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This column originally appeared in Forbes

With the confidence of someone who will not be held accountable if his advice is followed, Paul Krugman, the Nobel Prize-winning economist, has been arguing in his New York Times column and blog that the Canadian- and European-led consensus at the G-20 meetings towards belt-tightening will cause another Great Depression. He invokes Keynesian theory to argue for a cookie-cutter approach to running deficits in order to avoid Herbert Hoover-style deficit reduction. To support his point, he cites Ireland and Latvia's short-term spikes in unemployment, economic swoons and high interest rates since they cut their stimulus spending.

Scary stuff. But is he right? No. Surprisingly, Krugman has completely misread Keynes, which is why President Obama and the rest of the world should ignore him, lest policymakers truly cause a Greater Depression by mortgaging away our children's futures.

John Maynard Keynes never argued that government should borrow money indefinitely to stimulate the economy. He argued that it should stimulate the economy to reduce fear, so that business activity could begin to return to normal and to get credit markets working again. In other words, government must wait until sentiment improves enough before stepping back and letting the private sector take up the slack. He never proposed that governments borrow so much they dig themselves into holes deeper than BP's wells. Debts have to be paid back at some point.

Creating confidence that markets will one day return to normal and that war and starvation are not around the corner is a critical government function. Companies are run by people, and people hunker down and stop spending when they fear that they won't be able to pay their families' food and medical costs. Look at how many guns, cigarettes and cans of Spam Americans bought after Lehman Brothers collapsed. I personally know well-educated, sane people who cashed in their Citigroup (C) and Bank of America (BAC) bank accounts to bury money and gold bars in their backyards.

It takes years to build up confidence in a country's institutions and just hours to lose it. A misreading of human psychology is one reason for the failure for many stimulus programs and for the myth among many central bank governors and economists that low interest rates alone will stimulate economies. They focus too much on quantitative models that don't accurately reflect human emotions. Companies and people won't borrow money if they don't think they can use it to actually make money; profit-driven banks won't lend it if they don't think they can get paid back; and consumers won't spend it even if they're given a job, if they're not proud of that new job. That is why nonfinancial large-capitalization companies are sitting on a stockpile of $1.8 trillion in cash, higher than at any time in the last half-century, as Fareed Zakaria haspointed out in the Washington Post.

President Hoover and Treasury Secretary Andrew Mellon cut spending too quickly in the early 1930s, exacerbating the Great Depression. However, whenever an economy hits a rough spot, it is natural for there to be some pain. When an individual buys too many vacation homes and cars and has to declare bankruptcy, it takes years for him to dig himself out of his hole. A sane person in bankruptcy would not use more credit cards to fuel the same inflated lifestyle. Sane nations shouldn't either.

It is impossible for an economy to restructure after a bubble bursts without pain for the economy and the people. Governments should not reinflate bubbles, as following Krugman's prescriptions would do; rather, they should engineer soft landings by creating conditions for business to pick up again and by taking care of the less fortunate. Ireland and Latvia are indeed suffering short-term pain, as Krugman rightly points out. However, their fiscally responsible actions will help them in the long term. Instead of myopically looking at the last two years, Krugman should take note of how South Korea rebounded after implementing severe austerity measures in the wake of the Asian financial crisis of 1997. Married couples even donated their gold wedding bands to melt down for the country. The pain in the short term was terrible, but less than a decade later Korea was thriving again.

The question, therefore, is whether or not the private sector can start to replace government stimulus money. The answer: yes. It is time for President Obama to cut back on spending and reallocate dollars going foolishly to nation-building in Afghanistan and Iraq back to nation-building at home, meaning creating jobs that Americans are proud to have.

Despite the pessimism of Krugman and other bears, the world economy is moving in the right direction. Fears about the euro and the eurozone breaking apart because of Greece's economic problems are greatly exaggerated. World leaders have invested too much political capital in the creation of the euro and the eurozone not to bail out countries when necessary, albeit while throwing a bone to domestic voters. Moreover, despite criticism, the euro and the economic interdependence of the EU that underpin it remain brilliant inventions that have helped ease tension and conflict among the many disparate countries of a continent where bloodshed has been almost a constant for centuries.

The slowing down of China's economy is also good, as the government there has engineered a soft landing in the real estate sector. Real estate sales volumes in China's top 100 markets dropped 70% last month, yet prices have remained stable. That indicates that buyers of real estate are not overleveraged, and panic selling won't happen.

Moreover, with the slowing of China's economy, the prices of raw materials like oil and iron ore will drop, which will help businesses generate greater profits. High commodity prices and volatile currencies have squeezed profit margins too much over the past two years.

It may be years before the world economy soars again. But Krugman's fears of the world collapsing into a second Great Depression because of the eurozone's problems--and his accompanying calls for austerity--are way overblown. World policymakers should indeed look to Keynes for guidance. They should heed his message that stimulus should be implemented to stave off depression but must be pulled back when the private sector regains confidence.

Disclosure: No positions

Source: This Is No Time for More Federal Stimulus