In “Boost Private Investment to Boost the Economy,” Hal Varian provides an excellent, succinct description in today’s WSJ of the basic problems we face in the economy today. He starts by saying,

These days it seems like it is our patriotic duty to consume more. And if we don’t choose to spend more money ourselves, the government will do it for us.

But wait a minute. Isn’t it excessive spending that got us into this mess in the first place? Spending more now seems like drinking Scotch to cure a hangover.

This apparent paradox is straightforward to explain. The problem is that excessive spending by some individuals, facilitated by easy credit, put them under water in a market with declining property values. The subsequent defaults, and the prospect of future defaults, weakened the financial sector by substantially raising the risk of borrowing, and hence lending slowed precipitously last summer. The meltdown in finance in September inspired the FED/Treasury interventions designed to preserve confidence in the system but at the same time inspired fear across the world by revealing the likelihood that the economy would plummet into a recession.

The average household around the world is now faced with two financial problems, even if they have not previously overborrowed and are not underwater on their mortgage. First, household wealth has fallen with the drop in real estate and stock markets, thus everyone feels poorer – since on paper they are. Second, the prospect of a possibly severe recession, with rapidly rising unemployment, raises the chances that one will lose his or her job. The natural response to both of these realities is to protect what one has by spending less and saving more.

Unfortunately when everyone consumes less and saves more at the same time, the economy gets worse rather than better, especially, as Varian points out, when that savings does not flow into additional private investment as it would in normal times.

If only we could inspire all of the people who will not lose their jobs and who are not underwater on their mortgages (and this describes most people in the economy) to spend and consume like they have traditionally done, then the economy would not sink so deeply. Unfortunately, no one knows whose jobs will be safe – there is no way to predict that – and hence it makes individual sense to be cautious in spending.

But what I wanted to emphasize in this post is that we should be cautious about broad sweeping statements to describe the economy. For example, we should not say that Americans have borrowed excessively and spent too freely, because this describes only some Americans, not all. Many Americans are living within their means, although we never hear about this in the popular press because people always present the averages, or the popular impressions, as if that describes everybody equally.

Thus, it is true that some Americans have borrowed excessively and been forced into default and it is also true that the size and extent of these defaults have crippled our financial system for the moment. However, at the same time it would be best if those households who have not overborrowed would maintain their consumption at previous levels. Since that seems unlikely to happen naturally, for the reasons described above, massive government spending plans, with all their inherent complications and difficulties, are the policy choice of the day.