Broken Trust Takes Time to Mend

The reason that we aren’t getting more expansionary macro policy is fundamental: a lack of trust. It’s not an easy problem to fix, but the place to start is by recognizing it.

This article was originally published in The New York Times

President Obama caused a stir recently when he said that “the private sector is doing fine” and pinned many of the nation’s economic troubles on a decline in public-sector employment. He cited some interesting numbers, but he didn’t draw the right lesson — namely, that America is witnessing a collapse of trust in politics, including the shaping of its broad economic policy.

Since Mr. Obama took office, 780,000 private sector jobs have been created, while the number of public sector jobs has fallen by about 600,000, mostly at the state and local level. A quick look might suggest that we need only to bolster the number of public sector jobs to have a healthier economy, but there is a deeper way to think about the problem.

State and local governments are controlled by politicians and, indirectly, by voters. And for better or worse, those voters have lost faith in the social returns of these jobs and our ability to afford them. The voters have responded by looking to cut expenses, and they’ve chosen state and local government employment as a target.

During the financial crisis, the prices of stocks, homes and other assets all fell, leaving the American public feeling less wealthy. In fact, the Federal Reserve reported last week that the crisis had erased almost two decades of accumulated prosperity for a typical family. The American economy and its financial system failed a giant stress test, at least when compared with previous expectations. Feeding the fears today are the crisis in the euro zone, the slowdown in China and political polarization at home.

In short, there is a prevailing sense that we are simply not as safe, financially speaking, as we used to be. The productive capacity of the economy may appear largely intact, but the perceived risk is significantly higher.

Should state and local government jobs be such a low priority? There is considerable disagreement on this issue, but voters in most states have hardly been screaming to have those fiscal decisions overturned. Indeed, voters in San Diego and San Jose, Calif., chose earlier this month to sharply reduce pension benefits of city workers. Clearly, the decline in perceived wealth has brought a new, hard-to-manage shift away from government investment.

In response, some people have moralized about this shift — sometimes by telling voters they’re stupid to let government shrink. But that kind of talk can lower public trust even further. First, we all need to understand the problem.

Simply recreating those state and local government jobs, without making other significant and confidence-restoring changes, may not bring much prosperity. After all, if the public feels a basic need to take less risk and to invest less money, such tinkering with one part of government spending would only bring demands to make offsetting cuts somewhere else.

The slow cure for this problem is to allow asset prices, along with perceived wealth and trust, to return to or exceed the previous levels over time. Americans would then spend and invest more money, bolstering both aggregate demand and supply, and in both the private and public sectors. But the process would be cumbersome, partly because trust is more easily destroyed than restored.

Various policies that are being put on the table, including forms of fiscal and monetary stimulus, try to accelerate this repair process. They would all be likely to underperform, partly because the public, rightly or wrongly, doesn’t see them as ways to rebuild confidence. We have become skeptical of our own macroeconomic authorities and abilities, and that, in turn, makes successful policy harder to pull off.

For instance, there is a good case to be made for monetary expansion, given the current low rate of inflation and high rate of unemployment. But if fear of inflation puts off the American public, such a policy will again underperform, relative to what we have learned in textbooks. There won’t be a credible commitment to see the monetary stimulus through, as people panic that resulting inflation will be used to redistribute wealth. (Although Sweden and Switzerland have had effective monetary policies recently, both of those countries have especially high rates of trust in government.)

The American problem is a particularly strong spin on John Maynard Keynes’s concept of “animal spirits” — the human emotion that drives confidence. These days, however, it’s often the government that is spooking Americans. Too much debate is focusing on textbook remedies, and not enough on just how much trust has been broken.

We often hear the argument that our government should borrow and spend more money because the real rate of return on government borrowing is so low, as evidenced by bond yields. Maybe, but those yields are low because alternative investments are perceived as so risky, and people want a haven for their money.

Should government double-down on these risks by borrowing more money and pursuing more investment? After all, such a policy is supposed to be self-validating because of the accompanying economic stimulus. But will it be seen that way? Will government protect us from the risks of its potential mistakes?

That’s not an easy debate to settle here, but suffice it to say that without more trust, it won’t happen on a large scale.

The reason that we aren’t getting more expansionary macro policy is fundamental: a lack of trust. It’s not an easy problem to fix, but the place to start is by recognizing it.