In 2011, the Nobel laureate economist Paul Krugman characterized conservative discourse on budget deficits in terms of “bond vigilantes” and the “confidence fairy.” Unless governments cut their deficits, the bond vigilantes will put the screws to them by forcing up interest rates. But if they do cut, the confidence fairy will reward them by stimulating private spending more than the cuts depress it.
Krugman thought the “bond vigilante” claim might be valid for a few countries, such as Greece, but argued that the “confidence fairy” was no less imaginary than the one that collects children’s teeth. Cutting a deficit in a slump could never cause a recovery. Political rhetoric can stop a good policy from being adopted, but it cannot stop it from succeeding. Above all, it cannot make a bad policy work.
I recently debated this point with Krugman at a New York Review of Books event. My argument was that adverse expectations could affect a policy’s results, not just the chances that it will be adopted. For example, if people thought that government borrowing was simply deferred taxation, they might save more to meet their expected future tax bill.
On reflection, I think I was wrong. The confidence factor affects government decision-making, but it does not affect the results of decisions. Except in extreme cases, confidence cannot cause a bad policy to have good results, and a lack of it cannot cause a good policy to have bad results, any more than jumping out of a window in the mistaken belief that humans can fly can offset the effect of gravity.
The sequence of events in the Great Recession that began in 2008 bears this out. At first, governments threw everything at it. This prevented the Great Recession from becoming Great Depression II. But, before the economy reached bottom, the stimulus was turned off, and austerity – accelerated liquidation of budget deficits, mainly by cuts in spending – became the order of the day.
Once winded political elites had recovered their breath, they began telling a story designed to preclude any further fiscal stimulus. The slump had been created by fiscal extravagance, they insisted, and therefore could be cured only by fiscal austerity. And not any old austerity: it was spending on the poor, not the rich, that had to be cut, because such spending was the real cause of the trouble.
Any Keynesian knows that cutting the deficit in a slump is bad policy. A slump, after all, is defined by a deficiency in total spending. To try to cure it by spending less is like trying to cure a sick person by bleeding.
So it was natural to ask economist/advocates of bleeding like Harvard’s Alberto Alesina and Kenneth Rogoff how they expected their cure to work. Their answer was that the belief that it would work – the confidence fairy – would ensure its success. 1
More precisely, Alesina argued that while bleeding on its own would worsen the patient’s condition, its beneficial impact on expectations would more than offset its debilitating effects. Buoyed by assurance of recovery, the half-dead patient would leap out of bed, start running, jumping, and eating normally, and would soon be restored to full vigor. The bleeding school produced some flaky evidence to show that this had happened in a few instances.
Conservatives who wanted to cut public spending for ideological reasons found the bond vigilante/confidence fairy story to be ideally suited to their purpose. Talking up previous fiscal extravagance made a bond-market attack on heavily indebted governments seem more plausible (and more likely); the confidence fairy promised to reward fiscal frugality by making the economy more productive.
With the help of professors like Alesina, conservative conviction could be turned into scientific prediction. And when Alesina’s cure failed to produce rapid recovery, there was an obvious excuse: it had not been applied with enough vigor to be “credible.” 1
The cure, such as it was, finally came about, years behind schedule, not through fiscal bleeding, but by massive monetary stimulus. When the groggy patient eventually staggered to its feet, the champions of fiscal bleeding triumphantly proclaimed that austerity had worked.
The moral of the tale is simple: Austerity in a slump does not work, for the reason that the medieval cure of bleeding a patient never worked: it enfeebles instead of strengthening. Inserting the confidence fairy between the cause and effect of a policy does not change the logic of the policy; it simply obscures the logic for a time. Recovery may come about despite fiscal austerity, but never because of it.
Although Krugman invented his discourse for an American readership, it perfectly fits the British case as well. In his first budget in June 2010, Chancellor of the Exchequer George Osborne warned that “you can see in Greece an example of a country that didn’t face up to its problems, and that’s a fate I am determined to avoid.”
In presenting the United Kingdom’s 2015 budget in March, Osborne claimed that austerity had made Britain “walk tall” again. On May 7, that claim will be put to the test in the UK’s parliamentary election. British voters, still wobbly from Osborne’s medicine, can be forgiven if they decide that they should have stayed in bed.