Will G-20 win the confidence game?

Developed nations must invest in confidence-renewing measures like the Marshall Plan.

On April 2, the G-20 will hold a summit in London to discuss what we may hope will be an internationally coordinated plan to address the world economic crisis. But can such a plan really work?

The basic problem, of course, is confidence. People everywhere, consumers and investors alike, are cancelling spending plans, because the world economy seems very risky right now. The same thing happened during the Great Depression of the 1930s.

A contemporary observer, Winthrop Case, explained it all in 1938: economic revival depended 'on the willingness of individual and corporate buyers to make purchases that necessarily tie up their resources for a considerable length of time.

For the individual, this implies confidence in the job, and in the end comes equally back to the confidence of industry leaders.' Unfortunately, confidence did not return until World War II ended the depression.

If the leaders meeting in London are to succeed where governments failed in the 1930s, they must commit themselves to a fiscal target that is sufficient to restore full employment under normal credit conditions.

They must also commit themselves to a credit target that will restore lending to normal.

People will not spend normally unless they have both a job and normal access to credit. During the Great Depression, such targets were not used on a large enough scale, merely fuelling public despair that stimulus policies would ever work.

The G-20 Summit should also be an occasion for affirming some basic principles. Confidence isn't built up on the basis of spending or lending alone. People need to believe that the money represents something more lasting than stimulus measures, which may eventually end in failure.

After all, the Great Depression did not end simply because of the massive stimulus of war-related expenditures. Why should World War II have produced any confidence in the future?

To be sure, World War II reduced the unemployment rate in the United States dramatically, from 15 per cent in 1940 to 1 per cent in 1944, and had a similar effect in other countries. But this was not because of a revival in business confidence.

It was because of a nasty war, plain and simple, with people drafted into fighting, or into industries supplying the war effort.

The real recovery of confidence did not occur until after World War II, when the world did not sink back into depression. The US Council of Economic Advisors warned of this possibility in 1949, and it was not alone.

There appears to be more than one reason why, on the contrary, confidence came roaring back. First, there was a general perception of 'pent-up demand.'

After years of privation (and in many countries the physical destruction of war), people just wanted to live normally - to rebuild, own a home, a car, and other consumer goods.

The widespread impression that there was such pent-up demand also led people to believe that there could not be another depression. The perception of pent-up demand was like a powerful economic stimulus package, and it had the advantage that people believed it would be long-lasting. Indeed, the same long-term confidence triggered the post-war 'baby boom.'

According to some contemporary observers, however, 'pent-up demand' was only part of the story. During the brief but deep recession of 1949, the financial commentator Silvia Porter reflected on the attitudes that led to the 1929 crash: "We saw nothing wrong - in fact, we saw everything right - with the wild speculative boom and credit inflation that.culminated in the now almost unbelievable gambling orgy of 1929."

But now, Porter wrote, after the depression and war, "We began to listen to the idea that a hundred million citizens, acting through a central government, could achieve much more than a hundred million acting as separate selfish units. We developed, in short, a new attitude toward the responsibilities of government."

She concluded that the positive effect of 'pent-up demand' and government measures can 'make sense only when viewed against the background of our changed economic and political philosophy."

The Marshall Plan, which operated from 1947 to 1951, became a symbol of this new attitude. The US gave billions of dollars of aid to rebuild war-ravaged countries in Europe.

The plan was widely viewed as reflecting a new kind of enlightenment, a recognition of the importance of supporting people who needed help. Europe would not be allowed to languish, and the stimulus came from abroad.

After the war, Keynesian economic theory, which was generally not accepted or understood during the Great Depression, became the basis of a new social compact.

It was a theory that was perfectly suited to a generation that had just endured exceptional sacrifices, for it reaffirmed a belief in our responsibility for each other. The effect of economic stimulus is redoubled by this kind of inspirational belief.

That is why all of the commitments made and intentions expressed at the upcoming G-20 summit matter. The countries represented must show a generous spirit and make the world economy work for all people.

Seemingly peripheral issues, like aid to the developing world and the poor, who suffer the most from a crisis like this one, will be part of the primary story of the renewal of confidence, just as the Marshall Plan was part of that story after World War II.

The author, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Copyright: Project Syndicate, 2009.