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.
Good post, much better and more reasonable than Krugmans arrogance.
But you describe what I had been thinking shortly before reading your post, these so called right-wing supply-siders, and left-wing government stimulators are basically saying the same thing.
They want to create employment by encouraging medium term spending by encouraging shortterm confidence, and seem to believe that ever increasing confidence automatically produces good results.
But surely does not. Is it not possible to be overconfident ?
I owned part of a house in 2007, my family wanted me to buy them out so my brother could buy his own, I refused saying I was not confident that the housing market was valued correctly.
Turns out, I was right to have less confidence than them..
Wealth can’t just be ever increasing inline with ‘confidence’ there becomes hard limits, largely in modern times dictated by the costs of havesting natural resources, food, energy.
So I disagree with both ideas.
Confidence does not drive the economy (although agree that an unfounded ‘scare’ can have a short term negative effect).
We first must produce the wealth before we can spend it. Its no coincidence that those Asia countries focusing on production are seen as the rising powers. They don’t borrow like Brown, and the PIIGS.
Yes there is such a thing as overconfidence, and a lot of the supposedly golden decade before the crisis was built on it. Confidence is still a necessary precondition of progress. But wealth and growth need to have solid foundations, and many macro-economists, like Krugman, simply assume that these take of themselves, while they pontificate about aggregate statistics like national income.
I think I’d look at it the other way around though.
You say confidence is a necessary precondition of progress.
I’d say solid foundations are a necessary precondition for real (as opposed to just wishful thinking) confidence.
You say Krugman assumes the foundations will take care of themselves if we have enough confidence. Both confidence with legitimate reason or otherwise..
I’d say confidence can take care of itself quite easily, as long as we have the foundations right.
It really does seem to me, that they have it backwards.
For me, strong foundations mean a few things, but especially having a debt that is within a managable size. (smaller than what we have now).
An apprenticeship program to get the young integrated into the work force. We can’t have a strong economy in the long term when so many of the young are sidelined.
A secure and properly managed energy supply.
Key issues I believe the previous government got badly wrong.
I know there are many more issues, but I didn’t wanna go on too much.
I will read more posts.
Do you not think that it is actually very dangerous for the government to be trying to throw money at the problem, without doing a better job at sorting out the foundations first?
If you have a losing business model and you pump more money into the business you simply lose more money in the long run, without the right changes taking place.
I don’t understand why they push ahead with ‘high-speed’ rail in the current economic climate, costing them 30billion+.
If these projects were so great for the economy why didn’t we do them before?
I believe the government are simply cluching at straws, so they can tell people they are ‘doing something’.
@ “no”
The thing is “building the foundations” in reality isn’t free. Apprentices have to eat. On an individual employer level, only an idiot would turn down the chance for state subsidised labour as a close to like-for-like replacement, rather than a supplement, for their existing workforce. These schemes, as you suggest later, look good on paper, with stats of how many people are benefiting from them and how much economic activity that has flown from it. But they have unintended consequences that often negate their benefit.
The problem is not an obsession with confidence, but an obsession with GDP growth.
Well agree with that, and GDP ‘growth’ is recently mostly just manipulated statistics imo, especially in the last few years.
They say the financial crisis has cost us 5 years GDP growth. nonsense, if we had really grown that much it wouldn’t have disappeared so easily.
We lost it, because it wasn’t really there.
I understand getting good foundations aren’t free. But apprenticeship programs in this country were common until we recently decided 50%+ needed to go to University. So I’m not suggesting something new, but going back to what worked in the past.
Paying people to live on benefits costs a lot of money, I would suggest simply some of that money to a business for 2 year of on the job training. Obviously there would need to be some rules, such as you can only get it if you are employing extra people, not replacing existing staff.
Isn’t it the obsession with GDP that causes the obsession with confidence.
GDP is based on the amount of spending going on within the economy, the government want to boast about increased GDP, so they try to trick people into spending more by trying to create a false air of confidence.