Illusion of Confidence and the Confidence of Illusion

January 30, 2009

by Mario Rizzo

 

One hears a lot about restoring confidence in the economy these days. What is that? The economy is a complex entity. In fact, Friedrich Hayek wanted to drop the use of the term and replace it with “catallaxy” that is, an abstract order of interpersonal exchanges. The word “economy” has its origins in the idea of household management and consequently of a household manager. It is remarkable how the etymology of the word is preserved in its current meaning (or, at least, connotation). Most macroeconomists seem to believe that the economy can be managed or steered out of its current difficulties. (Is it cheeky to ask how did it get into its current difficulties if management were possible?)

 

Now the latest is Olivier Blanchard arguing that what fundamentally ails us is “Knightian uncertainty.” If this can be made to go away then our economic difficulties would be many fewer and far less severe. To accomplish this, he proposes the usual array of stimulus. So all of that to get to the “consensus policy.”

 

In the first place, Austrian economists have been talking about Knightian or radical uncertainty for quite a long time. Gerald O’Driscoll and I made a “big deal” of it in the first edition of The Economics of Time and Ignorance in 1985 (and in the 1996 edition as well). In that book we argued that neoclassical and neoclassical-synthesis economists virtually ignored it in favor of mere risk or objectively measurable uncertainty. Earlier, Ludwig von Mises captured some of the same idea in his distinction between case probability and class probability (ordinary risk). Israel Kirzner made the idea of unknown ignorance central to his concept of entrepreneurship. And, of course, there is G.L.S. Shackle. It is also true that Post Keynesians and Keynes himself thought radical uncertainty is an important aspect of human decisionmaking. More recently, Edmund Phelps suggested that many of the models that were used to assess innovative financial products were paying exclusive attention to risk in the sense of variance of historical outcomes and not at all to Knightian uncertainty.

 

But let’s go beyond the history of thought lesson. Is radical uncertainty alleviated by covering over the misdirection of resources that constitutes the core of the recession? In other words, do agents in particular markets (say, the housing market) gain confidence – meaning the willingness to engage in exchange – by propping up prices by putatively temporary measures? The actions of the Fed/Treasury/Congress are creating their own radical uncertainty. How long and to what extent will these policies last? I am unaware of any good models that forecast this political-economic behavior under “unprecedented circumstances” (as we are told). What will be the later consequences for interest rates – and thus housing prices – of the enormous public debt we are creating?

 

We should make more use of the idea of radical uncertainty in analyzing economic phenomena. It is important, though, to recognize all of the sources of this uncertainty. Simplistic stimulus policies that prevent resource re-allocation will put us all in a fantasy land of distorted prices. (I agree with Tyler Cowen’s cautions about stimulating consumer and other particular forms of demand as a means of restoring confidence.)  If there is a “recovery” under these consensus policies it will be illusory – ready to collapse at the next radically uncertain shock.

 

 

   

10 Responses to “Illusion of Confidence and the Confidence of Illusion”

  1. Max Says:

    Instead of trying to remove uncertainty from the world, economists should be explaining to people the uncertainty is an inextricable part of the world. The economy should not be “run” in a way that reduces uncertainty, but rather organized in the most robust manner that is capable of responding to uncertainty in an interesting manner.

    There is no getting rid of uncertainty; so, what Blanchard is talking about when he refers to uncertainty is, I think, merely a lack of confidence in the system. But a lack of confidence in the system is not necessarily a bad thing. A lack of confidence could be a rational response to the ad hocery of policy-makers.

  2. Bogdan Enache Says:

    The technical version of the metaphorical animal spirits & liquidity fetishism’ crisis of confidence the destabilises the economy would say that negative expectations in one or more sectors give rise to negative coordination externalities (or high transaction costs if one prefers this terminology). The question is then if government interventions can lead to positive coordination externalities.

  3. Mario Rizzo Says:

    The problem is that when the “illusory” nature of the prices and resource allocation in those sectors not allowed to adjust is revealed, the negative coordination externalities will reassert themselves. And if agents get the idea ex ante that markets have not adjusted properly, why should there be positive coordination externalities in the first place?

  4. Bogdan Enache Says:

    Dear professor Rizzo,

    I guess the answer to this question depends on the relation between expectations and the underlying reality. If the negative coordination externality is a response to a set of negative expectations that deviate away from the underlying reality, then improving confidence (however than might be achieved) would probably help re-establish coordination. But if the cause of the crisis are changes in the underlying reality then expectations are in line and aiming to change them would be self-defeating.

    But the difficulty in knowing the difference between expected in underlying reality is another word for uncertainty, so in a way we’re running in circles.

  5. Joe Calhoun Says:

    The uncertainty was started over a year ago by the Fed when they started the TAF. The goal of the TAF was to allow banks to borrow from the Fed without the transparency of the discount window. The practical result was the lack of confidence between banks that froze the interbank market. I wrote about this back in September and not a thing has changed:

    http://alhambrainvestments.com/blog/2008/09/27/trust-capitalism/

    The only way for the government to restore confidence is to lead by example. That means reducing spending and reducing debt. The old confidence of the buy now, pay later culture is gone for at least a generation. And it isn’t coming back no matter how much money the government spends on “stimulus”. Confidence cannot be restored by more obfuscation. It requires something in short supply in DC – honesty.

    It is the government interventions that destroyed confidence. If the bad banks had been allowed to fail, people could be confident that the survivors are worthy of their confidence. Now, even the well run banks are suspect because no one knows the real condition of any financial institution. Propping them up with government provided capital will not induce confidence but more suspicion. Why should anyone have any confidence in the system when the well connected get bailed out and taxpayers are forced to pay the tab? How could giving new, cheap capital to those who have failed miserably possibly instill confidence?

    I’m an investment advisor dealing with individuals. I talk to a lot of average joes and I can tell you that the lack of confidence is tied directly to the bailouts. My clients are naturally mad at the greed they see at the banks and brokers, but they are just as upset with the politicians who enabled them. Restoring confidence to these people will require the bank/broker executives to feel some pain, preferably in a cell with Bubba, and the politicians to tell the truth. My clients are overwhelmingly opposed to the stimulus plan. They see it as the same business as usual that got us in this mess. They want the country to do what they’ve done; get out of debt (or better, never get in debt), work hard, save and invest for the future. Until someone in DC gets that message, confidence isn’t coming back.


  6. Knightian uncertainty is a small problem compared with the uncertainty that is generated by interventinist ideologues in power. A primary function of responsiblle governenmt is to maintain whatever stability and continuity can be oranised, essentially to govern by rules rather than orders.

    http://clubtroppo.com.au/2008/10/23/rules-and-orders-the-dangers-of-ad-hoc-interventionism/

    Channeling Popper:

    “The legal framework can be known and understood by the individual citizen; and it should be designed to be so understandable. Its functioning is predictable. It introduces a factor of certainty and security into social life. When it is altered, allowances can be made, during a transitional period, for those individuals who have laid their plans in the expectation of its constancy.”

    “As opposed to this, the method of personal intervention must introduce an ever-growing element of unpredictability into social life, and with it will develop the feeling that social life is irrational and insecure. The use of discretionary powers is liable to grow quickly, once it has become an accepted method, since adjustments will be necessary, and adjustments to discretionary short-term decisions can hardly be carried out by institutional means. This tendency must greatly increase the irrationality of the system, creating in many the impression that there are hidden powers behind the scenes, and making them susceptible to the conspiracy theory of society with all its consequences – heresy hunts, national, social, and class hostility. In spite of all this, the obvious policy of preferring where possible the institutional method is far from being generally accepted. The failure to accept it is, I suppose, due to different reasons. One is that it needs a certain detachment to embark on the long-term task of re-designing the ‘legal framework’. But governments live from hand to mouth, and discretionary powers belong to this style of living-quite apart from the fact that rulers are inclined to love those powers for their own sake.”


  7. Perhaps animal spirits and confidence have their own rhythm and do not dance to the beat of policy or behave according to how economists think they should behave. Possibly they would not be animal spirits were that not true. And yet right now this is the most important variable in determining future asset prices, aggregate demand and output.

    For example, credit spreads currently imply a huge number (40%?) of investment grade companies will default based on historical recovery rates. If spreads and rates stay where they are, these default rates may well be realised, because companies will be unable to roll over their debt at economic levels. Of course, should the fear in the market dissipate and spreads tighten to more ‘normal’ levels, the rollover of financing will go fine and defaults will also be within the high end of the normal incidence.

    We know there is a cyclical aspect to confidence/risk appetite/velocity/desired leverage ratio, and that although it is currently very weak after some years it is likely to stage a recovery, at least of sorts. We also know that policy reacts with a lag to events and there is a lag before policy measures once decided, take effect.

    So it is highly likely that policy response will be based on the cycle low point and that initially not a lot may happen. So if the first Obama stimulus program is perceived to have been insufficient, it will be followed by another, more dramatic one along with more aggressive monetisation of corporate, mortgage and treasury debt. It seems quite likely that the effects of this combined programme will kick in just as risk appetite picks up.

    So we may go from panicking about deflation to a concern about inflation at a time when the fragility of the financial system makes it difficult for the Fed to tighten policy quickly enough (from a political perspective, if nothing else).

    Just how is the political economy of the Fed leaving the lending business going to look?

  8. Drewfuss Says:

    Do you remember the terrible recession that occured after the 1987 stock market crash, due to the radical Knightian-Keynesian uncertainty that that event, and all the dire predictions that immediately followed, caused?

    Neither do i.

    Are you aware of the miserable growth rates that occured in the few years after the econonmy stabilized in early 1933, due to an unwillingness of investors to take risks, following sustained negative growth, deflation and rampant bank failures, and in an environment of rapidly escalating, often arbitary business regulation?

    Neither am i.

    The whole ‘animal spirits’ hypothesis is laughable in the context of history, and its popularity among economists is farcical.

    Whatever problems Capitalism has, a lack of animal spirits is not one of them.


  9. Funnily enough – despite very little change on the policy front since my last post – credit spreads have come in massively, with the IBOXX high yield CDS index coming from 14% to 8%. Thirty year breakeven inflation rates have moved up from 1.5 % to a recent high of 2.5%

    Drewfuss, I do not know whether you were addressing my comment above. But I suppose I would tend to believe that your examples tend to support my idea that having some model of animal spirits as well as the underlying ‘fundamentals’ is helpful for getting a sense for the prospects for economic activity and asset market prices.

    A very simple contrarian model of mass psychology and animal spirits made it quite clear that a depression was unlikely to develop given the sentiment extreme present from October 2008 to March 2009.

  10. Drewfuss Says:

    Laeeth,
    are you suggesting that there are actually two primary psychological variables that affect macro outcomes – one being ‘animal spirits’ and the other being ‘sentiment’? And perhaps that these psychological forces work in an inverse manner, a bit like bond prices and interest rates?

    What pattern do you suggest these variables followed during the Great Depression? What about after the 1987 stock market crash – did they both remain at normal levels so that OECD nations kept growing?

    “…having some model of animal spirits as well as the underlying ‘fundamentals’ is helpful for getting a sense for the prospects for economic activity and asset market prices.”

    But is it really? I don’t see that there is any good evidence for these psychological speculations at all. ‘Animal spirits’ is a phrase so vague and laced with mystical overtones that it makes dark energy/matter theories, by comparison, sound extremely precise and thorough.

    Also, it is too easy to assume that some hard to define, highly random and yet unknowable (ex ante) variable is critical to the growth path of the economy. And yet is highly convenient for the Keynesian who are enchanted by the idea of an unstable capitalistic order, but one that can set onto a stable path by technocratic ‘planning’.


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