How to fix the flatline economy

The global economy doggedly refuses to re-start. Employment is flat, demand is flat, prices are flat, housing sales are flat, growth is nearly flat.

Stagflation and inflation, the old fears, have given way to the flatline economy. Sometimes flatlined patients can be revived. Clear! But what should the therapy be?

Republicans are responding to the flatline economy by demanding what they are programmed to demand — tax cuts for the upper class. Democrats are responding to it by demanding what they are programmed to demand — more government spending.

Both approaches have already been tried, and both don't work. Only a gridlocked partisan political system would keep demanding more nostrums.

Federal income taxes were cut significantly in 2001 and again in 2003. The recession of 2008 began under a regime of tax cuts. The tax cuts probably did not cause the recession, but they obviously did not stop it either. Federal taxes were cut again in 2010, this time both income and payroll taxes were reduced. No response from the flatline economy.

Lower taxes are nice, of course. But when an idea – tax cuts to spur the economy — has been tried three times, at the cost of trillions of dollars in national debt, and it hasn't worked, it is time to accept that tax cuts are not the solution.

Stimulus spending has been enacted twice, in 2008 and again in 2009. Lack of reduction in government spending despite declining government receipts is a Keynesian response. Since the 2008 recession began, no federal spending program has known any meaningful reduction, while many have been pumped full of funny-money. Since 2008, the United States has borrowed and spent $5.5 trillion, and is on track to borrow another $1.2 trillion in 2012. Another $450 billion in borrowing will be added if President Barack Obama's latest stimulus bill is enacted.

That means more than $7 trillion in borrowing for the economy in just five years, roughly the amount per capita, in today's dollars, the United States borrowed during World War II. Amazingly, some commentators call this "austerity." Whatever the label, the Keynesian borrow-to-spark-demand formula has not worked. It is time to accept that more government spending is not the solution.

If more borrowing or more tax cutting aren't what the economy needs, what is? Optimism. Human psychology is a bigger force in economics than current policy debate acknowledges.

In 2005, many fundamentals of the economy were worrisome – a housing bubble, highly leveraged banks and investment banks, a profusion of liars' loans. Yet the economy boomed, partly because optimism was universal.

In 2011, many fundamentals of the economy are sanguine – high corporate profits, no resource shortages, low interest rates, ample money supply, low international tensions. Yet the economy is flatlined, partly because there is little optimism.

Consumers make decisions about whether to spend, and corporations make decisions about whether to invest, based mainly on whether they are optimistic. Psychological research shows expectations about the near future to be a more powerful motivator than circumstances of today.

As social scientist Carol Graham of the Brookings Institution noted in her 2009 book "Happiness Around the World": "In economics, individuals' expectations about the future are as important as objective trends in the present."

In his 1995 book "Demosclerosis", Jonathan Rauch warned that "the rise of entrenched interest groups" using ever-improving lobbying tools would slow economic growth by "locking in subsidies, rewarding political bickering and discouraging concern for the greater good." Rauch argued that use of government to channel favours to campaign donors and voter blocs will grow steadily worse until government enters gridlock. That, it turn, will cause economic growth to stagnate, while reducing optimism about the American prospect. Rauch's book, sadly out of print, seems eerily word-for-word a forecast of 2011.

Gridlock prevails in Washington, with politicians of both parties acting like spoiled crybabies, instead of leaders. This causes pessimism regarding the future – which is likely a larger factor in the flatline economy than government spending levels or tax policy.

Footnote: Don't like my theory that lack of optimism is the core economic problem? Then check Jeremy Rifkin's new book "The Third Industrial Revolution", which offers a different explanation.

Rifkin has a reputation as a goofy futurist, but often his analysis is astute. The book argues that recent economic turbulence syncs less with financial shenanigans than with the price of oil. When the U.S. economy begins to grow, oil prices shoot up; that makes demand fall, dampening expansion; lower demand causes oil prices to decline, and growth resumes; oil prices then rise, dampening growth. Rifkin shows that the less oil-addicted an economy is, the more consistent its economic expansion. This is a disturbing message at a time when the same forces causing gridlock in politics are resisting attempts to move the United States beyond oil.

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Gregg Easterbrook is a Reuters columnist.