decent “back up” far as I know.

    • Markets are very very bad at making decisions about investing which is why we have massive overshoots and undershoots. Look at semiconductors, that business is in a permanent state of chaos due to bad investments, and don’t even get me started on fracking, Uber, Netflix, WeWork, etc etc etc

  2. The entire discussion misses that Treasuries are used in repo markets to fund investment. The repo price of Treasuries is independent of the yield. The government debt has a price on markets that is independent of taxes. You trade Treasuries overnight, so you aren’t waiting for the government’s tax money.

  3. Lars,
    You might want to consider this passage from Keynes’ GT (p. 94) where he was was discussing factors affecting the propensity to consume (and therefore also the propensity to save):
    “Changes in Fiscal Policy – In so far as the inducement to the individual to save depends on the future return which he expects, it clearly depends not only on the rate of interest but on the the fiscal policy of the Government. Income taxes, especially when they discriminate against “unearned” income, taxes on capital-profits, death duties and the like are as relevant as the rate of interest; whilst the range of possible changes in fiscal policy may be greater, in expectation at least, than for the rate of interest itself.”
    This sounds very close to Barronian (we won’t call it Ricardian) equivalence.

  4. Dear Lars,

    What I don’t quite understand is the following: If it has been established that David Ricardo thought the exact opposite of what the “Ricardian” equivalence claims, why everyone keeps referring to it as if it were his idea or theory?

    Isn’t this an archetypal example of perpetuating ignorance?

    • You’re, of course, absolutely right. This is a misnomer as gross and misleading as when
      economists call themselves ‘New Keynesians’ when in fact their theory and models have pretty little to do with Keynes!

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