LONDON – 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.