What’s absent from today’s economic discourse is the concept of consumer and investor confidence in a nation’s government and economy. This wasn’t always the case. As the Cambridge don John Maynard Keynes put it: “The state of confidence, as they term it, is a matter to which practical men pay the closest and most anxious attention.” Another Cambridge economist of his era, Frederick Lavington, identified confidence as a key component of the business cycle. His 1922 book, The Trade Cycle, described the “tendency for confidence to pass into errors of optimism or pessimism,” which triggers booms and busts.
By ignoring the confidence factor, economic theory can lead to wildly incorrect conclusions and misguided policies. Just consider naïve Keynesian fiscal theory—the type presented in textbooks and embraced by most policymakers and the general public. According to Keynesian theory, an expansionary fiscal policy (an increase in government spending and/or a decrease in taxes) stimulates the economy, at least for a year or two after the fiscal stimulus. To put the brakes on the economy, Keynesians counsel a fiscal contraction.
A positive fiscal multiplier is the keystone for Keynesian fiscal theory because it is through the multiplier that changes in the budget balance are transmitted to the economy. With a positive multiplier, there is a positive relationship between changes in the fiscal balance and economic growth: larger deficits stimulate growth and smaller ones slow things down.
So much for theory. What about the real world? Suppose a country has a very large budget deficit. As a result, market participants might be worried that a further loosening of fiscal conditions would result in more inflation, higher risk premiums and much higher interest rates. In such a situation, the fiscal multipliers may be negative. Fiscal expansion would then dampen economic activity and a fiscal contraction would increase economic activity. These results would be just the opposite of those predicted by naïve Keynesian fiscal theory.
The possibility of a negative fiscal multiplier rests on the central role played by confidence and expectations about the course of future policy. If, for example, a country with a very large budget deficit and high level of debt makes a credible commitment to significantly reduce the deficit, a confidence shock will ensue and the economy will boom, as inflation expectations, risk premiums and long‐term interest rates decline.