A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

13

The Ricardian approach to budget deficits

Robert J. Barro

Journal of Economic Perspectives (1989) 3, Spring, pp. 37-54

In recent years there has been a lot of discussion about US budget deficits. Many economists and other observers have viewed these deficits as harmful to the US and world economies. The supposed harmful effects include high real interest rates, low saving, low rates of economic growth, large current-account deficits in the United States and other countries with large budget deficits, and either a high or low dollar (depending apparently on the time period). This crisis scenario has been hard to maintain along with the robust performance of the US economy since late 1982. This performance features high average growth rates of real GNP, declining unemployment, much lower inflation, a sharp decrease in nominal interest rates and some decline in expected real interest rates, high values of real investment expenditures, and (until October 1987) a dramatic boom in the stock market.

Persistent budget deficits have increased economists’ interest in theories and evidence about fiscal policy. At the same time, the conflict between standard predictions and actual outcomes in the US economy has, I think, increased economists’ willingness to consider approaches that depart from the standard paradigm. In this paper I will focus on the alternative theory that is associated with the name of David Ricardo.


THE STANDARD MODEL OF BUDGET DEFICITS

Before developing the Ricardian approach, I will sketch the standard model. The starting point is the assumption that the substitution of a budget deficit for current taxation leads to an expansion of aggregate consumer demand. In other words, desired private saving rises by less than the tax cut, so that desired national saving declines. It follows for a closed economy that the expected real interest rate would have to rise to restore equality between desired national saving and investment demand. The higher real interest rate crowds out investment, which shows up in the long run as a smaller stock of productive capital. Therefore, in the language of Franco Modigliani (1961), the public debt is an intergenerational burden in that it leads to a smaller stock of capital for future generations. Similar reasoning applies to pay-as-you-go social security programs, as has been

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