The New York-based blogger for The Economist‘s Free Exchange replies to my lament by arguing that economists do have a theory of the psychology of coordinated expectation. They do, sort of. But they don’t have the kind of theory that I have in mind. Harvard’s Gregory Mankiw admits as much when he blogs:
Yale’s Bob Shiller argues that confidence is the key to getting the economy back on track.
I think a lot of economists would agree with that. The question is what would make people more confident. Bob thinks that confidence would rise if the government borrowed more and spent more. Other economists think that confidence would rise if the government committed itself to, say, lower taxes on capital income. The sad truth is that we economists don’t know very much about what drives the animal spirits of economic participants. Until we figure it out, it is best to be suspicious of any policy whose benefits are supposed to work through the amorphous channel of “confidence.” [emphasis added]
In what macro textbook can one find references to empirical psychological work on confidence? On individual-level variability in confidence, on the conditions under which the confidence of various personality types is affected by economic variables, on the relationship between changes in condfidence and changes in economic behavior, on the social “infectiousness” of changes in confidence, etc.
I have a lot of respect for Shiller, but Mankiw is right. Shiller doesn’t have any real evidential basis for claims about what policies will induce confidence. And neither does anyone else.
This is maybe overglib, but it seems to me that if we knew the answer to this and similar questions, we wouldn't need markets to begin with.
I think our socialism-for-the-rich economy requires confidence in the same way that continued participation in three-card-Monty requires confidence.
I get the feeling that the Keynesians think that the economy is Dumbo and the stimulus is the magic feather that he thinks enables him to fly.
If we buy into this story, we should feel guilty telling people that the feather isn't really magic. That'll spoil everything!
The furthest I'm willing to go with this analogy is to say that I think the feather is more like an anchor, and that Dumbo will be better able to fly if he had no anchor, lost some weight, strengthened his ears, and understood the truth about what enables him to fly, rather than continuing to get impeded by purveyors of phony cures that might give a temporary placebo benefit, but leave him worse off.
So, I don't feel guilty at all condemning policy that I think will do much more harm than good.
We should advocate policies that will inspire justified confidence.
The big problem with economics is an inadequate model of the human being.
This is why there are interesting convergences between artificial intelligence and economics.
But people get attracted to economics because of its “ability” to give clear-cut answers to complex questions. That clarity is an asset in some cases, but it is a liability (false clarity) in others.
The type of people who are attracted to economics, I think, are less socially aware and tend to like the idea of the human as a sort of robot. So you get a profession of people emotionally attached to unrealistic models, making predictions based on those models. The predictions are bad, and there is little agreement. In the face of this pervasive model uncertainty, economists fall back on their other common personality trait — their folk theory of justice — to fill in the gaps where their models fail to explain the world.
That's my model, if you will, of the economics profession. Economists tend to be mathy, shy types with a folk theory of justice. And, uh, the results are sometimes problematic.
Will is right that there is zero empirical psychology on confidence incorporated into academic macroeconomics. This should make us suspicious of glib references to “confidence” or the “mood” of the market.
There is another sense, however, in which economists do have a rigorous theory of “confidence.” Macroeconomists do lots of work with rational expectations, the notion that market participants intelligently use available information to form hypotheses about the future and guide their decisions.
Mixing rational expectations with the right kind of neo-Keynesian framework, you'll find situations where improvements in expectations of the future increase present production and consumption across the board. You may have a “bad equilibrium,” where companies aren't producing because they (rationally) don't think anyone will buy in the next year, and people indeed don't buy because they're (rationally) preparing for the possibility of losing their job, that shifts to a “good equilibrium” after a nudge to expectations provided by government stimulus.
Now, what exactly are rational expectations, and how do consumers form them? That's a good question, and the unfortunate answer is that in econ-land, it depends on the model being used. Since market participants are “rational,” economists working with a given model assume that agents will logically derive the probable outcomes of that model. Of course, any model is an approximation, and most of us have mental models even cruder than anything academic macroeconomists have dreamt up, making this an unsatisfying answer. Certainly it doesn't address the “animal spirits” of Keynes and Shiller, or provide anything close to the rigorous behaviorial economics that Wilkinson admires.
But it does give us a reasonable set of circumstances where confidence makes all the difference. And, contra commenter “GilM” above me, the question of whether confidence is “justified” or not doesn't necessarily even make sense. In the right model, your negative expectations about the future may be rationally premised on everyone else's negative expectations about the future, and little else. Introduce some slight shock to the system, prompting a large-scale reevaluation of expectations, and you may slide back to the good equilibrium where positive expectations prevail.
Well, I think confidence being justified does make sense. It's just not independent of one's estimate of other people's confidence.
But, there are other important factors that affect whether people will be likely to maintain their confidence. I think that those other factors being better, along with the reasonable expectation that this improvement will improve the aggregate confidence of other market participants, leads to a justified increase in confidence.
Hurting the allocation of resources, piling on debt, and introducing uncertainty with huge, unpredictable, “shocks to the system”, doesn't seem (to me) like a good strategy to improve long-term (or even short-term) confidence.
“Action is, by definition, always rational. One is unwarranted in calling goals of action irrational simply because they are not worth striving for from the point of view of one’s own valuations.”
Ludwig von Mises, Epistemological Problems of Economics, p. 35
“Rational conduct means that man, in face of the fact that he cannot satisfy all his impulses, desires, and appetites, forgoes the satisfaction of those which he considers less urgent.”
Ludwig von Mises, Human Action, p. 172
It is clear to economists from the Austrian School that since all conscious human actions aim at a purpose every time, then human actions must always be rational. By this the Austrians mean that actions are guided by the individuals intellect and will, not that the actions are always 'rational' from the perspective of an external observer. We need to point out that it does not matter if actions are driven by emotion or the need to satisfy some instinct because no mater the motivation the acting individual still acts and considers both costs and benefits.
I hate to be consistent but it is clear that the Austrian School has the best answer to this question. As Menger pointed out, individuals choose what they perceive to be the most desirable action between different alternatives. That is what rationalism means to Austrians, that an individual makes the decision that he thinks best, not that the choice made by each individual will actually be the best one possible.
“Behavioural economists” focus on the idea that man has some built in defects in his cognitive and reasoning abilities that bias his choices and use he term “irrational” to describing these findings. The problem is that the meanings of the term can vary. It can mean the violation of specific economic axioms, a failure to satisfy Bayesian axioms or simply a high time preference.
Of course, the defect is with the researchers because they begin with an arbitrary standard of value and a specific idea of what constitutes rational action, which usually fits some model. But the average human being does not behave as any particular model may expect. And given the fact that different researchers may have different notions of what constitutes rational behaviour, we may find that it is possible for a person to act rationally according to one model but not according to another.
Trying to impose an an arbitrary standard of value is not likely to lead anywhere and behavioural economics will fail badly, particularly when it is tied in to economic theories that promote statistm.
You may be interested in looking at the commentary at the link below.
https://mises.org/journals/qjae/pdf/qjae10_2_1.pdf
Sorry but I am having a really hard time posting here. For some reason I missed an extra paragraph that I thought had been removed. My posting above should have been as follows:
“Action is, by definition, always rational. One is unwarranted in calling goals of action irrational simply because they are not worth striving for from the point of view of one’s own valuations.”
Ludwig von Mises, Epistemological Problems of Economics, p. 35
“Rational conduct means that man, in face of the fact that he cannot satisfy all his impulses, desires, and appetites, forgoes the satisfaction of those which he considers less urgent.”
Ludwig von Mises, Human Action, p. 172
It is clear to economists from the Austrian School that since all conscious human actions aim at a purpose every time, then human actions must always be rational. By this the Austrians mean that actions are guided by the individuals intellect and will, not that the actions are always 'rational' from the perspective of an external observer. We need to point out that it does not matter if actions are driven by emotion or the need to satisfy some instinct because no mater the motivation the acting individual still acts and considers both costs and benefits.
“Behavioural economists” focus on the idea that man has some built in defects in his cognitive and reasoning abilities that bias his choices and use he term “irrational” to describing these findings. The problem is that the meanings of the term can vary. It can mean the violation of specific economic axioms, a failure to satisfy Bayesian axioms or simply a high time preference.
Of course, the defect is with the researchers because they begin with an arbitrary standard of value and a specific idea of what constitutes rational action, which usually fits some model. But the average human being does not behave as any particular model may expect. And given the fact that different researchers may have different notions of what constitutes rational behaviour, we may find that it is possible for a person to act rationally according to one model but not according to another.
Trying to impose an an arbitrary standard of value is not likely to lead anywhere and behavioural economics will fail badly, particularly when it is tied in to economic theories that promote statistm.
You may be interested in looking at the commentary at the link below.
https://mises.org/journals/qjae/pdf/qjae10_2_1.pdf
The 'lets do something to increase confidence' is usually the statist argument to any economic slowdown. What they fail to realize is that it is usually government interference with the economy that is responsible for the slowdown in the first place. Without the Fed's monetary policies and the government's idiotic promotion of lending to poor credit risks the bubble that created this crisis would not have been formed in the first place.
This is maybe overglib, but it seems to me that if we knew the answer to this and similar questions, we wouldn't need markets to begin with.
I think our socialism-for-the-rich economy requires confidence in the same way that continued participation in three-card-Monty requires confidence.
I get the feeling that the Keynesians think that the economy is Dumbo and the stimulus is the magic feather that he thinks enables him to fly.
If we buy into this story, we should feel guilty telling people that the feather isn't really magic. That'll spoil everything!
The furthest I'm willing to go with this analogy is to say that I think the feather is more like an anchor, and that Dumbo will be better able to fly if he had no anchor, lost some weight, strengthened his ears, and understood the truth about what enables him to fly, rather than continuing to get impeded by purveyors of phony cures that might give a temporary placebo benefit, but leave him worse off.
So, I don't feel guilty at all condemning policy that I think will do much more harm than good.
We should advocate policies that will inspire justified confidence.
The big problem with economics is an inadequate model of the human being.
This is why there are interesting convergences between artificial intelligence and economics.
But people get attracted to economics because of its “ability” to give clear-cut answers to complex questions. That clarity is an asset in some cases, but it is a liability (false clarity) in others.
The type of people who are attracted to economics, I think, are less socially aware and tend to like the idea of the human as a sort of robot. So you get a profession of people emotionally attached to unrealistic models, making predictions based on those models. The predictions are bad, and there is little agreement. In the face of this pervasive model uncertainty, economists fall back on their other common personality trait — their folk theory of justice — to fill in the gaps where their models fail to explain the world.
That's my model, if you will, of the economics profession. Economists tend to be mathy, shy types with a folk theory of justice. And, uh, the results are sometimes problematic.
Will is right that there is zero empirical psychology on confidence incorporated into academic macroeconomics. This should make us suspicious of glib references to “confidence” or the “mood” of the market.
There is another sense, however, in which economists do have a rigorous theory of “confidence.” Macroeconomists do lots of work with rational expectations, the notion that market participants intelligently use available information to form hypotheses about the future and guide their decisions.
Mixing rational expectations with the right kind of neo-Keynesian framework, you'll find situations where improvements in expectations of the future increase present production and consumption across the board. You may have a “bad equilibrium,” where companies aren't producing because they (rationally) don't think anyone will buy in the next year, and people indeed don't buy because they're (rationally) preparing for the possibility of losing their job, that shifts to a “good equilibrium” after a nudge to expectations provided by government stimulus.
Now, what exactly are rational expectations, and how do consumers form them? That's a good question, and the unfortunate answer is that in econ-land, it depends on the model being used. Since market participants are “rational,” economists working with a given model assume that agents will logically derive the probable outcomes of that model. Of course, any model is an approximation, and most of us have mental models even cruder than anything academic macroeconomists have dreamt up, making this an unsatisfying answer. Certainly it doesn't address the “animal spirits” of Keynes and Shiller, or provide anything close to the rigorous behaviorial economics that Wilkinson admires.
But it does give us a reasonable set of circumstances where confidence makes all the difference. And, contra commenter “GilM” above me, the question of whether confidence is “justified” or not doesn't necessarily even make sense. In the right model, your negative expectations about the future may be rationally premised on everyone else's negative expectations about the future, and little else. Introduce some slight shock to the system, prompting a large-scale reevaluation of expectations, and you may slide back to the good equilibrium where positive expectations prevail.
Well, I think confidence being justified does make sense. It's just not independent of one's estimate of other people's confidence.
But, there are other important factors that affect whether people will be likely to maintain their confidence. I think that those other factors being better, along with the reasonable expectation that this improvement will improve the aggregate confidence of other market participants, leads to a justified increase in confidence.
Hurting the allocation of resources, piling on debt, and introducing uncertainty with huge, unpredictable, “shocks to the system”, doesn't seem (to me) like a good strategy to improve long-term (or even short-term) confidence.
“Action is, by definition, always rational. One is unwarranted in calling goals of action irrational simply because they are not worth striving for from the point of view of one’s own valuations.”
Ludwig von Mises, Epistemological Problems of Economics, p. 35
“Rational conduct means that man, in face of the fact that he cannot satisfy all his impulses, desires, and appetites, forgoes the satisfaction of those which he considers less urgent.”
Ludwig von Mises, Human Action, p. 172
It is clear to economists from the Austrian School that since all conscious human actions aim at a purpose every time, then human actions must always be rational. By this the Austrians mean that actions are guided by the individuals intellect and will, not that the actions are always 'rational' from the perspective of an external observer. We need to point out that it does not matter if actions are driven by emotion or the need to satisfy some instinct because no mater the motivation the acting individual still acts and considers both costs and benefits.
I hate to be consistent but it is clear that the Austrian School has the best answer to this question. As Menger pointed out, individuals choose what they perceive to be the most desirable action between different alternatives. That is what rationalism means to Austrians, that an individual makes the decision that he thinks best, not that the choice made by each individual will actually be the best one possible.
“Behavioural economists” focus on the idea that man has some built in defects in his cognitive and reasoning abilities that bias his choices and use he term “irrational” to describing these findings. The problem is that the meanings of the term can vary. It can mean the violation of specific economic axioms, a failure to satisfy Bayesian axioms or simply a high time preference.
Of course, the defect is with the researchers because they begin with an arbitrary standard of value and a specific idea of what constitutes rational action, which usually fits some model. But the average human being does not behave as any particular model may expect. And given the fact that different researchers may have different notions of what constitutes rational behaviour, we may find that it is possible for a person to act rationally according to one model but not according to another.
Trying to impose an an arbitrary standard of value is not likely to lead anywhere and behavioural economics will fail badly, particularly when it is tied in to economic theories that promote statistm.
You may be interested in looking at the commentary at the link below.
https://mises.org/journals/qjae/pdf/qjae10_2_1.pdf
Sorry but I am having a really hard time posting here. For some reason I missed an extra paragraph that I thought had been removed. My posting above should have been as follows:
“Action is, by definition, always rational. One is unwarranted in calling goals of action irrational simply because they are not worth striving for from the point of view of one’s own valuations.”
Ludwig von Mises, Epistemological Problems of Economics, p. 35
“Rational conduct means that man, in face of the fact that he cannot satisfy all his impulses, desires, and appetites, forgoes the satisfaction of those which he considers less urgent.”
Ludwig von Mises, Human Action, p. 172
It is clear to economists from the Austrian School that since all conscious human actions aim at a purpose every time, then human actions must always be rational. By this the Austrians mean that actions are guided by the individuals intellect and will, not that the actions are always 'rational' from the perspective of an external observer. We need to point out that it does not matter if actions are driven by emotion or the need to satisfy some instinct because no mater the motivation the acting individual still acts and considers both costs and benefits.
“Behavioural economists” focus on the idea that man has some built in defects in his cognitive and reasoning abilities that bias his choices and use he term “irrational” to describing these findings. The problem is that the meanings of the term can vary. It can mean the violation of specific economic axioms, a failure to satisfy Bayesian axioms or simply a high time preference.
Of course, the defect is with the researchers because they begin with an arbitrary standard of value and a specific idea of what constitutes rational action, which usually fits some model. But the average human being does not behave as any particular model may expect. And given the fact that different researchers may have different notions of what constitutes rational behaviour, we may find that it is possible for a person to act rationally according to one model but not according to another.
Trying to impose an an arbitrary standard of value is not likely to lead anywhere and behavioural economics will fail badly, particularly when it is tied in to economic theories that promote statistm.
You may be interested in looking at the commentary at the link below.
https://mises.org/journals/qjae/pdf/qjae10_2_1.pdf
The 'lets do something to increase confidence' is usually the statist argument to any economic slowdown. What they fail to realize is that it is usually government interference with the economy that is responsible for the slowdown in the first place. Without the Fed's monetary policies and the government's idiotic promotion of lending to poor credit risks the bubble that created this crisis would not have been formed in the first place.
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