Paul Krugman has another piece today in the NYT about the need for more government stimulus. So again I want to suggest conditions under which the Krugman stimulus would work and conditions under which it would not work. The key, I think, is the effect the stimulus has on people’s confidence and expectations of the future.

In my last post I emphasized that because citizens see a ballooning budget deficit and rising debt while there seems to be no clear effect of government policy on unemployment, it is dashing their confidence of the future and keeping them from resuming their old spending habits.

In the meantime Krugman says we must substitute government demand for household and business demand for as long as the private sector needs to pay down debt and resume their own confidence. This does make sense if it can work as intended, but there are several problems with the implementation.

First of all, because of the political process the types of spending that would do the most to reduce the unemployment rate quickly are not the same as the pet projects that legislators have in mind when they construct a stimulus plan. If real legislation could mimic what Obama’s own advisor Larry Summers suggested, and probably what Krugman would advise, then the plan has a better chance of working. However, a second stimulus would likely be constructed in the same way as the first and lead to too much waste.

Second, a massive fiscal stimulus now would be much less worrisome to households and businesses if government had not accumulated so much debt during the good times of rapid economic growth. Imagine if our national debt were only $500 billion dollars when the crisis began. In that case the effect of spending $1 – $2 trillion quickly to avert disaster would have been received more favorably and thus could have inspired confidence in the private sector.

This leads to two lessons; first, it suggests the importance of keeping the government budget deficits low in all periods so that fiscal policy will be effective in an emergency; and second, it suggests that the impression the government makes on the people is critically important.

Many citizens lost confidence long ago that the government could manage its budget prudently. With that impression in place any new plan to spend more is met with doubt and uncertainty. This is especially true when all of the best and brightest who should know what is best are disagreeing over policy.

All this means that even if Krugman’s policy could work in principle, it very well may not work in practice and in this situation. Households and businesses have little confidence that the government knows what it is doing. Thus, any grand proposal to spend more will only be met with falling expectation and confidence.

Krugman is right that if only people didn’t think this way, his plan could work. But there is no way a few columns in a newspaper is going to shift the beliefs of a large group of people. These beliefs were created out of years of government excesses that we cannot wish away.

Appropriate government policy today must take full account of these beliefs and expectations and policymakers need to learn how to shift them in a more positive direction. Chances are good that positive expectations will not arise from leaders within the current political parties.

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