Rational Expectations, the stimulus and the Bush Tax cut

[Baruch Menachem]

There is an economic theory, under much debate, called the Rational expectations theory. One of its tenents is the the economy, but not the actors in the economy, has perfect information. The result of that is the government can't make much of a change in the economy in the short and medium term, because the market has discounted all the government's actions.

Under rational expectations, a law like the last stimulus can not do anything for the economy because it is a one shot deal. People know it is a one shot deal, and respond to it as such. If you get a windfall, the usual response is to pay down debt and continue to consume at the same level as before, as the windfall does not really change your income stream. People budge based on their regular earnings, not on single events.

The reason the Kennedy, Reagan and Bush tax cuts were stimulative was because they deepened the income stream, as opposed to the stimulus packages of the last 4 years which were all one shot in nature.

Extending the Bush tax cuts for two more years wont do anything for the economy. The fact they are going to expire soon is already causing folks to change their budgets, as they know they will have less money soon. The Expiration of the Bush tax cuts won't cause a huge decline in the economy, because everyone has already budgeted for them.