Does Stimulus Spending Work?

The Case against Ricardian Equivalence

by Joe Blackwell

Today the use of fiscal policy (expanding government spending or reducing taxes) to stimulate GDP growth in times of recession has become one of the most controversial policy areas of modern macroeconomics. For those who favour free market based solutions, commonly known as neoliberals, interventionist fiscal policy is inherently wasteful and distorts the processes of the market system. On the other side of the debate are the various groups of Keynesians who see fiscal policy as a crucial stabilisation tool to prevent the economy entering a deep and prolonged recession.

The case for stimulus spending is often based on John Maynard Keynes’s concept of the paradox of thrift. This is a simple idea that during a recession businesses and consumers will cut back on their spending thus making the recession worse. This is because as consumers cut back on their spending, the revenue of businesses will fall and eventually they may have to reduce the amount of labour they employ, leading to further decreases in consumer spending as unemployment goes up. The concept highlights the fact that what is perfectly sensible and rational behaviour at the (micro) individual level can have negative consequences for the macroeconomy (at the aggregate level).

The dynamics then become a self-reinforcing cycle known as the downwards multiplier that, when left unchecked, can lead to a deep and prolonged recession. Fiscal policy is a tool that can stop and reverse this cycle as it is an injection of extra income into the economy that boosts the spending power of consumers. For example, let’s suppose that in response to the onset of a recession the government increases spending on infrastructure investment. This means that the government will need to employ labour that has been left unemployed by the recession (the downwards multiplier). The workers employed by the government infrastructure projects will receive a wage in exchange for their labour. This wage will therefore allow them to substantially increase their consumption spending, relative to their unemployed level of spending, which will increase business revenues.

If the fiscal stimulus is large and prolonged enough, the increase in business revenues will mean businesses will want to increase output to meet the extra demand for goods and services in the economy – this will increase their use of labour which will decrease the unemployment rate. This will then lead to an upwards multiplier as the newly employed workers are able to increase their consumption spending therefore increasing the demand for goods and services further and putting more pressure on businesses to employ more workers from the pool of unemployed labour. This process therefore reverses the downwards multiplier triggered by the recession and creates an upwards multiplier to stimulate the economy out of the recession.

The above argument relies on the crucial assumption that consumers will spend a substantial portion of the extra income the government injects into the economy. Mainstream neoclassical economics and neoliberalism rejects this assumption and instead argues in favour of a concept called Ricardian Equivalence.

This concept argues that consumers are rational and forward looking therefore they won’t spend any of the extra income the government injects as they know that any increased government spending today will have to be offset by higher taxes in the future, therefore rational forward looking consumers save all of the extra income to pay for the higher taxes in the future. Since the consumer doesn’t spend any of the extra income there isn’t a multiplier and government attempts to stimulate growth using fiscal policy are completely futile and wasteful.

In recent years neoclassical economics have begun to accept that credit constrained consumers will spend all of the extra income since they would like to spend more anyway but are prevented from increasing their consumption spending by their inability to borrow. The Ricardian Equivalence effect still applies, however, and any increase in consumption spending today will be followed by decreases in consumption spending in the future, as the consumer saves in anticipation for higher taxes. So according to neoclassical economics, the multiplier either doesn’t exist or is offset by a negative multiplier in the future.

For the sake of argument, let’s accept the assumption that consumers are perfectly rational and forward looking (despite how flawed this assumption is). Would it be rational for a consumer to assume that increased spending today has to be paid for by increased taxes tomorrow? The simple answer is no.

Data source:

Taking the US as an example, the Federal Government has ran a surplus (taxed more than it’s spent) for only 14 years since 1929 and, as the graph shows, the government has sustained deficits (spent more than it’s taxed) for most of the 89 year period shown. The trend is overwhelmingly that increased spending today is usually not followed by increased taxes in the future and the US Federal Government is able to run a deficit on a consistent basis. Therefore the Federal Government spends more than it taxes and boosts the economy’s income, which contradicts the assumption of Ricardian Equivalence – that extra government spending raises income today, but decreases it in the future in the form of higher taxes.

A rational forward looking consumer is far more likely to expect taxes not to increase in the future and therefore it would be irrational for them to save all of the extra income injected into the economy by the government when they could increase their consumption. Modern Monetary Theory (MMT) shows that because the USA is a currency issuing country on a free floating exchange rate system, the federal government can never run out of US Dollars and therefore can run a deficit on a consistent basis indefinitely. The constraint on the size of the deficit is the availability of real resources for businesses to increase output, not a budgetary constraint.

The empirical evidence suggests that fiscal policy is an effective stabilisation tool to smooth out recessions and prevent losses in output and prolonged increases in unemployment.

Data Source:

The New Deal is one of the biggest examples of a fiscal stimulus in the history of industrial capitalism; so it is a good empirical example with which to judge the merits of fiscal stimulus policies. From 1929 to 1933, during the depths of the Great Depression, GDP growth averaged -7.26% with a low of -12.89% in 1932. The first New Deal measures were then introduced over 1933 and 1934 which led to an expanded federal deficit which successfully stimulated growth to 10.78% in 1934, and with it peaking at 12.94% by 1936. This strongly suggests that the fiscal stimulus was successful at producing an upwards multiplier and implies that consumers spent the extra income. Thus, Ricardian Equivalence is an inaccurate model of human behaviour.

Another empirical example is the UK after the 2008 Financial Crash and the resultant austerity policies of the Conservative led coalition government formed in 2010.

Data Source:

Prior to the new administration in 2010, the incumbent Labour government responded to the 2008 Financial Crash with a moderate fiscal stimulus. At its deepest the recession led to a real growth rate of -2.2% in the final quarter of 2008. After public spending was increased by the Labour government, growth peaked at 0.9% in the second quarter of 2010. Once the Conservative coalition started to introduce its austerity policies in the final quarter of 2010, growth dropped to 0.1% and the economy wouldn’t reach the 0.9% post-recession peak again until the third quarter of 2013 (excluding the one of stimulus of the London Olympics in the third quarter of 2012). The evidence suggests that the austerity policies pursued by the Conservative coalition had a negative impact on the UK’s GDP growth, which implies that austerity led to downwards multiplier effects as the government spent less into the economy and therefore negatively affected the spending power of consumers.

Ricardian Equivalence is a key part of why neoclassical economics rejects fiscal policy as a stabilisation tool, but as argued above, the idea doesn’t survive the most basic of theoretical and empirical scrutiny. Despite what mainstream economists might argue, Keynes is still absolutely relevant.

Joe Blackwell is a London based economics student with an interest in MMT, Post Keynesianism and critiques of orthodox economics. His undergraduate background was in political science – the effect of economic conditions on the rise of populism in Europe and the USA. Joe can be reached over Twitter: and Email:

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