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Government: Shifting from stimulating spending to stimulating confidence?

July 8, 2011 |  2:36 pm

Obama Boehner Reid Pelosi By urging congressional leaders to swing for the deficit-reduction fences, President Obama may be switching sides -- in terms of economic theory, at least.

To this point, Obama has been focused on goosing the economy through deficit spending, whether it takes the form of government spending programs (e.g., aid to schools or "cash for clunkers" subsidies) or tax cuts. That's consistent with the Keynesian theory that the government should go deeper into the red to sustain economic activity when the private sector stumbles.

The economy's fitful growth since the recession officially ended in June 2009 has led many Americans to question the value of government stimulus. Republicans, whose power multiplied in the 2010 elections, have even argued that the extra deficit spending was the problem, not the solution.

The president still defends the 2009 stimulus package and continues to call for more spending (on infrastructure) and tax cuts (for employees) aimed at creating jobs. But he's also started advocating deep cuts in federal spending and the end to some tax breaks, with an eye toward reducing projected deficits by $4 trillion over the coming decade.

The details are squishy, naturally. Yet at no point has Obama said that the spending cuts and tax increases should wait until the economy is humming again, or at least until the unemployment rate has improved from outrageous to merely bad. (Joblessness has been heading in the other direction lately, climbing from 8.8% in March to 9.2% in June.) That sort of precondition has been de rigueur among liberal economists, who warn that slashing federal spending now could throw the country back into recession.

Even conservative economists acknowledge that cutting spending in the near term will probably be a drag on GDP. But former Federal Reserve economist Kevin Hassett, now at the right-of-center American Enterprise Institute, said there's another factor to consider: the effect that a deficit-cutting deal would have on the expectations of corporate and individual taxpayers. In particular, Hassett said, a deal that removes the threat of big tax increases in the future could give businesses the confidence to start expanding.

The same could be true for individuals worried about the fate of Social Security and Medicare, both of which have significant financial problems. A deal that puts both of those programs on sound fiscal footing, even if trims benefits, could make people more confident about their financial security in retirement -- making them feel wealthier and increasing their willingness to spend.

This alternative to Keynesian thinking is called the "expectational view," and there's vigorous debate among economists about its validity. In a paper in December on deficit-cutting around the industrialized world, Hassett and two other AEI scholars admitted that there's disagreement about whether such efforts can improve economic growth. But plans that are heavy on spending cuts -- particularly in entitlements -- and light on tax increases tend to succeed in making real deficit reductions while also promoting growth, they argued.

The position Obama has staked out is far more reliant on spending cuts than tax increases. But as Hassett notes, that's not enough to fit the expectational model. The deal has to give the public confidence about the future. The protests from Republicans against any increase in revenue and from Democrats against any reduction in Medicare, Medicaid or Social Security benefits suggest that it will be hard for Obama and Congress to craft a deal that looks like a long-term solution to Washington's fiscal woes.

Economics isn't a precise science, so any deficit-reduction plan is going to involve a leap of faith to some extent. During the first two years of Obama's tenure, the administration and congressional Democrats clung to the notion that borrowing and spending more would help the economy. Now, it seems that Obama may be thinking that the answer is borrowing and spending less.

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Photo: President Obama meets Thursday with, from left, House Minority Leader Nancy Pelosi, House Speaker John Boehner and Senate Majority Leader Harry Reid. Credit: Larry Downing / Reuters

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