At Least One Cheer for Rational Expectations


Robert Frank takes on the argument from rational expectations against a stimulus bill:

[Lee Ohanian’s] argument, and that of stimulus opponents generally, thus boils down to this striking contention: As the government spends borrowed funds, consumers will start to realize that the resulting debt spells higher taxes in the future, which will lead them to curtail their current spending. Those cuts will offset increased government spending, leaving no net stimulus.

Although there may be people who would actually spend less now to hedge against uncertain future tax bills, it’s unlikely that you know any of them. As behavioral economists have been saying for decades, that’s just not the way most people act. Hardly any consumers even know how big the national debt is, much less how it will affect future taxes.

This is all true, but it’s worth noting that the conclusion doesn’t follow even if we stick to strong rational expectations. As Brad DeLong says “Increased nominal government spending financed by future taxes is crowded out by a reduction in nominal private consumption spending if and ony if what the government spends money on is a perfect substitute for what private consumers spend money on.” And of course that’s not true.