When the Tooth Fairy Meets Goldilocks

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The war is
the Middle East is escalating. The U.S. stock market is down because
of this. Investors perceive that these events could lead to higher
oil prices. They perceive that this would be bad for the economy.

The problem
is, the upward move of the stock market since 2003 has paralleled
both the two-front war and rising oil prices. What was it about
the war that seems to have been beneficial for the stock market?

Ever since
1940, when the U.S. unemployment rate fell in the wake of Great
Britain’s wartime spending on American-made armaments, popular economics
has concluded that war is good for business, just so long as the
American home front is out of the line of fire.

The economic
reasons why U.S. employment rose during World War II are never discussed
in history textbooks or economics textbooks. There were two main
reasons: (1) inflated dollars, coupled with price controls and rationing,
pushed down real wages, thereby increasing the demand for labor;
(2) approximately 12 million men were drafted and taken out of the
domestic labor markets.

after World War II ended, but before price controls were removed,
the United States government began to fight a new war: the Cold
War. From that time until now, government spending on the military
has remained part of the economists’ "tool kit" of policies
to overcome unemployment.

I call this
approach to economics "tooth fairy economics."

My parents
played the tooth fairy game with me. I briefly believed that old
teeth had a market value. They also told me that Santa Claus brought
me presents. Briefly, I believed that a man in a red suit and a
white beard — a Karl Marx look-alike — brought free goodies to good
little girls and boys. But, eventually, they told me the truth.

Modern tooth
fairy economics takes the level of implausibility up a notch. War
is part of the fairy’s tooth-extraction program. She knocks out
teeth in order to give adults the raw materials required in her
wealth-creation program. In political circles, this is called guns
and butter. I call it Keynesianism with an attitude.


I decided early
in life that I would never believe in tooth fairies again, of any
variety. That is what kept me from becoming a Keynesian economist.

When I was
in college, almost every academic economist was a Keynesian. Why?
Because they just could not shake off the emotional effects of their
childhood belief in the tooth fairy. They merely shifted their faith
to a different fairy.

Keynes — pronounced
"Canes" — believed that the Great Depression was caused
by inadequate consumer spending. Individuals were saving far too
much money, but they were not investing it properly. Businesses
should have been hiring new workers. But there was low or falling
demand for goods and services, so business owners were unwilling
to borrow to expand production except to buy labor-saving equipment,
leading to additional unemployment. Here is a standard explanation
of Keynes’ theory. It appears in the Wiki encyclopedia.

To Keynes,
excessive saving, i.e. saving beyond planned investment, was a
serious problem encouraging recession even depression. Excessive
saving results if investment falls, perhaps due to falling consumer
demand, over-investment in earlier years, or pessimistic business
expectations, and if saving does not immediately fall in step.

Does this sound
reasonable to you? If it does, then you should ask yourself the
following questions:

  1. If there
    is literally no demand for borrowed funds, why won’t people just
    hoard currency?
  2. If they
    hoard currency, why won’t prices fall even more?
  3. When prices
    fall far enough so that some people think the bottom has been
    reached for the items they want to buy, why won’t they spend their
    hoarded currency?

The price of
goods cannot fall to zero. We live in a world of scarcity. We do
not live in the Big Rock Candy Mountain. So, at some point, consumers
will start spending.

Keynes’ position
assumes that people are either irrational or uninformed about what
to do with their own money.

I ask: What
is it about economic freedom that leads to bad results for the overall
economy when people act in their own self-interest, based on the
information available to them in their specific situations?

Then there
is Keynes’

theory suggested that active government policy could be effective
in managing the economy. Rather than seeing unbalanced government
budgets as wrong, Keynes advocated what has been called counter-cyclical
fiscal policies, that is policies which acted against the tide
of the business cycle: deficit spending when a nation’s economy
suffers from recession or when recovery is long-delayed and unemployment
is persistently high — and the suppression of inflation in boom
times by either increasing taxes or cutting back on government
outlays. He argued that governments should solve short-term problems
rather than waiting for market forces to do it, because "in
the long run, we are all dead."

This is a correct
summary of Keynes’ position. He wrote this in his magnum opus, General
Theory of Employment, Interest, and Money

Ancient Egypt
was doubly fortunate, and doubtless owed to this its fabled wealth,
in that it possessed two activities, namely, pyramid-building
as well as the search for precious metals, the fruits of which,
since they could not serve the needs of many by being consumed,
did not stale with abundance. The Middle Ages built cathedrals
and sang dirges. Two pyramids, two masses for the dead, are twice
as good as one; but not so two railways from London to York. (p.

He was a defender
of government make-work projects. When we were children, teachers
assigned us busy work to keep us occupied. Eventually, we caught
on: the work was not meaningful. It was wasting our time. Keynes
advised the governments of his era to imitate our teachers.

If the Treasury
were to fill old bottles with banknotes, bury them at suitable
depths in disused coal mines which are then filled up to the surface
with town rubbish, and leave it to private enterprise on well
tried principles of laissez-faire to dig the notes up again. (Ibid.,
p. 129)

While Keynesian
economics textbooks rarely quote his words, which are too embarrassing,
they present equations that show — or seem to show — that the solution
to unemployment is government spending. The government can spend
its money on projects that will create demand for labor.


What is the
answer to this line of reasoning?

First, where
does the government get the money to increase spending? There are
only three sources: (1) new taxes; (2) borrowing from the public;
and (3) selling IOUs to the central bank, which creates money out
of nothing to buy the IOUs.

Taxation removes
money from one group in order to hand it over to another group (minus
handling charges). Borrowing removes money from one group, backed
by the legal power to tax people in the future, to then hand it
over to another (minus handling charges.)

The third approach,
monetary inflation, is an indirect form of taxation. It redistributes
real wealth to those people who gain early access to the newly created
money, who then spend it at yesterday’s prices. Then the new money
pushes up prices. The late-comers pay because of reduced purchasing

The second
answer is to follow the money. Whatever is spent by the recipients
of government spending, including the government bureaucrats who
administer the spending programs, is not spent by the taxed groups
or the groups that lend money to the government.

In other words,
there is no such thing as a free lunch.

Put differently,
there is no tooth fairy.

Third, with
the exception of those few people who hide currency at home, the
money that would have been saved by the taxed groups or the lending
groups would have been used by businessmen to buy something. The
largest component of all purchases goes to labor. A small percentage
— usually under 10% — goes to raw materials owners. The more advanced
the economy, the lower this percentage is. So, someone receives
the money. The money is always in someone’s bank account.

The Keynesians
tell us what a great benefit the government offers to the public
at large: lots of new spending. Businesses will increase hiring
in order to meet the expected new demand provided by the government
and its designated spenders.

To see what
is involved in this line of thinking, think of the government as
a pickpocket.

You ask yourself:
"What about all those people who had their wallets lifted?
What happens to their spending?" You ask this because (1) you
never really understood your one college course in economics, and
(2) you read articles like this one. There are not many people like
you. They don’t constitute a major voting bloc.


Butter is a
consumer good. Except in the surplus goods stores, military equipment

When scarce
resources are used to create new consumer goods, the result is new
demand, assuming that the buying public wants these new goods at
the prices offered. This demand comes from people as producers.
They have wealth to trade.

When resources
are used to create weaponry, there is monetary demand from those
who produced the weapons, but there is a reduced supply of consumer
goods. The resources that were used to create weapons are not used
to produce new consumer goods.

If the Federal
Reserve System does not buy assets, it’s a case of "existing
money chasing fewer goods." If the FED does buy U.S. debt in
order to hold down interest rates, then it’s a question of "new
money plus old money chasing fewer goods." The reality is fewer

The inflationists
insist: "You can’t eat gold!" We can’t eat nuclear aircraft
carriers, either.

As wars in
the Middle East escalate, the American economy will get poorer than
it would otherwise have been.

The investing
public believes in tooth fairy economics. Like Goldilocks, investors
don’t want too much war, but they don’t want too little, either.
They want a "just right" amount of war.

There is a
growing perception that the American economy is moving from "just
right" to "too much" war. The stock market is reflecting
this concern.


We are caught
in a lobster trap. We cannot back out until the voters decide that
getting out of the trap is more important than worrying about being
labeled "cut and run." So, the Administration pushes the
nation more deeply into the trap, in the ever-fading hope that there
is a solution ahead.

Now that the
State of Israel is at war on two fronts, with armed Arab revolutionaries
on both borders in the position of being able to hit and run at
will, it has become apparent that democracy has failed in the Islamic
Middle East.

Lebanon is
democratic. Its government remains powerless to deal with Hezbollah,
which has elected representatives in the government.

The Palestinian
Authority is democratic. Hamas was elected to run it.

Iraq is democratic.
It is moving into civil war.

Iran is democratic.
It is run by a populist with a Ph.D. in engineering and a desire
to extend Iran’s influence, meaning Shi’ite influence, across the
Middle East. He wants Israel pushed into the sea.

Result: more
guns, less butter.

who thinks that it’s morning for the U.S. economy is a victim of
tooth fairy economics. Mourning, maybe.

19, 2006

North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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