When the Tooth Fairy Meets Goldilocks

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.

Immediately 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:

If there is literally no demand for borrowed funds, why won’t people just hoard currency?If they hoard currency, why won’t prices fall even more?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’ solution.

Keynes’s 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 (1936).

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. 131)

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 power.

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 isn’t.

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 goods.

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.

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

July 19, 2006

Gary 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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