Some technical references but the key point does not need them
This is a contribution to the discussion about models started by Krugman, DeLong and Summers, and in particular to the use of confidence. (Martin Sandbu has an excellent summary, although as you will see I think he is missing something.) The idea that confidence can on occasion be important, and that it can be modelled, is not (in my view) in dispute. For example the very existence of banks depends on confidence (that depositors can withdraw their money when they wish), and when that confidence disappears you get a bank run.
But the leap from the statement that ‘in some circumstances confidence matters’ to ‘we should worry about bond market confidence in an economy with its own central bank in the middle of a depression’ is a huge one, and I think Tony Yates and others are in danger of making that leap without justification. Yes, there are circumstances when it may be optimal for a country with its own central bank to default, and Corsetti and Dedola (in a paper I discussed here) show how that can lead to multiple equilibria.
But just as Krugman wanted to emulate Woody Allen, I want to as well but this time pull Dani Rodrik from behind the sign. In his excellent new book (which I have almost finished reading) Rodrik talks about the fact that in economics there are usually many models, and the key question is their applicability. So you have to ask, for the US and UK in 2009, was there the slightest chance that either government wanted to default? The question is not would they be forced to default, because with their own central bank they would not be, but would they choose to default. And the answer has to be a categorical no. Why would they, with interest rates so low and debt easy to sell.
The argument goes that if the market suddenly gets spooked and stops buying debt, printing money will cause inflation, and in those circumstances the government might choose to default. But we were in the midst of the biggest recession since the 1930s. Any money creation would have had no immediate impact on inflation. Of course their central banks had just begun printing lots of money as part of Quantitative Easing, and even 5 years later where is the inflation! So once again there would be no chance that the government would choose to default: the Corsetti and Dedola paper is not applicable. (Robert makes a similar point about the Blanchard paper. I will not deal with the exchange rate collapse idea because Paul already has. A technical aside: Martin raises a point about UK banks overseas currency activity, which I will try to get back to in a later post.)
Ah, but what if the market remains spooked for so long that eventually inflation rises. The markets stop buying US or UK debt because they think that the government will choose to default, and even after 5 or 10 years and still no default the markets continue to think that, even though they are desperate for safe assets!? In Corsetti and Dedola agents are rational, so we have left that paper way behind. We have entered, I’m afraid, the land of pure make believe.
So there is no applicable model that could justify the confidence effects that might have made us cautious in 2009 about issuing more debt. There are models about an acute shortage of safe assets on the other hand, which seem to be ignored by those arguing against fiscal stimulus. Nor is there the slightest bit of evidence that the markets were ever even thinking about being spooked in this way.
Martin makes the point that just because something has not yet been formally modelled does not mean it does not happen. Of course, and indeed if he means by model a fully microfounded DSGE model I have made this point many times myself. But you can also use the term model in a much more general sense, as a set of mutually consistent arguments. It is in that sense that I mean no applicable model.
Now to the additional point I really wanted to make. When people invoke the idea of confidence, other people (particularly economists) should be automatically suspicious. The reason is that it frequently allows those who represent the group whose confidence is being invoked to further their own self interest. The financial markets are represented by City or Wall Street economists, and you invariably see market confidence being invoked to support a policy position they have some economic or political interest in. Bond market economists never saw a fiscal consolidation they did not like, so the saying goes, so of course market confidence is used to argue against fiscal expansion. Employers drum up the importance of maintaining their confidence whenever taxes on profits (or high incomes) are involved. As I argue in this paper, there is a generic reason why financial market economists play up the importance of market confidence, so they can act as high priests. (Did these same economists go on about the dangers of rising leverage when confidence really mattered, before the global financial crisis?)
The general lesson I would draw is this. If the economics point towards a conclusion, and people argue against it based on ‘confidence’, you should be very, very suspicious. You should ask where is the model (or at least a mutually consistent set of arguments), and where is the evidence that this model or set of arguments is applicable to this case? Policy makers who go with confidence based arguments that fail these tests because it accords with their instincts are, perhaps knowingly, following the political agenda of someone else.