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Home > Another look at Ricardian equivalence: The case of the European Union

Another look at Ricardian equivalence: The case of the European Union

Another look at Ricardian equivalence: The case of the European Union

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Can European countries share their debts? This column argues that higher government indebtedness means larger household net financial assets. Thus, any pooling of European legacy debt would be considered unacceptable by countries with less government debt unless it also involved the pooling of households’ financial assets. Yet, this would be legally and technically insurmountable. The EU must face forced Ricardian equivalence: the countries with the largest legacy-debt burdens must reduce them by increasing the tax burden or, alternatively, reduce their budget expenditure.

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The so-called Ricardian equivalence suggests that a government will have the same effect on private spending whether it raises taxes or takes on additional debt to finance higher government spending. The logic behind it is that as the government gets more indebted, people would put aside more money in expectation of higher taxes in the future. However, there is no consensus on the empirical validity of Ricardian equivalence (see Seater 1993 for a comprehensive review).

However, an obvious corollary of the Ricardian equivalence is that the countries with more government debt should also be the ones with higher accumulated savings by households. A look at the situation in the EU15 countries before the Great Recession provides some empirical support to this statement. We have compared the government debt burdens and the net financial assets of households in the EU15 countries other than Luxembourg in 2007, the last year for which full data on household financial assets is available from Eurostat. To arrive at a proxy for household NFAs we subtracted the household loan stock at the end of 2007 as per the OECD statistics database from the households’ stock of financial assets1 as a percentage of GDP as calculated by Eurostat. According to Eurostat (2009), loans represent above 90% of household financial liabilities in most EU countries.

At first glance the correlation between the government debt-to-GDP ratio and the ratio of household net financial assets to GDP appeared to be rather weak, as shown in the chart below.

Figure 1. Household NFAs and government debt (2007)

Source: Eurostat, OECD, authors' calculations.

Greece

However, there is one clear outlier in the data set: Greece. Not only did it have the highest debt-to-GDP ratio among the EU15 countries, it was also the only country where government debt exceeded household net financial assets in 2007. As we know now, it was also the only country that defaulted on its government debt in the aftermath of the financial crisis, although Portugal and Ireland also required bailouts and Spain needed help to prop up its ailing banking sector. Excluding Greece from our analysis, we get a much stronger correlation with an R-squared of 0.53.

Figure 2. Household NFAs and government debt (2007)

Source: Eurostat, OECD, authors' calculations.

Finally, excluding the UK, which is the other outlier, we get a strong correlation between government debt burdens and net financial assets accumulated by households for the remaining 12 EU15 countries with an R squared value of 0.70.

Figure 3. Household NFAs and government debt (2007)

Source: Eurostat, OECD, authors' calculations.

We can thus observe that before the financial crisis hit, the countries with the highest government-debt burden were in most cases also the ones with the highest household net financial assets to GDP. The chart above also serves to debunk the still popular myth about the ‘rich Germans and poor southern Europeans’. As one can see from the above chart, measured by net financial assets to GDP, Italian households were considerably wealthier than German households in 2007, and both France and Portugal were at about the level of Germany while Spain was not far behind.

According to our estimates, at the end of 2007 the average Italian held about €53,000 worth of net financ