The problem with the economy? Confidence.
How could several trillion dollars of fiscal and monetary stimulus barely move the needle of gross domestic product growth? That's the question President Obama needs to answer in the wake of the midterm elections. Why was his policy so ineffective at multiplying its stimulative effects throughout the economy?
The Krugman theory is that the stimulus just wasn't large enough. But this is arguing a tautology - by definition, the policy can never be wrong. The stimulus should have always been larger, according to this thinking.
A more compelling theory is that global assets remain overvalued. Specifically, the price of real estate debt and sovereign debt on bank balance sheets, propped up by government actions, remains too high. The economy can't gain traction until these prices reflect realistic valuations.
Asset prices are important because America has never had a recovery without residential housing leading the way. Real estate values are still high by historic standards. The value of all real estate is roughly $18 trillion, with mortgage debt about $10 trillion. The ratio of mortgage debt to GDP value is 56 percent. In the 1960s and 1970s, the ratio was 29 percent. In the late 1990s it was only 38 percent.
Related to this thinking is the deficit theory. The new mountain of deficits and debt - accumulated in part to pay for this elaborate system of bailouts, subsidies and other government schemes to prop up asset values - may have come to inhibit consumer confidence. Consumers hold back on purchases because they bear a heavy load of personal debt or fear that the nation's debt will hit them eventually through higher taxes, higher inflation or both. In the process, the debt is a reason domestic demand remains weak.
Coming into office, Obama's greatest mistake may have been his hubris. The stimulus was presented as an elixir for overnight success. The White House mismanaged expectations at a time when fundamental economic changes were underway after the financial bubble burst.
Today, Republicans risk making the same mistake if they offer simplistic bromides and fail to take a cold, hard look at the nature of America's economic predicament. They should begin with this analysis, calculated by economist Niall Ferguson: Had Americans not been able to take out cheap home equity loans during the George W. Bush administration, the economy would have grown annually by an average of only 1 percent.
From the end of World War II until the year 2000, our economy grew at an average annual rate of 3.2 percent. Yet since 2000, annual growth has averaged only 2.4 percent. That modest 0.8 percentage point difference is a large part of the reason so many Americans are unemployed or underemployed. Sadly, the U.S. economy is plagued with structural problems, including impediments to the lending process, inadequate training of our human capital, an internationally noncompetitive business tax system and a general fixation with trading financial paper rather than making things. These are likely to defy quick-fix remedies from either party.
Recovery will be a long, hard slog, and our national mood could make the difference between success and failure. Fortunately, America's problem is not a lack of money. Nor is it a lack of adequate stimulus. It is a lack of confidence. Between $2.5 trillion and $4 trillion of private capital is waiting on the sidelines to "reliquify" a new era of American confidence and innovation.
Drawing in that money requires bipartisan leadership. Obama has two years to persuade Americans, as journalist David Brooks put it, "to salivate for the future again." It seems unlikely that will happen without a bipartisan effort to reduce our deficits and debt, to provide certainty about future rates of taxation and to reform a badly slipping public educational system without increasing our debt.
Obama's natural attraction is toward zero-sum politics: We win if our enemies lose. I am confident that the White House can run tactical circles around the incoming congressional Republicans - but while the president can certainly win most of the battles in partisan food fights, he will lose the war. Over time, voters will remain angry and consumers will remain disillusioned about their futures.
The president needs to bring all Americans together. For Obama, that means becoming the private-sector innovation president - even if some people, while creating jobs, become rich in the process.
Here's the essential question: What conditions would induce a talented innovator in this threatening climate of uncertainty to take the risk of striking out with a new job-creating venture? The president and presumptive House Speaker John Boehner need a consensus answer.
When all is said and done, optimism is critical to a nation's long-term prosperity. Today, the Chinese possess the optimism that once defined Americans; more than 86 percent believe their country is headed in the right direction. Unless Americans can be brought together to rediscover their historic optimism, today's long, hard slog will be even longer and harder.
David M. Smick is a global financial policy strategist and the author of "The World Is Curved: Hidden Dangers to the Global Economy."