Duncan’s Economic Blog

Why I worry about the confidence fairy

Posted in Uncategorized by duncanseconomicblog on June 12, 2011

I’m a fan of Paul Krugman – he writes well and frequently, I share many of his views and he has the added enhancement of having won a Nobel Prize. Because of this many left leaning commentators in the UK (myself included) frequently quote him to add credibility to a view they are expressing. So I don’t disagree with him lightly. But I worry that one argument he has been pushing lately may be off-target in a US context and actually dangerous in a UK one. I’m talking about the idea of the ‘confidence fairy’.

Krugman argues that much of the US (and indeed European) right are basing their economic agenda on a believe in an imaginary ‘confidence fairy’. They (the right) argue that any increase in government spending would cause more uncertainty, damaging the confidence of business (and possibly consumers) further and leading to a fall in investment (and possibly consumption) that would more than offset the expansionary effects of further government spending.

The US has the advantage of being the world’s sole issuer of the reserve currency of choice, so in a US context Krugman is on firmer ground. But this isn’t an advantage which the UK has.

I think it’s right to worry about the ‘confidence fairy’, indeed I think not to worry about the confidence fairy would be actually dangerous.

As I’ve been trying to explain for the past few months, the fiscal policy debate is actually fairly nuanced. The real debate is about a balance of risks – the risk of extreme austerity hammering the recovery versus the risk of a bond market taking fright at a slower pace of fiscal adjustment and driving up interest rates. The Treasury places more emphasis on the later risk, whilst I worry more about the former.

But that isn’t to say that the later risk doesn’t exist.

I supported the then government’s fiscal stimulus in late 2008 and would have liked to have seen a second stimulus at the 2009 budget. Demand was falling off a cliff in late 2008 and the VAT cut (not my ideal type of stimulus it must be said) together with the bringing forward of investment stopped the economy falling off a cliff. A second stimulus (more focussed on investment) possibly would have meant that the recession ended earlier than it did and helped to kick start a more robust recovery. We’ll never really know.

But I think there is a difference between arguing the case for a stimulus in late 2008/09, at a time when most world governments were doing the same, and arguing for one now (as some on the left are doing|).

Britain is a very open economy, we have a high propensity to import – I worry that a stimulus in Britain alone would mainly leak abroad with less macroeconomic impact that it’s proponents claim. In effect government debt would be increased without a large kicker to growth. And much as many on the left don’t want to face this – there would be a market reaction. Osborne, Cameron, Clegg and co are wrong to argue that Britain was ‘on the brink of bankruptcy’ last May. There is simply no evidence for that in the market prices of UK government debt at that time. But this was, at least partially, because of the existence of the strong framework for deficit reduction set out by Darling.

There is room for a more growth friendly fiscal consolidation – using a higher banks’ levy and/or bonus tax to fund specific earmarked, high impact programmes such as more social home building for example. Equally the pace, if not the end point, of deficit reduction can be changed. As I have argued before I am a fan of the Dolphin/Lent proposed ’deficit reduction averaging’ approach – whereby the pace of reduction would be adjusted to reflect the strength of the underlying economy. I think this is actually a more credible and realistic course than either the Darling or Osborne plans.

We have seen since May last year the importance of confidence. Osborne’s over-tough talk and the general air of gloom he created, led to a collapse in consumer and business optimism. The result of which has been six months of zero growth and stagnation before his fiscal adjustment has even started to really bite. As I have argued, Osborne has placed too much stress on appeasing bond markets and not enough on supporting the real economy. But that doesn’t mean there should be no stress on keeping the markets on side.

What I am trying to say is that the traditional macroeconomic policy levers are failing. A spending led stimulus programme risks higher debt for no real growth impact, tax cuts (Osborne’s preferred ‘growth package’) seems a exercise in wishful thinking with little evidence that it would help, interest rates cannot be cut further and more monetary stimulus (QE) would probably simply result in higher asset prices.

George Osborne has got it wrong. His fiscal contraction is too deep and damages the economy, his corporation tax cuts and emphasis on further labour market flexibility are unlikely achieve higher growth. But that doesn’t mean proposing the opposite is the right course either. Talking about a ‘confidence fairy’ is unlikely to help.

In an ideal world we won’t be starting from here. But here is where we are.

Labour needs new and original policies. Policies which aim to make the economy less dependent on increasing debt (either government or private), policies which help wages to grow and allow for solid, domestic, private sector growth.


10 Responses

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  1. Barry Thompson said, on June 12, 2011 at 7:31 pm

    Imagine this scenario: the UK housing bubble deflates rapidly over the next few years, so that the private sector is paying down debt in aggregate, credit is shrinking and unemployment is rising fast.

    What should the government response be?

    You would argue that worrying about bond markets is important. But under this extreme scenario, the Bank of England can decide to purchase large quantities of government bonds (short- and long-term) to keep interest rates low as the government provides sustained stimulus. The inflationary force of this action is desirable in the face of massive deflationary forces and many debtors under stress.

    The whole point of the bond system – rather than the government just creating money itself – is to allow the bond markets to restrict excessive government money creation and spending when they consider it to be innappropriate AND when the Bank of England does not intervene. But in a real depression, the Bank of England can and should intervene – so fear of the bond market is not warranted.

  2. Barry Thompson said, on June 12, 2011 at 7:45 pm

    One more point.

    “The confidence fairy”, as I read Krugman, means the idea that cutting government borrowing will not just keep the bond markets happy, but will ALSO lead to increased borrowing and investment by the private sector and hence, to a restoration of economic growth.

    But, of course, even very low interest rates are not leading to sufficient private sector borrowing under the current ‘balance sheet recession’ conditions.

  3. Dave Holden said, on June 12, 2011 at 11:01 pm

    Other than your appraisal of Krugman – who I don’t have much time for, see Steve Keens latest http://www.debtdeflation.com/blogs/2011/06/11/dude-where%E2%80%99s-my-recovery/ for just one of many examples why – I agree with pretty much all of this.

    @Barry – I think your scenario of the UK housing bubble bursting is the most likely outcome at present. By the Economists housing metric they’re still thirty percent overvalued. Add to that the non wage related inflation we’re experiences and those debts are getting bigger. Add to that the demographic shift in debt with students now leaving education with 30 plus grand of debt and they’re seem even more unsustainable. The can was kicked down the road at great expense but we’re now catching back up to it.

    I think that the reality is those debts should have been destroyed in the private sector rather than being taken onto government books but that’s not where we’re at .

  4. ovaut said, on June 13, 2011 at 2:48 am

    When people talk of confidence I wish they wouldn’t neglect to specify *whose*.

    I agree it’s chancy to import the ‘confidence fairy’ conceit into British debate. For the Democratic Keynesians, it encapsulates the inanity of Geithnerism: Geithner seems to expect *confidence itself* to be the source of confidence, rather than anything more concrete, and so politically hazardous, and worries about its threatened decrease in one group — bondholders — at the expense of the devastated and still hobbled confidence of another — everyone else, basically.

    It’s not clear to me that we have British Geithnerians at whom we’d do well to aim the phrase. For Osborne, the relevant fairy is that of exports.

    (Lacking promising ideas for growth, will we require Labour to effect a transvaluation whereby people refer to the same state of affairs they used to refer to negatively, as ‘stagnation’, neutrally, as ‘steady-state’?)

  5. jomiku said, on June 13, 2011 at 3:16 pm

    Not that it matters, but confidence fairy is a reference to the Great Depression and the repeated statements – by Andrew Mellon in particular – about confidence being the way back to normalcy. The point is there was an actual set of reasons for the Depression and lack of confidence wasn’t one of them and irrational confidence wouldn’t get us out. In fact, just like today, too much confidence brought us to our knees. When FDR came in, his announcement that the only fear is fear itself was different: it meant we cannot be afraid to take action because we’re frightened by the conditions we’re in. That’s the historical context. When Krugman uses it, he means in this context: the actions being taken in the name of austerity are the opposite of what FDR talked about and instead are playing into and running with the fear and they invoke confidence in the same way Mellon and Hoover did. The confidence fairy is the belief that contracting has a magical effect on confidence when demand, when failure of aggregate demand, remains the big problem.

    The idea is really part of the old battle with those who invoke supply models: the output gap, which is huge in the US, would be eliminated if business has the confidence to increase supply and that confidence is created by austerity, by contracting spending. The point Krugman makes is this argument is silly: how does contraction signal to business that though people have less money and fewer jobs they actually would like more stuff to buy without of course having that money to spend? His point then becomes more technical and comments on how supply models fail in exactly this circumstance: how exactly does this confidence mechanism work, especially when you’re at the 0 bound? You don’t see borrowing costs or in the US inflation expectations rising in any meaningful way, which is exactly what a demand model, not a supply model describes as fitting this circumstance. It really is a version of Mellon & Hoover versus Keynes and FDR. It’s also a lot of Chicago style economists trying to find a way to make their models work in these unusual circumstances and they can only do this by claiming there’s a special role, now and magically, for confidence.

    • Agog said, on June 14, 2011 at 8:16 am

      Great comment. Good points in Duncan’s post too, and while in the short term I’d agree that there some effort might need to be made to ‘keep markets on side’ surely in the medium to long term it’s more important to ensure that responsible democratic means are used to shape economic policy.

  6. Paul Newman said, on June 13, 2011 at 4:37 pm

    This new reasonable tone is much more like it .

  7. metatone said, on June 13, 2011 at 6:11 pm

    jomiku points to the references Krugman is making with the phrase – so I’ll step across that and point out that your position of “balancing fears” is a problem because (as Krugman frequently points out) there is no time at which one cannot say that “the bond markets might take fright” and so to invoke that as a constraint implicitly rules out anything you suggest would frighten the bond markets.

    However, as we’ve seen in the Irish case, the bond markets can be frightened by cratering your economy with Osborne style austerity just as much as by excessive spending… yet somehow that never works it’s way into your or George’s equations…

    Krugman’s point is that you assert traditional macroeconomic levers are failing, but in the US and UK case, the stimulus applied falls far short of that which the traditional theory indicates is necessary. As such, to say it is failing looks a bit dishonest.

  8. Gazza said, on June 21, 2011 at 9:40 pm

    Not sure where the evidence is for your “… worry that a stimulus in Britain alone would mainly leak abroad”.

    What is the mechanism by which it would “leak” abroad?

    • duncanseconomicblog said, on June 21, 2011 at 9:51 pm

      Used to buy imports. So in terms of GDP = G (govt spending) increases but so does Im (imports) meaning little increase in actual GDP, instead stimulus for those providing our imports.

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