Our economy has been confronted by two crises of confidence: the confidence that financial institutions have in each other and the confidence households have in the future.
Various steps taken by the Fed and the Treasury have had the effect of restoring some confidence in financial institutions. There are signs that credit markets are thawing as a result, albeit at a steep price in terms of intervention in the marketplace.
The remaining serious danger we face at the moment is a crisis in consumer confidence about the future which is manifest by something economists call the "paradox of thrift." If we all lose faith in our ability to meet our needs for the future and increase the amount we save by a considerable amount at the same time, the resulting decline in current consumption expenditure can accelerate the loss of jobs and income in a market economy.
Household balance sheets and government budgets have deteriorated due to the decline in asset values and shrinkage of incomes and the tax base.
There is a natural desire for households and institutions to repair the situation quickly through saving. But as we reset our plans, it is important to take a long view. If possible, these balance sheets and budgets need to be repaired in five or ten years where possible, not one year. Taking that longer view will reduce the short term disruption in demand and can help prevent the further collapse in the real economy.
President-elect Barack Obama and his team are walking an economic tightrope. They must explain how a policy of tax cuts and spending increases can be a real solution to economic problems that are attributed to years of collective "overspending." For these short term policies to be effective, it is critical that they be paired with a credible long term plan for taxation and spending that restores people’s faith in our economy.
If we can restore people’s confidence in the future, households will find it easier to take that longer view, rebuild their positions more gradually, and mitigate the damage of the paradox of thrift.
Michael Knetter, Ph.D., is the dean of the University of Wisconsin School of Business and is a former presidential economic advisor. Knetter will return to provide a macroeconomic overview at the Northern Trust Economic Trends Breakfast to be presented by BizTimes Milwaukee on Wednesday, Jan. 21, To register to attend, visit www.biztimes.com/trends.
