Paul Krugman, the economics Nobel laureate and New York Times columnist, likes to talk of the “confidence fairy”. It is a critique of right-wing “supply side” economists, who advocate cutting back on taxes and public expenditure and reducing government regulation. These counter the criticism that such policies suck demand out of the economy and cause unemployment with the idea that confidence in the soundness of the government’s policies would boost business investment and consumption, and so create jobs. But such beliefs have no more substance that a belief in fairies.
Mr Krugman believes in solid government management of aggregate demand of a type that is often called “Keynesianism”. He was bitterly critical of the Obama government for not trying to enact a much bigger stimulus programme in 2008, at a time when the usual criticism was that he was spending to much. These same arguments are emerging in the UK between the Chancellor of the Exchequer George Osborne and his Labour Shadow Ed Balls.
To be fair, Mr Osborne and his supporters, especially the Lib Dem ones, never made much use of the confidence fairy in the sense that Professor Krugman uses it. The confidence they that they had in mind in supporting austerity was that of investors in government bonds, and the scary consequences of losing it. But ultimately Mr Osborne does believe that business and consumer confidence will provide the economic growth and employment he seeks. But what fewer people understand is that the policies advocated by Mr Balls and Professor Krugman require the confidence fairy too.
Let us consider the logic of the “Keynesian” stimulus. Cut VAT as Mr Balls suggests and put this money in consumers’ pockets, who go out and spend it, creating jobs, which create further demand. The Keynesian multiplier (no need for quotation marks here) does its stuff and £10bn of government stimulus might increase total demand in the economy by perhaps £20bn in a year. But then what? The extra demand has helped offset the cost (so the £10bn direct cost has been reduced to perhaps £6bn), but the national debt has still gone up. But growth drops back to zero (or worse) unless there is yet another stimulus package of yet more tax cuts or government spending programmes. To the extent that these measures are temporary (such as the temporary tax cuts advocated by Mr Balls, or the job programmes and extensions to unemployment benefit favoured by Professor Krugman) then the whole process goes into reverse, multiplier and all. And if the programmes aren’t temporary, the government structural deficit has just got a lot bigger. Unless the confidence fairy waves her magic wand.
And it is this boost in confidence that lies behind the case for government stimulus. It is reinforced by the metaphors used to describe it, such as “kick-start”, “getting the economy moving” or the word “stimulus” itself. A catalyst that improves confidence and hence gets businesses to invest and consumers spending more and saving less. And the results would indeed be magical. By spending and borrowing more you would reduce borrowings in the medium term by more than a strategy based on austerity. But without the fairy it works no more than the supply-side policies do. The problem is deferred and made worse, not solved.
So can such a stimulus boost confidence? In the right circumstances it certainly could, such as those induced by a temporary external shock, perhaps literally as in an earthquake (one of the reasons why earthquakes seem to do such little damage to an advanced economy). And here there is a genuine divergence of view. Mr Balls, who perfectly literate economically, does not believe that the British economy pre crisis was fundamentally unsustainable, and so thinks that it should be relatively easy to recover the lost ground. In economist-speak the British economy has plenty of spare capacity. A number of professional economists, including the FT’s Samuel Brittan, one of my heroes, seem to agree. But government economists and many others, apparently including the independent Office for Budget Responsibility, disagree. The previous economy was over dependent on debt spending by consumers and government and cheap imports, sustained by an overvalued exchange rate and financial support from abroad that can no longer be counted on. Mr Brittan thinks that the lower capacity of the economy is a self-fulfilling prophesy (i.e the longer the economy is depressed, the more difficult the recovery), but personally I think that the 2007 economy was in a very bad place, and was always going to take a long time to sort out.
But even if you don’t accept this, there is another problem. The extra confidence induced by a stimulus package can be overwhelmed by outside events, such as the Euro crisis. The UK economy, much more than the US one, is dependent on the world economy and is open to such shocks. Right now looks the wrong time to bet on a calm world economy.