Saturday, December 19, 2009

Ricardian Equivalence Anyone?

Ron Lieber at the New York Times notes that the household savings rate in America have risen in the recent year and tries to explain it.

Yet he strangely fails to note one of the more obvious explanations: household income have been boosted greatly by falling tax revenues and higher government spending. This have both increased the ability and the willingness of households to save.

The increased willingness to save reflects the so-called Ricardian equivalence. Because deficits today likely mean future fiscal austerity, higher deficits will make it rational for households to save some of the money they receive from (or don't have to send to) the government.

Because of short-sightedness, borrowing restraints, belief that government debt will increase permanently and other factors, Ricardian equivalence is unlikely to hold true fully in the sense that the increase in household savings will be exactly as large as the increase in government borrowing. However, it is likely to be partially true in the sense that household savings will increase, even if not fully as much as government borrowing.

The data does indeed suggest that the increase in government borrowing has increased household savings, but not fully as much as the increase in government borrowing.

Between the third quarter of 2008 and the third quarter of 2009, household savings increased from $235.7 billion to $489.9 billion, while government savings fell from -$724.8 billion to -$1359.8 billion. Net national savings meanwhile fell from -$15.8 billion to -$369.2 billion*. Or in other words, about 40% of the increase in government dissaving was compensated by a higher household savings rate.

Because other factors affect household savings the extent to which the increase in government dissaving caused household savings to increase may not be exactly 40%. Because the drop in asset prices can be expected to increase savings, the causal effect is probably somewhat lower, but probably still very significant.

*= All numbers are at an annualized rate. Note that government dissavings are not exactly equal to government borrowing because of government investment and capital consumption.