Ricardian Equivalence Theorem

Keynesians have the same answer whenever there’s a recession: spend, spend, spend. Then, uh...spend some more.

Who? Everyone. You, your mom, your BFF, and the government, too. The theory: spending is what makes the cogs of the economy turn. Saving slows them down. Therefore, we must spend. To get more people to spend, sometimes a government will spend money via debt. Maybe on public works, maybe as a stimulus package, maybe giving more liquidity for banks to lend out. That should get people spending, right?

Economist David Ricardo said, "I don’t think so."

The Ricardian equivalence theorem is the theory that debt-financed government spending doesn’t get people to spend more. During economically down times, people will save money. If they get more money than they anticipated, they’ll save that too. Why? Because it’s still gloomy outside, and because people expect tax increases in the future to pay off that debt the government accumulated. Ricardo (perhaps foolishly) believed people are no fools—if they see government debt rising, they know they’ll have to pay for it one day.

The bottom line? Ricardo thinks that, whether the government tries to stimulate spending by using debt or taxes, it doesn’t matter—people will behave the same. And that, therefore, a government can’t really get people to spend by spending itself.

That’s a big assertion, since most modern governments attempt to affect their economies via their central banks, doing monetary policy things. So...be mindful of whom you’re talking to on this one.