One of the key macroeconomic policy decisions looming is whether to implement another fiscal stimulus program. Because unemployment remains stubbornly high, many are contemplating the advice of Paul Krugman that not only is more stimulus called for but the original stimulus plan back in 2009 was too restrained.

The logic behind the stimulus is straightforward. Because households have become cautious, they have reduced consumption and boosted saving or paid down debt. The reduction in consumption means a drop in demand for many products and a slowdown in sales growth in many industries. Families buy fewer TVs, go on fewer or shorter vacations, and put off purchasing a new sofa. Without a pickup in sales, businesses will not add to their workforce.

However, if the government increases its demand for products to offset the drop in demand by consumers, then businesses will sell more and hire more workers. As the unemployment rate falls, consumer confidence will rise and eventually will revert to old spending patterns. Once confidence is restored, the government stimulus can end.

The key to eliminating high unemployment, then, is the restoration of consumer confidence. But consumer confidence will not return if the government stimulus plan does not clearly arrest the unemployment problem and if confidence isn’t further dampened by fears of rising budget deficits.

The problem with the 2009 stimulus is that people are not convinced that it affected the unemployment situation but are convinced it contributed greatly to rising deficits and government debt. Because of this consumer confidence is falling over time instead of rising.

If a new fiscal stimulus plan is implemented soon, consumer confidence could fall even further if the plan doesn’t quickly and decisively reduce the unemployment rate. Otherwise the fear of excessive government indebtedness will grow even further and the slow economy will sputter along for good while longer.

Advertisements