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Confidence in Nothing But Government

e21 | 07/25/2011 |

Economics Professor and New York Times Columnist Paul Krugman has consistently argued that the government has done too little to stimulate the economy in the wake of the financial crisis.  In many ways, he appears to have anticipated the slow growth and continued joblessness that currently plagues the American economy.  For this reason, he has a large degree of credibility with certain audiences who wish President Obama had asked for a larger stimulus package or acted more aggressively to secure an additional fiscal stimulus.  

This general line of reasoning suggests that our economic problems stem from too small a dosage of the stimulus medicine.  It’s certainly tempting to believe that government purchases can and should supplement for household and business spending whenever the two are inadequate to maintain full employment.  The problem is that believing that the government can fill this void is also partly what causes the employment and output gap to persist in the first place.  The very medicine supposed to cure the illness actually worsens it by creating uncertainty that diminishes businesses’ willingness to take risks.  

Krugman dismisses this view, arguing instead that the lack of business investment stems from inadequate demand.  But income and expenditure are two sides of the same coin: demand comes from income and vice versa.  Are businesses reluctant to hire and invest because of subdued household consumption expenditures?  Or is it businesses’ reluctance to hire and invest that reduces household income, consumer confidence, and suppresses the growth of consumption expenditures?  In the classic Keynesian models, planned business investment was considered the exogenous variable that adjusted to equate supply and demand.  This means that increases in business investment would result in increased consumption expenditure and a virtuous circle of more employment and spending.  This is the origin of the Keynesian psychological concept of “animal spirits” and the economy’s dependence on the willingness of business leaders to assume risks and increase investment.  

Krugman routinely ridicules the idea that today’s weak economy could be the unintended side-effect of government policy as belief in the “confidence fairy.”  Yet, anyone willing to listen to contemporary business leaders would immediately realize that government interventions have very badly damaged confidence and suppressed “animal spirits.”  In an earnings conference call, Wynn Resorts CEO Steve Wynn delivered a broadside against the policies of the President and the real world impact of government intervention:  

… I could spend the next 3 hours giving you examples of all of us in this market place that are frightened to death about all the new regulations, our healthcare costs escalate, regulations coming from left and right…my customers and the companies that provide the vitality for the hospitality and restaurant industry, in the United States of America, they are frightened of [the policies of] this administration.  And it makes you slow down and not invest your money. Everybody complains about how much money is on the side in America. 

You bet and until we change the tempo and the conversation from Washington, it's not going to change. And those of us who have business opportunities and the capital to do it are going to sit in fear…  

These comments were echoed days later by Bernie Marcus, founder of Home Depot.  Marcus argued that “Home Depot would never have succeeded if we'd tried to start it today.”  Much of America’s net investment and job creation comes from entrepreneurs like Bernie Marcus that try to turn small businesses into large ones.  Making the investments to go from a successful small business to a huge corporation requires a leap of faith.  In technical terms, it means that business leaders have to apply low discount rates to uncertain future cash flows.  But when the cost of regulations and future tax rates are anticipated to go up, these cash flows get discounted at higher rates to account for the cost of government.  The result is less investment and employment.    

While economics should never be reduced to relying on questionnaires of business leaders to explain outcomes, there is broad consensus in the mainstream economics establishment about the negative effects of discretionary government interventions.  In many ways, the current situation is playing out exactly as predicted.  Intervention is almost certainly responsible for the sluggishness of the recovery, which not only badly lags the 1983-84 recovery from a similarly deep recession, but is also tepid even by post-financial crisis standards.   For example, Sweden experienced a financial crisis of comparable magnitude in 1991 yet managed to grow by 8%, cumulatively, between 1993 and 1995.  The U.S. economy managed 2.8% growth in 2010 (the equivalent of 1993) and is on pace for less than 1.8% growth in the first half of 2011.   

In addition to dismissing the importance of business confidence, Krugman is also insistent that the current situation is really a “global slump.”  Just as he mocks the notion that a rollback of government intervention could increase confidence and investment, he similarly laughed at suggestions that the U.S. could export its way out of the slowdown unless we could export to “another planet.”  Yet, the IMF is not concerned about a world growing at a single, slow speed but rather the challenges posed by a global economy growing at “two speeds.”  All of developing Asia, most of Latin America, and Africa grew faster than 5% in 2010, while Northern Europe grew faster than its post-2000 trend rate.  Perhaps growth in the developing world doesn’t sound particularly important, until one considers that it accounts for 47% of the global economy (p. 171).  Indeed, the growth in Northern Europe was very much propelled by exports to these fast growing economies – an export-led growth path Krugman said did not exist.  

Krugman correctly predicted the trajectory of the U.S. economy since 2009, but this should hardly earn him a special place of honor among policymakers and analysts.  What Krugman poses is essentially a choice between persistently slow growth and high unemployment or Soviet-style command economics.  Krugman’s “expressway to serfdom” would be to increase government intervention in the economy, use the resulting decline in private sector investment as evidence of the need for more government intervention – rinse and repeat.  The long-run growth of the U.S. economy would not benefit from trading fewer Bernie Marcuses for more bridges to nowhere.    


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