Confidence as a political device

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.     

Confidence

Mainly for economists

Francesco Saraceno reminds us about the days in which very important people believed in the confidence fairy (aka expansionary fiscal austerity), which are not so very far away. He also points to some recent ECB research which shows that confidence - as measured by surveys - clearly falls following fiscal austerity. The confidence fairy, rather than waving her wand to make everything alright again, may be making austerity worse. 

However, looking at the research in detail revealed some results I found at first surprising. In particular, revenue cuts have a bigger effect on consumer confidence than spending cuts. In terms of GDP impacts, theory - and most but not all empirical evidence - suggests that temporary spending cuts will have a larger impact on overall activity than temporary tax increases, if there is no monetary offset and incentive effects are not very large. Do these empirical results contradiction this?

To answer that you need to ask two further questions. First, what does consumer confidence actually measure? Second, and perhaps more interesting, what information do fiscal announcements actually reveal.

The answer to the first question seems to be a mixture of things, some of which relate to the individual household’s income, and some related to the general economic situation. To the extent that the consumer is thinking about the former, then it would make sense that a tax increase might have a larger impact on confidence than a spending cut. This would tell you very little about the economic impact of the two types of measure.

The obvious answer to the second question is that the information conveyed by an announcement of a spending cut or tax increase is just itself. If we stick to taxes, then if the announcement had not been made, the consumer would have just assumed lower taxes (for a time, or forever?). But this is naive from an intertemporal perspective, and clearly non-Ricardian. In the logic of Ricardian Equivalence, a tax increase today must imply cuts in taxes tomorrow for a given path of spending.

There are three alternative, more ‘rational’, ways of thinking about the announcement of a tax increase. Suppose the current government budget deficit is not sustainable. Taxes either need to rise today, or tomorrow after more borrowing. The announcement then tells us about the timing of the tax increase. If Ricardian Equivalence held it would have no impact on lifetime discounted income, but if for many possible reasons it did not hold, then a tax increase today could depress consumer confidence. However, to the extent that confidence depended on the general economic situation, you would expect ‘bringing forward’ expenditure cuts to have a much greater impact than bringing forward tax increases (with the caveats noted above), because of consumption smoothing. In that case spending cuts should reduce confidence more than tax increases.

A second possibility is that a tax increase could signal something about the future economic situation. Perhaps the consumer had thought the deficit was sustainable because they were optimistic about future growth, but the tax increase told them to be less optimistic. Reduced optimism could lead to reduced confidence. To the extent that the fiscal action conveys information about future pre-tax incomes, the tax increase conveys the same information as a spending cut.

A final possibility, which is generally ignored when discussing the plausibility of Ricardian Equivalence, is that the announcement of a tax increase tells consumers about the composition of any consolidation. Suppose again that the deficit is unsustainable. Either taxes have to rise or spending fall, but the consumer does not know which of these will happen. If spending is then cut, this tells the consumer that taxes will not rise, which in terms of the consumer’s own income would represent a plus. So in that case a spending cut could increase consumer confidence.

Trying to evaluate the impact of past fiscal actions is complicated, in large part because it is difficult to know what the counterfactual was, or what people thought the counterfactual was. Were changes thought to temporary or permanent? (Governments hardly ever say, and even if they did would they be trusted?) To what extent do people internalise the government’s budget constraint? If they do, are fiscal changes telling us about the timing of taxes or spending, or their mix, or something else? It seems to me that these difficulties arise whether we are trying to assess the impact of fiscal changes on confidence, or on activity itself. 

The Financial Market as a Vengeful God

                Reading this Jonathan Portes post, I recalled a point in my undergraduate lectures where I have a little fun at the expense of economic pundits from the City. After explaining Uncovered Interest Parity (if you do not know what UIP is, it does not matter), I tell them that they can now immediately comment on how the foreign exchange market reacts to an increase in interest rates, whatever happens to the exchange rate. If the exchange rate appreciates, that is because domestic assets are more attractive. If the exchange rate does not change, that is because the interest rate increase was already discounted. If the exchange rate depreciates, well the markets were expecting a larger increase.

                This is meant to make a serious point about the difficulties in testing UIP, but if I’m feeling mischievous I then point out that city pundits always seem to know with certainty why the markets have moved this way or that. Now in goods markets, firms pay market researchers serious money to find out why consumers are or are not buying their products, but in the financial markets this appears unnecessary. Despite market moves being made by thousands of trades and by thousands of people, the motivation for these trades appears clear. It is as if each trade is accompanied by the trader completing the following sentence: ‘I bought/sold this currency today because ....’. The truth, I reveal to my stunned audience, is that these pundits are just guessing based on no evidence whatsoever.

                Of course city pundits have no reason to be honest. When asked ‘why has the dollar appreciated’, I would like them to reply ‘well no one really knows, but one possible factor might be...’. They never do. If I wanted to be unkind, I might suggest that these pundits want to appear like high priests, with a unique ability to understand the mysterious mind of the market. As high priests have discovered over and over again, if you can convince people that you have a direct line to an otherwise mysterious but powerful deity, you can do rather well for yourself. And sometimes financial markets can appear a bit like vengeful gods, capable of sudden acts of destructive anger that appear to come from nowhere.

                If I wanted to ratchet up the unkindness I could go on as follows. It is in the priest’s interest to tell the faithful that the god is indeed quite fickle in its mood, and while placid at the moment, it could turn nasty at the slightest provocation. Keep those offerings coming, to make sure that the god stays happy (and don’t think about where those offerings go). If you are particularly generous, the priest will promise to give you the heads up if any changes in mood are imminent. If you cannot be a priest yourself, you can always set up as an advisor (HT DeLong), who will tell people which priests have a better line to the financial market god. 

                OK, this is a bit silly, but sometimes listening to policymakers you wonder whether they think this way. (Perhaps because they talk to the wrong people – see Jonathan again here.) For ‘confidence’, read the mood of the financial market god, or even the many gods of the economy as a whole. For offerings and sacrifices, read austerity. Muti and Padoan tell us “the Eurozone is still in a situation in which multiple equilibria can materialise”. They go on “In a situation of multiple equilibria, where confidence plays a crucial role, the distinction between short-term and long-term measures (suggesting the possibility of postponing action) is misleading and could be possibly dangerous. Short-term measures that weaken confidence would push the medium-term dynamics towards a bad equilibrium.”

                I assume this is about austerity. Here the game for many Eurozone countries is to demonstrate that they are not like Greece. I think that in this game there may be an advantage in front-loading austerity to demonstrate the ability and intension to avoid default, although I think Brad DeLong disagrees. However, as my very first post said, this need not be about appeasing a market god but instead the very human ECB. If deficit reduction programmes are reasonable and are implemented (in cyclically adjusted terms, without moving the potential output goalposts every time output falls), the ECB should ensure interest rates on debt are low enough to make those programmes sustainable.

                Having just gone through a recession largely caused by excessive over confidence in the financial markets about the ability to manage risks, it is natural to think everything is down to confidence. (The word appears eight times in Muti and Padoan’s article.) However in most situations I think markets and economies react in straightforward and understandable ways. The importance of confidence can be overdone, as it is often a symptom rather than a prime cause. To treat financial markets or the economy as a whole as always behaving like a vengeful god whose mood and confidence can ebb and flow at the slightest provocation is not the way to make good policy.

                Jonathan’s post also quotes Shakespeare, so how about this from Julius Caesar

Men at some time are masters of their fates;

The fault, dear Brutus, is not in our stars,

But in ourselves, that we are underlings.