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Hal Snarr: More on Fiscal and Monetary Folly

February 24, 2017

“You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time”. – Abraham Lincoln


Economists have long understood the effects of rational expectations on the economy and policy-making. Irving Fisher recognized that current spending depends on current and expected future income. Although John Maynard Keynes’ consumption function implies that spending depends on today’s disposable income, he acknowledged that “waves of optimism and pessimism” could affect economic activity. Milton Friedman’s permanent income hypothesis implies that current consumption depends on the present value of expected future incomes.

After Milton Friedman and Edmund Phelps pointed out that monetary stimulus does not affect unemployment over the long run, because workers can only be fooled into accepting employment at inflated wages in the short run, Robert Lucas took and ran with this idea all the way to the 1995 Nobel Prize. After adapting microeconomics’ rational expectations to macroeconomics, he concluded that monetary policy could only work over the long run—if money grows at a rate that was more than expected.

Rational expectations theory implies that you can fool most of the people in the short run, but you cannot fool most of the people over the long run. If it is ignored, mainstream macroeconomics says fiscal stimulus can boost aggregate demand. In the hypothetical situation modeled in the figure below, aggregate demand shifts from the black line labeled AD to the gray line. As aggregate demand increases (from point A to point B), high unemployment declines toward its natural rate.

The loanable funds market above shows why fiscal policy is fiscal folly. When Treasury supplies more bonds to finance fiscal stimulus, it demands more loanable funds. This shifts loanable funds demand from the black line labeled DLF to the gray line. This results in a higher interest rate—assuming the Federal Reserve does not intervene. Higher interest rates reduce private investment and increase foreign purchases of U.S. securities. U.S. exports fall as foreign investors demand more dollars. These effects combine to push aggregate demand back down to point A.

Under rational expectations theory, households anticipate that government will raise taxes in the future to retire bonds it used to finance today’s fiscal stimulus. Because this will reduce future economic activity and disposable incomes, people will save the money they receive from today’s fiscal stimulus to pay tomorrow’s higher taxes. The resulting increase in savings means consumption and investment do not rise by what government had expected when it enacted fiscal stimulus. Instead of aggregate demand shifting outward, it remains at point A, and unemployment remains high.

The increase in savings also raises loanable funds supply from the black line labeled SLF to the blue line passing through point E. Since financing fiscal stimulus pushed demand from the black line labeled DLF to the gray line that also passes through point E, the loanable funds market equilibrates at point E. At the new equilibrium, private investment remains unchanged at $10 trillion, and the $500-billion fiscal stimulus, which had raised loanable funds to $10.5 trillion, is financed at the same rate as private investment, 2.5%.

Thus, fiscal stimulus is impotent in rational expectations theory because it has no effect on private investment, exports, GDP, interest rates, and unemployment. Recent experience with tax cuts and rebates supports this conclusion. According to Gary Shilling, “consumers saved 80% of the tax rebates they received in the summer of 2008. And they initially saved 100% of 2009’s tax cuts and special payments [to each] Social Security beneficiary” (“The Chances of a Double Dip,”, 9/20/2010)

Since 2008, the Congress, President and Federal Reserve have enacted historic fiscal and monetary stimulus. The Fed paid banks interest on reserves, kept interest rates near zero, and digitized trillions of dollars in new money. Congress and the President temporarily cut taxes, spent billions on shovel-ready projects that were not shovel-ready, and raised government debt to $20 trillion. The doubling of government debt, the trillions of idle new dollars that are waiting to become inflation, and the growth of onerous regulation are infringing on our personal and economic liberty. This lose in liberty is reflected in our country’s economic freedom ranking dropping 12 spots from fifth in 2008 to 17th today (see

The solution to the near decade-long recessionary gap is more personal and economic freedom, not more fiscal and monetary policy. In our heart of hearts, we know this to be true. We buy products and services from businesses that are relatively free of government intervention, and from enterprises that are heavily regulated, managed, or owned by the government. In the former, prices generally fall and quality tends to rise (e.g., Lasik eye surgery, cellular phones, tablets, electronics, software, and computers). In the latter, there is inflation, stagnant quality, inefficiency, or moral hazard (e.g., health care and insurance, telephones prior to the Bell System breakup, banking, public education, and U.S. Postal Service).

With all the economic stimulus that was thrown at a near decade-long recessionary gap, it is time to seriously consider ending monetary and fiscal folly.


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