The political right’s dangerous support for economic quackery

You may remember Niall Ferguson’s disastrous attempt to claim that George Osborne’s imagined success proved Keynesians and Keynes were wrong. That kind of nonsense makes it into a serious paper like the Financial Times because it is written by a famous history professor, or maybe on other occasions by a senior policy maker. But for those who only read this serious press, it is in fact one example of many. There is a little cottage industry out there of so called journalists and think tanks who peddle economic quackery to support right wing policies.

Take, for example, this recent piece by James Bartholomew in the Spectator. Deficit spending by the government never works, he claims. Presumably the opposite also holds, which is that fiscal consolidation (aka austerity) never hurt anyone. Mainstream economics has it all wrong. One of the skills writers like this have is to make very little evidence seem like a lot. Mr. Bartholomew has two bits of evidence.

1. Papers by Alesina et al. He is quite right they briefly gained a lot of influence in Europe in particular, among policy makers who wanted to cut deficits and liked to argue this would not reduce output. What Bartholomew does not tell you is that following this policy of cutting deficits, we had a second Eurozone recession. Nor does he tell you that subsequent analysis by the IMF and others explained why these authors got the results they did, because of countervailing influences that did not apply in the Eurozone in the years following 2010. Nor does he mention the huge number of past and recent studies that confirm fiscal policy does what Keynesians say it does. The only other authority he quotes is Tim Congdon.
   
   
2. Lots of historical examples where fiscal action did not, supposedly, have the expected impact. The thing is, anyone can write this kind of stuff about anything in macroeconomics, because in the economy there are lots of things going on. I’m sure I could come up with an equally impressive list to show you that monetary policy has no effect. Just look at 2009 and 2010: interest rates on the floor and the economy still crashed. That is why economists do econometric studies, the overwhelming (like 95%) majority of which show fiscal policy drives the economy in the expected direction.

To his credit Bartholomew does admit that logically Keynesian policies should work. But there is an awful lot he does not tell you. He does not tell you that the reason it should work is that additional private sector demand does increase output (except perhaps in booms), and that this, rather than fiscal stimulus, was the key insight that Keynes had. It is the insight that every central bank uses to guide monetary policy, using Keynesian models. Models that all say that without countervailing factors fiscal stimulus increases output and fiscal consolidation reduces it. There is no way that his article is a measured piece of journalism. It is designed to discredit the economics that is taught to every student the world over.

There is plenty of this on the left too: people who want to tell you mainstream economics is all wrong. Yet until very recently at least, the influence of this group on politicians on the mainstream left had been minimal, and this group has a far smaller public presence than their equivalent on the right. On the right they are ubiquitous.

Policy makers on the right might tell you that of course they are not influenced by this group, but instead consult serious economic analysis that you can find in mainstream universities. But how can we tell if they are telling the truth. When campaigning senior politicians on the right seem quite happy to talk about the government maxing out its credit card, the classic first year undergraduate ‘schoolboy’ error of treating the government like a household. In the UK, while the fiscal strategy of the Labour government was written up in Treasury documents that referenced the academic literature, there is nothing equivalent from the current government. Even the most technical of Osborne’s speeches just seemed horribly out of date in terms of its macroeconomics.

This is dangerous for two reasons. The first is that it can lead to major macroeconomic policy errors: in the UK think money supply targets, entering the ERM at an overvalued rate, and 2010 fiscal consolidation, in the Eurozone think of the Stability and Growth Pact and the 2011-13 recession. The second is that it encourages a lazy anti-science attitude, all too evident in climate change denial. If the political right in the UK and Europe want to see where this could lead, look across the Atlantic. With the left in disarray and flirting with non-mainstream economics, the right has an excellent opportunity (when a new Chancellor takes over in the UK, for example) to re-engage with mainstream economics, and cast off the quackery of the Ferguson and Bartholomew ilk.

Economics Rules by Dani Rodrik

I didn’t want to talk about this book before I had finished it: I somehow think Noah’s contrary approach has its shortcomings! The first and most important thing to say is this is a great book. Not because it gave me some huge new insight or knowledge, although I did learn quite a bit about other parts of economics, but because it had a way of putting things which was illuminating and eminently sensible. Illuminating is I think the right word: seeing my own subject in a new light, which is something that has not happened to me for a long time. There was nothing I could think of where I disagreed (which given the book’s wide scope is quite something), and plenty where the inner blogger in me said I wish I’d written that.

So who should read it? To be honest I cannot think of anyone who should not, as I think most of the material could be understood by interested non-economists. His writing style is enviable - it seems so effortless! (That’s me as blogger again.) The people who should especially read it are those who interact with economics or economists and are either unclear or distrustful about what economists are about (other social scientists particularly).

The first part of the book sets out a way of thinking about economics, and in particular to the models that economists could not live without. The key idea is that there are many valid models, and the goal is to know when they are applicable to the problem in hand. This idea has already attracted some attention, including Noah Smith’s post I linked to earlier.

I must admit when I first read it I thought well of course, doesn’t everyone understand that? I remember way back when I did my undergraduate degree, hearing a lecture from a young David Newbury I think, who said the days of big models (models of everything) were over in economics, and that today economists focused more on small but focused models, looking at particular problems or issues. But then as I read on I began to realise that I typically did not employ this knowledge into how I discuss the subject, which is exactly what Rodrik does. 

One area of economics that you might think this would not apply is macro, but it does. It is routine, for example, to split issues up by time: the famous short, medium and long run. A New Keynesian model is not going to tell you much about long run growth, but a Solow growth model does not tell you much about involuntary unemployment. The point here is not that an all encompassing model could not be built - it could, and sometimes individuals or institutions try to do that - but if it was it would be unwieldy, and we would want to break it up in our minds to understand how it works. (I used a related idea of ‘theoretical deconstruction’ in an EJ paper some time ago.) An important point that follows from that is that although we work with different models, it is important that we know how they interconnect, or at least how they relate to each other.  

Rodrik spends a good part of the book describing how you ‘navigate among models’. He warns that these methods are as much a craft as a science. Many have picked up on that, presuming that this is something that a proper science would not do. But as I have often said, the best analogies for economics are with medicine rather than physics. When a doctor diagnoses an illness based on symptoms, they could also be said to be using craft rather than science.

Let me give you a simple example from macro. How do we know if most economic cycles are described by Real Business Cycles (RBC) or Keynesian dynamics. One big clue is layoffs: if employment is falling because workers are choosing not to work we could have an RBC mechanism, but if workers are being laid off (and are deeply unhappy about it) this is more characteristic of a Keynesian downturn. This simple test beats any amount of formal econometric comparison. Craft maybe, but not a very difficult craft in this case.    

Lots of people get hung up on the assumptions behind models: are they true or false, etc. An analogy I had not seen before but which I think is very illuminating is with experiments. Models are like experiments. Experiments are designed to abstract from all kinds of features of the real world, to focus on a particular process or mechanism (or set of the same). The assumptions of models are designed to do the same thing.

Although I found that Rodrik’s discussion of how you select the right model familiar and sensible, it remains vague in the philosophical sense, as Emrah Aydinonat points out. But he also finds them instructive, so they are a work in progress that hopefully philosophers and economists can interact on. (It is worth passing on a point which Aydinonat makes, which is that unlike many economists who write about methodology, Rodrik has read the relevant literature!) Thinking about alternative models that differ in their applicability to particular problems is certainly a more insightful approach than the kind of Popperian stuff that most economists remember.

If this makes the book sound like a philosophical tome, that is quite wrong. It is a very readable account of how economists do what they do: the philosophical grounding is there but it is not intrusive, and instead the book focuses on practical examples. What Rodrik then does with this perspective of many models is to think about a lot of the issues outsiders have about economists: how ideological are they, for example. Towards the end he discusses what went wrong in the financial crisis. Once again the perspective is illuminating: there were for sure models that said a crisis should not happen, but also plenty of models around at the time that explained pretty well why it could. The mistake many economists made was to choose the wrong models, and he discusses why that might have happened. This perspective shows why a simple ‘the crisis shows economics must be flawed’ misses the point.

Hopefully that is enough to make you read this book.  

Heterodox economists and mainstream eclecticism

I knew when I wrote this post some economists would not like it. These are economists who locate themselves outside the mainstream: heterodox economists. They often claim that mainstream economics is this narrow discipline wedded to particular assumptions that are both implausible and ideological. So when I argue that in principle and practice it is not, they will not like it. Simply saying (as I do) that economists are often too reluctant (sometimes for good reason in terms of the sociology of economists) to explore this freedom is not enough for them. Some of them require mainstream economics to be beyond redemption.

Sure enough, Lars Syll attacks my post. He writes 

“And just as his colleagues, when it really counts, Wren-Lewis shows what he is — a mainstream neoclassical economist fanatically defending the insistence of using an axiomatic-deductive economic modeling strategy.” 

I can only think that reading my post got him so angry he temporarily lost his critical faculties. Because what he writes is completely false. I wrote a comment on his blog but it has not appeared, although fortunately Bruce Wilder makes my point in very gentle terms. As I have been here before with Syll (see the footnote to this post), I will be less gentle.

My post ended with the following sentence:

“Mainstream academic macro is very eclectic in the range of policy questions it can address, and conclusions it can arrive at, but in terms of methodology it is quite the opposite.”

I argue in the post that “this non-eclecticism in terms of excluding non-microfounded work is deeply problematic.” I then link to my many earlier posts where I have expanded on this theme. So how I can be a fanatic defender of insisting that this modelling strategy be used escapes me. Unless I have misunderstood what an ‘axiomatic-deductive’ strategy is. Perhaps for Syll not following this strategy means being able to completely (180 degrees completely) misrepresent what someone else says.

That out of the way, I wanted to say something more substantive. In macro, the insistence on using microfounded models also works as an exclusion device. (I am suggesting this as a fact, not a deliberate strategy.) You cannot just write down an aggregate macro model, based on other people’s work or empirical findings or whatever. You have to microfound it, and that requires a lot of skill and practice, as many a PhD student has found out.

If it also turns out when doing this that the issue you want to address or the innovation you want to make is ‘difficult’ in terms of finding an acceptable microfoundation, there are many wise supervisors who will suggest that the student tries something else. It is hardly surprising that this might put some people off mainstream macro.

I think some knowledge of these things is essential - the kind of knowledge to be able to read and understand a journal article. But the depth of knowledge required to be able to create your own microfounded model, if your own interests are more empirical but you nevertheless want to explore the implications of your empirical work for the economy as a whole? Here I think what Lars Syll says has validity. But his wish to tar even the critics of this aspect of mainstream macro with this brush is just bizarre. More generally heterodox economists misdirect their fire when they accuse mainstream macro of being inescapably narrow in its subject matter or assumptions, when their criticism should be directed at the limitations implied by microfoundations formalism.

Is mainstream academic macroeconomics eclectic?

For economists, and those interested in macroeconomics as a discipline

Eric Lonergan has a short little post that is well worth reading. Not because it is particularly deep or profound, but because it makes an important point in a clear and simple way that cuts through a lot of the nonsense written on macroeconomics nowadays. The big models/schools of thought are not right or wrong, they are just more or less applicable to different situations. You need New Keynesian models in recessions, but Real Business Cycle models may describe some inflation free booms. You need Minsky in a financial crisis, and in order to prevent the next one. As Dani Rodrik says, there are many models, and the key questions are about their applicability.

If we take that as given, the question I want to ask is whether current mainstream academic macroeconomics is also eclectic. (My original title for this post was can DSGE models be eclectic, but that got sidetracked into definitional issues, but from the way I tend to define things it is the same question.) My answer is yes and no.

Let’s take the five ‘schools’ that Eric talks about. We clearly already have three: New Keynesian, Classical, and Rational Expectations. (Rational Expectations is not normally thought of in the same terms, but I understand why Eric wanted to single it out.) There is currently a huge research programme which aims to incorporate the financial sector, and (sometimes) the potential for financial crises, into DSGE analysis, so soon we may have Minsky too. Indeed the variety of models that academic macro currently uses is far wider than this.

Does this mean academic macroeconomics is fragmented into lots of cliques, some big and some small? Not really, in the following important sense. I think that any of this huge range of models could be presented at an academic seminar, and the audience would have some idea of what was going on, and be able raise issues and make criticisms about the model on its own terms. This is because these models (unlike those of 40+ years ago) use a common language. The idea that the academic ranking of economists like Lucas should reflect events like the financial crisis seems misconceived from this point of view.

It means that the range of assumptions that models (DSGE models if you like) can make is huge. There is nothing formally that says every model must contain perfectly competitive labour markets where the simple marginal product theory of distribution holds, or even where there is no involuntary unemployment, as some heterodox economists sometimes assert. Most of the time individuals in these models are optimising, but I know of papers in the top journals that incorporate some non-optimising agents into DSGE models. So there is no reason in principle why behavioural economics could not be incorporated. If too many academic models do appear otherwise, I think this reflects the sociology of macroeconomics and the history of macroeconomic thought more than anything (see below).

It also means that the range of issues that models (DSGE models) can address is also huge. To take just one example: the idea that the financial crisis was caused by growing inequality which led to too much borrowing by less wealthy individuals. This is the theme of a 2013 paper by Michael Kumhof and colleagues. Yet the model they use to address this issue is a standard DSGE model with some twists. There is nothing fundamentally non-mainstream about it.

So why is the popular perception so different? Why do people talk about schools of thought? I think there are two reasons. First, while the above is true in the realm of academic understanding and discourse, it does not carry over into policy. When it comes to policy, we get to learn which models academic think are applicable to particular policy problems, and here divisions can be sharp. Second, there are plenty of people outside academia who have a public voice about economics (and generally a policy orientation), and they often do see themselves as school followers.

In terms of working practice rather than the hot end of macro policy decisions, most academic macroeconomists would regard themselves as eclectic in terms of the kind of work they are prepared to spend an hour or two seeing presented. But this view, and the common language that mainstream academics use, leads me to the No part of the answer to my original question. The common theme of the work I have talked about so far is that it is microfounded. Models are built up from individual behaviour.

You may have noted that I have so far missed out one of Eric’s schools: Marxian theory. What Eric want to point out here is clear in his first sentence. “Although economists are notorious for modelling individuals as self-interested, most macroeconomists ignore the likelihood that groups also act in their self-interest.” Here I think we do have to say that mainstream macro is not eclectic. Microfoundations is all about grounding macro behaviour in the aggregate of individual behaviour.

I have many posts where I argue that this non-eclecticism in terms of excluding non-microfounded work is deeply problematic. Not so much for an inability to handle Marxian theory (I plead agnosticism on that), but in excluding the investigation of other parts of the real macroeconomic world. (Start here, or type microfoundations into this blog’s search box and work backwards in time.) But for me at least this as a methodological point, rather than anything associated with any school of thought. Attempts to link the two, which I think many people including myself have been guilty of, just confuses.

The confusion goes right back, as I will argue in a forthcoming paper, to the New Classical Counter Revolution of the 1970s and 1980s. That revolution, like most revolutions, was not eclectic! It was primarily a revolution about methodology, about arguing that all models should be microfounded, and in terms of mainstream macro it was completely successful. It also tried to link this to a revolution about policy, about overthrowing Keynesian economics, and this ultimately failed. But perhaps as a result, methodology and policy get confused. Mainstream academic macro is very eclectic in the range of policy questions it can address, and conclusions it can arrive at, but in terms of methodology it is quite the opposite.

Personal debt

A simple point, not very deep or constructive

This earlier post, which has been followed by pieces in the financial press saying similar things, was meant as an antidote to alarmist popular commentary that you can find all over the shop (except the financial press). It was not meant to imply that there are not serious issues to consider in a more thoughtful way around personal debt. (For more discussion on some of these articles, see here.)

There is a view, that some economists hold, that in aggregate we are highly unlikely to ever get a situation where there is too much personal debt, because on average people will not take out more debt than they can afford to pay back. That does not mean that personal debt is always at its optimal desired level, because there are various reasons why people may be unable to borrow as much as they should be able too. [1] But it means aggregate personal debt is either at or below its optimal desired level. There is no reason why an economy can have too much personal debt. (Banks can have too much leverage, but that is different.)

As I said, that is a view that some economists hold. It is not my view, for various reasons, some better than others. First, calculating how much debt you can afford to take out is very very difficult, and as a result there is no reason why on occasion people in aggregate might not be systematically too optimistic. This is obvious to non-economists, but for economists I would say: Friedman’s Billiard player analogy does not hold here because in life we only get to play one game. To put it another way, although I believe rational expectations are the best starting point for analysis, that does not mean we should never look at the possibility of departures from it. Second there may be deep reasons why the young may on average be over optimistic. A third possible reason explored by some is that a widening distribution of income may encourage people to take out too much debt because they aspire to keep up with others. A fourth, which may be a combination of the above, is that debt can be systematically missold, as we discovered in the subprime crisis in the US.

For these reasons I think it is interesting to ask how much personal debt there should be in the economy if people were totally rational and their borrowing was unconstrained, and compare that to how much debt there actually is. Macroeconomic theory tells us this is a tricky calculation to do. Many people will be in debt for what we might call ‘life cycle reasons’: they are students with a loan, or the young(er) household with a mortgage. In other cases people may be borrowing because times are bad (they have become unemployed), but they expect/hope they will get better. So to do the calculation we need a lot of information about the distribution of income over time. (I do not know of any study that tries to do this, so if you do please let me know.)

But at present it is even more complicated than that. This was brought home to me when I saw a chart showing a tight correlation between household debt and car purchases, but I’m afraid I cannot find it again so instead I’ll have to fall back on something more personal. I’m lucky enough to be able to afford to buy a new car when I need it using cash. Yet when I bought my current car, the dealer insisted I took out a zero percent loan with the manufacturer. Although nominal interest rates on the liquid assets I hold are very low they are still not negative, so why turn down an interest free loan?

So I am in debt, because in effect the car manufacturer wanted to lend me money for free. I suspect they saw it as another way of making their car more attractive, and if I was a microeconomist I would probably have fun speculating why they preferred that to just cutting the price. But the point was it made me part of the ‘personal debt time bomb’! I didn’t fall into either of the categories I outlined above, but I was in debt because of the competition strategy of car manufacturers.

This is another reason why aggregate personal debt may be above the level that an economist might think of as reasonable, but the reason for it is utterly benign. It is a danger to no one, as those taking out the debt have the liquid assets to pay off that debt immediately. I’m afraid my conclusion is that any good answer to the question 'is there too much personal debt' is bound to be very complicated.

[1] These credit constraints may change over time, as the financial sector evolves, as I have discussed elsewhere. This means that rising debt income ratios may tell us that credit is getting easier because people are becoming less (unnecessarily) credit constrained, rather than because they are borrowing too much.    

Will Trident be Corbyn’s undoing?

and why Trident is not like austerity

Not being a Labour Party person, I’ve not until now thought much about what Corbyn should do about the Trident issue. (For non-UK readers Trident is the UK’s independent nuclear deterrent.) On a personal level I have never heard a convincing argument for keeping Trident, and a great many bad ones, and it is a very large amount of money. So unless anyone convinces me otherwise I would happily votes against keeping it.

Labour leader Jeremy Corbyn is firmly against Trident, but current Labour policy and many Labour MPs strongly hold the opposite view. It is a far more fundamental issue for Labour MPs, with deep roots, than any debate about Syria. (Postscript: this LRB article by David Runciman is well worth reading.) This post/article from Steve Richards of The Independent, coupled with the recent Labour reshuffle, suggests it may define Corbyn’s leadership.

I have written in the past that Corbyn’s election by Labour Party members was in good part a response to the inept drift in policy that the other three candidates were associated with. (As Jolyon Maugham says, it may be unfair on the non-Corbyn candidates that they were so clearly associated with this failed strategy, but elections are often unfair in this sense.) I suspect the many Labour MPs and commentators who think that Corbyn got elected because most party members prefer purity to government do this because they do not want to admit how hopeless their own electoral strategy clearly was. I have talked about this before, but Chris Dillow does it better.

The implications are that if in the few years a rival candidate emerges who seriously looked like they could beat the Conservatives while remaining close to the policies of the Blair/Brown government (minus Iraq and City regulation, obviously), I suspect they could easily win against Corbyn if the Corbyn/McDonnell combination looked like it was both incompetent and unable to lead more than a small number of their MPs.

That is why I have also written that Corbyn/McDonnell are likely to play a long game: to adopt for now policies that the majority of Labour MPs can unite behind, and try and gradually change the platform once they had shown that they could competently lead this majority (which means after 2020). As a poll disaster could still ruin this strategy, what they should also do (but I have always doubted that they would do) is focus on improving the Labour party’s spin machine. (Notions that Corbyn would automatically galvanise disenfranchised working class voters seem problematic for various reasons. The fact that almost no one in the media supports the current Labour leadership means that more, not less, energy has to be put into getting their message across.)

You can see why trying to change the Trident policy might go against that strategy of playing a long game. Damian Carrington, who has done more work exposing the government’s flooding débâcle than anyone I know, recently tweeted: “when @UKLabour shd have been holding Cameron to account for huge failings on #flooding, they put on a late Christmas pantomime”. It is pointless to say it is not his fault but that of the Labour MPs and media, because these are facts that Corbyn has to work with.

Please note that I’m not arguing that Trident might be better left as a battle to be fought on another day because most voters want to keep Trident. Voters views on the issue of Trident are not as clear as some Trident supporters like to pretend, and any poll that does not make the opportunity cost clear in any question (how many less teachers, nurses …) is meaningless anyway. The Conservatives are going to argue that Labour threaten national security whatever Labour’s actual policy is as long as Corbyn is leader. I am arguing that anything that breaks the long game strategy is not in Corbyn’s own interest. Remember also that Corbyn’s choice will have no influence on what actually happens to Trident before 2020, because the Conservatives will win any vote in parliament.

Now someone might say I’m being inconsistent here, because I would not apply the same argument to the macroeconomic policy of austerity. Is this because I have a deep professional interest in macroeconomics but not in defence policy? It is a good point, but my response would be this. If Labour under any leader agreed to follow Osborne’s fiscal charter, they would be going down exactly the same road as the parliamentary party seemed to heading before Corbyn was elected - the road to nowhere. Or as John Harris put it, they were “in danger of shrinking into meaninglessness”. Their ambivalence on the austerity issue under Miliband/Balls (having a sensible policy but trying not to talk about it) helped lose them the election for a variety of reasons I have talked about before.¹ Austerity, not Trident, was a key reason that Corbyn was elected. 

The Trident issue may therefore be critical for Corbyn. He would obviously like to campaign in 2020 on a manifesto that clearly pledges to scrap it, and there may even be electoral advantages in clarity. But if in doing so he alienates so many Labour MPs that the only image in voters minds for the next few years is Labour disunity, he may lose his support among the majority of party members, who actually meet those voters on the doorstep. Compared to getting this choice right, fixing his economic policy right must seem easy.

1 My previous posts have focused on Labour’s huge tactical failure: the only area before the election where the the Conservatives had real strength was economic competence, and how this was based on a false narrative that Labour failed to challenge. I have briefly talked about the demise of the European left more generally in terms of ‘political capture’ by the dominant elite’s narrative: some more articulate thoughts are discussed by Henry Farrell here.   

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.