By Philip Pilkington, a writer and journalist based in Dublin, Ireland. You can follow him on Twitter at @pilkingtonphil
Fairytales and nursery rhymes are quite popular among the economists. Economists and economic commentators will couch magical thinking in rational sounding phrases — but that doesn’t stop it from being hokum. Some within the profession attack these juvenile tendencies. Paul Krugman, for example, has often lambasted the idea, fostered by some of his colleagues, that the current crisis is due to a lack of confidence among investors. In a flash of irony he labeled this idea that of the ‘confidence fairy‘.
Of course, Krugman is absolutely right; the idea that a lack of confidence is responsible for the current crisis is a fairytale pure and simple. Our current economic problems are caused by a lack of aggregate demand. Investors are absolutely right to lack confidence at this moment in time because, just like in the 1930s, there is no rational reason to invest more because the population lacks the adequate purchasing power to consume more goods and services. Matias Vernengo over at the excellent Naked Keynesianism blog provides a classic quote from Roosevelt’s Fed chairman Marriner Eccles that summarises the situation well:
Confidence itself is not a cause [of economic depression]. It is the effect of things already in motion. What passed as a ‘lack of confidence’ crisis was really nothing more than an investor’s recognition of the fact that new plant facilities were not needed at the time.
Pretty straightforward point, but powerful nonetheless. And I think Krugman and other ISLM-Keynesians would broadly agree with it. That is, peculiarly, until they start talking about inflation targeting.
Proponents of inflation targeting claim that if the central bank sets a higher inflation target investors will react to this by, well, investing more. Krugman sums it up:
If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher… [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea.
Now, is it just me or does it appear that Krugman has just smuggled the confidence fairy in through the backdoor? Read that passage again carefully. The ‘idea’ here is to trick investors into investing by scaring them into thinking that the Fed will allow inflation to rise higher than it currently is.
Really? Come on. Does Krugman really believe investors are this stupid? Does he really think that they make their investment decisions based on what some central banker says is the target rate of inflation? Sure, the commentariat are eating this garbage up — the usually sharp crew over at FT Alphaville provided a glowing account of why the inflation-confidence fairy should be unleashed from its bottle — but when it comes to putting your money where your mouth is, are smart people really going to buy into this idiocy?
Short answer: no. Krugman and others treat investors like children. But investors — real investors who provide funds for new goods and services — are not children. Instead, they will continue to look at the economic fundamentals when making investment decisions. And if there is simply not enough demand for goods and services they will not make investments aimed at creating more goods and services. Duh! It really is quite obvious.
Now, the financial investment community might well react to this hocus pocus — but that is an altogether different thing. This is not because paper-shufflers are stupider than their entrepreneurial and corporate counterparts, but because they are concerned with perceptions and fairytales — it is largely upon these that their business rests. They do react irrationally to news simply because they think that their peers might react irrationally to the same news. The financial community is, in many ways, a hall of mirrors with everyone trying to guess everyone elses’ reaction to announcements and news. But just because the financial community may react to a higher inflation target by no means entails that their money will end up funding goods and services that increase employment in the real economy.
If you actually look at how the financial community reacts to unorthodox announcements by the central bank the reality — as opposed to what abstractions like the ISLM will lead you to believe — is much different. The likely outcome of such an announcement in the present economic environment is obvious given that we now have four years of experience with these sorts of pseudo-policies: financiers will move their funds into so-called ‘inflation hedges’ like gold, silver and other commodities. What’s more, if the central bank manages to scare them sufficiently they may even move their funds out of government bonds and into these ‘hedges’. This will lead to increased upward pressure on the interest rate at which governments borrow which will, in turn, give the austerity brigade even more of a mandate to cut government spending and engage in other sorts of economic vandalism.
Unfortunately, Krugman and others will likely continue to publish their fairytales and recite their bedtime stories. Why? Because, to put it somewhat bluntly, it gives them something to do. It gives them something to talk about that makes them appear as if they have some specialised knowledge that only a select few Very Sophisticated People understand and have access to. It also gives them the assurance that their abstract models actually tell them something — something a priori and mysterious — about the real world that cannot be gleaned by simply observing empirical reality. In short, it gives them a power to fascinate the general public and policymakers and lull them to sleep. But of course this is exactly the same power of fascination that the parent exerts over the child at bedtime by telling them of faraway lands; of witches and of warlocks; of goblins and… of fairies.