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Can Classical Economics Explain the Approaching Fiscal Disaster?

Today’s US fiscal predicament includes unprecedentedly high federal spending financed by inadequate tax revenue and high federal budget deficits. There is a lack of sufficient buyers of US Treasury debt. Rating agencies have recently downgraded the US debt, and entitlement benefits are forecast to outstrip their trust funds in a few years. How might a nineteenth-century English economist be relevant to this predicament?

Might this fiscal predicament be resolved naturally by rational consumers following their own instincts, thus precluding mandated top-down austerity or other harsh measures? Does our constitutional structure allow sufficient legislative and executive branch compromise to improve our fiscal trajectory? Or perhaps the only resolution is a bipartisan fiscal commission to propose a plan that Congress must vote up or down in its entirety since elected officials appear incapable of reaching compromise to resolve our fiscal circumstance.

Adam Smith and David Ricardo

David Ricardo (1772–1823) was a British contemporary of the better-known Scotsman Adam Smith (1723–90). Both men were products of their time, when liberal Enlightenment concepts saw the flourishing of individual liberty, self-governance, reason, natural law, and a separation of church and state. These eighteenth-century liberal concepts spread across the Atlantic, inspiring the American Declaration of Independence and the US Constitution, and remain the guiding principles of our country.

Smith is remembered for his book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776 following his earlier less-known work The Theory of Moral Sentiments. He considered himself a moral philosopher, never claiming to be an economist—in fact, there was no discipline known as economics at that time—but he is now commonly considered one of the founders of the discipline. He is perhaps best remembered for his invisible hand metaphor, which posits that consumers and producers following their own self-interest create a positive outcome for the entire economy. He is also remembered for advocating specialization in production and trade, refuting the widely held contemporaneous conventional wisdom known as mercantilism.

Ricardo, a London stockbroker whose family had earlier emigrated from the Iberian Peninsula, published his major work On the Principles of Political Economy and Taxation in 1817. He offered a more refined theory of trade based on comparative advantage, and is perhaps best known for his labor theory of value, which posited that the value of any product is determined by the labor expended on and embedded in its production.

The significance of this Ricardian labor theory of value cannot be overestimated, since Karl Marx lifted it wholesale when sitting in London’s British Museum writing his Communist Manifesto, published in 1848. Marx applied Ricardo’s theory to explain why the exploited proletariat class would revolt and overcome the bourgeoise to take over the means of production and form a socialist economy to replace capitalism. Marx in effect turned Ricardo’s value theory on its head to advocate socialism and assert its inevitability.

“Ricardian Equivalence,” Today’s Federal Debt, and Entitlement Trust Funds

It is Ricardo’s concept of “Ricardian equivalence,” however, that is particularly relevant to the current US federal budget deficits and debt. He theorized that during periods of government deficit spending, consumers will reduce their current consumption and increase their saving in anticipation of tax increases later in order to repay the debt. Thus, consumers are smart enough to perceive the equivalence between today’s taxation to finance government spending and later taxation to repay government debt, realizing that their choices are “tax me now or tax me later.”

The applicability of Ricardian equivalence can be extended to the impending insolvency of Social Security and Medicare trust funds. If equivalence is operative, consumers should voluntarily increase their own retirement saving in 401(k)-defined contribution plans, which have replaced traditionally defined benefit retirement plans. And indeed, such a retirement saving shift has occurred over recent decades, in part responding to employers’ matching contributions.

Does Ricardian Equivalence Actually Work?

Ricardo himself later questioned whether his equivalence notion would reduce current consumption as he had originally theorized. Were he alive today, he would question how American consumers continue spending, often amassing sizable credit card debt while the federal government runs large budget deficits, since this consumer behavior appears to defy his own equivalence paradigm.

Today’s economists have long attempted to assess the validity of Ricardian equivalence with little consensus. Harvard macroeconomist Robert Barro has defended the notion, but no one has uncovered a demonstrable relationship between deficit spending and consumer saving rates. Still, the relationship appears intuitively appealing.

Why Equivalence May Not Work as Ricardo Theorized

One can imagine several possible explanations for consumers’ continued spending in the face of unprecedented federal spending:

  • Perhaps American consumers judge that they still have sufficient savings from the three large tranches of pandemic-related “stimulus” payments that totaled over $850 billion in 2020 and 2021.
  • Or perhaps Americans simply don’t believe that the federal debt can or will ever be repaid, or that it is even a significant matter, especially since they don’t observe political leadership expressing concern about the outstanding debt or the unfunded liabilities of the Social Security and Medicare trust funds.
  • Or perhaps consumers are influenced by the recent modern monetary theory, which asserts that sovereign governments with their own sovereign currencies can spend with impunity because they can always print more of their own currency to repay the debt.
  • Or perhaps it’s because there are today no constraints on consumer spending, either cultural or government imposed. At nearly 100 percent of current gross domestic product, today’s federal debt is the highest proportionate level since the end of World War II. But during that war, the nation imposed consumer rationing in order to keep inflation under control and to reserve sufficient supply for the war effort. Consumers were encouraged to be patriotic, save money, and buy war bonds. Today there are no constraints on consumer spending, and gross domestic product continues to consist of about two-thirds of consumption expenditures. If there’s one behavior that Americans are good at, it’s consuming stuff. Not for nothing do we speak of “Shop ‘til you drop.”
  • Or perhaps it’s because Americans simply don’t fully comprehend the extent to which their federal government is in hock (now $34 trillion), how quickly the debt has accumulated in the last several years (from $6 trillion in 2000, $13 trillion in 2010, and $22 trillion in 2019), and how much interest they pay on this debt (now nearly $1 trillion annually).

What Might Enhance the Possibility of Ricardian Equivalence

There are indications that Ricardian equivalence could naturally help us with our fiscal predicament:

  • Evidence that Americans are actively increasing their saving rates and paying down debt such as revolving credit.
  • Evidence that Americans understand that entitlement programs such as Social Security, Medicare, and Medicaid comprise two-thirds of federal spending. Entitlements do not require annual congressional appropriations, whereas discretionary spending must originate in Congress. Many Americans are under the mistaken impression that defense spending is larger than entitlement spending, whereas defense comprises only about 16 percent of total federal spending.
  • Evidence that Americans are making retirement and estate plans that include sufficient funds for them and their heirs to pay annual interest on outstanding federal debt, interest that currently runs as high as $1 trillion annually and is projected to increase over time.

Conclusion

Economists of the eighteenth century may offer us concepts relevant to today’s economic problems. Ricardian equivalence may help us understand and deal with our current fiscal predicament. Yet conditions are different from the assumptions in Ricardo’s original work, and the principle may not readily apply to the current predicament.

Smith and Ricardo would have assumed that consumers would instinctively react to and accommodate excess governmental spending by reducing their own personal spending. Neither man would have suggested a governmental budget commission to deal with federal deficits and debt. Nor could they have ever foreseen the inability of the US Congress and executive branch to negotiate and compromise to address our nation’s fiscal predicament.