June 12, 2011

It’s a cliche — but true — that a huge obstacle to a stronger economic recovery is the lack of confidence in a strong recovery. If consumers and businesses were more confident, they would be spending, hiring and lending more freely. Even a slight relaxation might do wonders for the subpar nature of the expansion, highlighted by May’s meager 54,000 increase in payroll jobs. Instead, we’re deluged with reports suggesting that, because the recession was so deep, it will take many years to regain anything like the pre-crisis prosperity.

Just last week, for example, the McKinsey Global Institute, the research arm of the consulting firm, released a study estimating that the country needs 21 million additional jobs by 2020 to reduce the unemployment rate to 5 percent. The study was skeptical that this would happen. Ugh. Pessimism and slow growth become a vicious cycle.

Battered confidence most obviously reflects the ferocity and shock of the financial collapse and the ensuing recession, including the devastating housing collapse. But there’s another, less appreciated cause: disillusion with modern economics.

Probably without realizing it, most Americans had accepted the fundamental promises of contemporary economics. These were: First, we know enough to prevent another Great Depression; second, although we can’t prevent every recession, we know enough to ensure sustained and, for the most part, strong recoveries. These propositions, endorsed by most economists, had worked themselves into society’s belief structure.

Embracing them does not preclude economic disappointments, setbacks, worries or risks. But for most people most of the time, it does preclude economic calamity. People felt protected. If you stop believing them, then you act differently. You begin shielding yourself, as best you can, against circumstances and dangers that you can’t foresee but that you fear are there.

You become more cautious. You hesitate more before making a big commitment — buying a home or car, if you’re a consumer; hiring workers, if you’re an employer; starting a new business, if you’re an entrepreneur; or making loans, if you’re a banker. Almost everyone is hunkered down in some way.

Economic models, based on past relationships and assumptions, don’t capture the shift, which embodies new assumptions and beliefs. Of course, most Americans have not consciously rejected the promises of modern economics. Neither did they consciously embrace them before. Judgments were seat-of-the-pants. People simply compared the promises against the evidence. Since the 1980s, recessions had been brief and mild; modern economics had ensured crude stability. Now, that no longer applies.

Attitudes and behavior change. One disturbing fact from the McKinsey report is this: The number of new businesses, a traditional source of jobs, was down 23 percent in 2010 from 2007; the level was the lowest since 1983, when America had about 75 million fewer people. Large corporations are standoffish. They have about $2 trillion of cash and securities on their balance sheets, which could be used for hiring and investing in new products. Meanwhile, the latest University of Michigan Survey of Consumers reports that “record numbers . . . thought that their incomes would lag inflation over the next five years.” Note: They didn’t expect high inflation so much as low income growth.

It’s not that economics achieved nothing. The emergency measures thrown at the crisis in many countries — exceptionally low interest rates, “stimulus” programs of extra spending and tax cuts — probably averted another Depression. But it’s also true that there’s now no consensus among economists as to how to strengthen the recovery. Some, for example New York Times columnist Paul Krugman of Princeton, favor aggressive stimulus. Others, for instance Harvard’s Martin Feldstein writing in the Wall Street Journal last week, want to reduce long-term budget deficits on the theory that doing so would improve confidence.

Economists suffer from what one of them (Ricardo Caballero of the Massachusetts Institute of Technology) calls “the pretense-of-knowledge syndrome.” They act as if they understand more than they do and presume that their policies, whether of the left or right, have benefits more predictable than they actually are. It’s worth remembering that the recovery’s present slowdown is occurring despite measures taken to speed it up: the two-percentage-point cut in the payroll tax; and the Federal Reserve’s QE2 program (i.e., the purchase of $600 billion of Treasury securities).

So modern economics has been oversold, and the public is now disbelieving. The disillusion feeds stubbornly low confidence. Because psychology is so important, the good news is that if the economy surprises on the upside, the boost to confidence could accelerate the recovery. The bad news is that if the recovery continues to disappoint, the discrediting of mainstream economic thinking will grow. The resulting intellectual void will summon forth new ideas. Some may be good, but others — though superficially appealing — will be fringe or lunatic.