Nothing new here. Think of this as a teaching post. Partly for the people of the concrete steppes, but for others too. I'm just going to talk about different ways that expectations can affect what happens. The main distinction is between multiple equilibria and unique equilibrium.
1. Multiple Equilibria
Here is one simple model of multiple equilibria: Y=E(Y)
Let Y be something that people do. Let E(Y) be people's expectations of what people do. The simple model Y=E(Y) says that people do whatever they expect other people to do. Expectations are totally self-fulfilling. People can expect anything they like, and it happens, just as they expect. There is a very large number (a continuum) of equilibria. Anything whatsoever can be an equilibrium. Or almost anything, if Y=E(Y) is only true over some range.
Here is another simple model of multiple equilibria, but where not everything is an equilibrium. Y=[E(Y)]2 + X, where X is some exogenous variable. This model has two equilibria. For any given level of X, there are two different levels of Y at which expectations will be self-fulfilling. But if people expect some other level of Y, their expectations will be falsified by their actions. And if X changes, both equilibria will change too.
It is easy to construct a model with three, or four, or any number of equilibria. Depending on how people form their expectations, and how they adjust their expectations if they turn out to be false, some of those equilibria may be unstable, and others stable.
Examples of multiple equilibria are all around us.
I use the word "cat" to mean cat, because I expect other people
around me to to do the same. (But when I'm talking to some other people
around me, I use the word "chat" to mean cat, because I expect those
people to do the same). There is no reason why we couldn't have a
different equilibrium in which we all used "cat" to mean dog, and "dog"
to mean cat. Almost any word could mean cat.
Another example is
which side of the road to drive on. Here, Y can only take on two values:
"left" or "right". If you expect everybody else to drive left, you
drive left, and if you expect everybody else to drive right, you drive
right.
Most people obey the law and follow the leader because they expect everybody else to obey that same law and follow that same leader. If everybody thought the law was a different law, or the leader a different leader, they would obey that different law and follow that different leader. The law is whatever people expect to be the law. The leader is whoever people expect to be the leader. Many different things (though perhaps not anything) could be the law, if people thought it was the law. Many different people (though perhaps not anyone) could be the leader, if people thought that person was the leader. The constitution, which is supposed to tell us who gets to make the law and who gets to be leader, wouldn't be the constitution if people didn't think it was.
2. Unique Equilibrium.
Here is a simple model with expectations and a unique equilibrium. Y=E(X). It is not X that determines what people choose to do; it is people's expectations of X that determines what people choose to do. It is not rain, but our expectations of rain, that determine whether we carry an umbrella.
Here is a slightly more complicated model. Y = 0.5E(Y) + 0.5X. What people choose to do depends partly on some exogenous variable X, and partly on what they expect other people to do. But there is only one level of Y, given X, at which people's actions will confirm their expectations of others' actions. Most static economic models are like that.
Now lets complicate that model slightly, by introducing time. Y(t) = 0.5E(Y(t+1)) + 0.5X(t). What people do today depends partly on X today, and partly on what people expect people to do tomorrow. Most dynamic economic models are like that. And you need to say something about how people form their expectations in order to solve those models.
One assumption is rational expectations. People's expectations are consistent with the model. Taking that same equation and leading it forward one period gives you Y(t+1) = 0.5E(Y(t+2)) + 0.5X(t+1). If people expect that that is how people will choose tomorrow, then E(Y(t+1)) = 0.5E(E(Y(t+2))) + 0.5E(X(t+1)). We can substitute this solution for E(Y(t+1)) into the first equation, repeat again and again, and get the equilibrium as:
Y(t) = 0.5X(t) + 0.52E(X(t+1)) + 0.53E(X(t+2)) + etc.
[Somebody please tell me politely if I've screwed up the math, as I usually do.]
The solutions to almost all modern macroeconomic models look like that. If X is some policy variable, then it is not just current policy that matters, but people's expectations of the whole path of future policy.
If you make a different assumption about expectations you will get a different solution. But if people think that policy affects what people do, and also think that expectations affect what people do, you will still get some sort of solution which looks something like that.
In that example, I used "0.5" as a numerical parameter value for both E(Y(t+1)) and X(t). That means that Y(t) is determined 50-50 by current policy and by expected future policy. If I had originally measured time in years, and then switched to measuring time in 6-month periods, I would need to change those parameter values, and make the model (roughly) Y(t) = 0.75E(Y(t+1)) + 0.25X(t). And the solution would now become:
Y(t) = 0.25X(t) + 0.752E(X(t+1)) + 0.753E(X(t+2)) + etc.
[Damn. i've screwed up the math there, haven't I. I need more coffee, or some help.]
Now Y(t) is only 25% determined by current policy, and 75% determined by expectations of future policy.
As we shorten the time-period still further, we approach a solution in which Y(t) is 99.99% determined by expectations of future policy.
3. Counterfactual conditional expectations matter too.
I do not break the speed limit. (OK, just assume I don't.) I do not expect the police to give me a speeding ticket. But I do expect the police would give me a ticket if I did speed. Which is why I don't speed. So in equilibrium I do not speed. And I don't expect the police to give me a tcket.
What people do in equilibrium is in part determined by people's counterfactual conditional expectations of what other people would do away from the equilibrium.
4. Monetary policy at the ZLB.
New Keynesian macroeconomic models have solutions that look like:
Y(t) = 0.25X(t) + 0.752E(X(t+1)) + 0.753E(X(t+2)) + etc.
Except:
4.1 For quarterly data, it's a smaller number than 0.25 (and so a bigger number than 0.75) and so expected future policy matters a lot more than current policy;
4.2 The policy variable X(t) is interpreted as a nominal interest rate, but the nominal interest rate is not exogenous. It is determined by a feedback rule so that it depends on Y(t). This means that people's expectations of policy can be described [I should have said "and must be described"] as beliefs about the parameters in that feedback rule, rather than expectations about the nominal rate of interest itself. In all New Keynesian models, if the central bank announced and stuck to a time-path for X(t) that was not a feedback rule, (and so did not depend on Y(t)), the model would have multiple equilibria, with nearly all of those time-paths for Y(t) leading to an explosive or implosive path for the inflation rate. (If expected inflation were to increase, that would reduce the real interest rate for any given nominal interest rate, which would increase demand for goods, which would increase inflation, which would increase expected inflation, and so on.) What prevents those explosive or implosive paths happening are people's expectations about what the central bank would do if one of those paths were to happen (it would increase nominal interest rates by enough to stop it happening). This means that counterfactual conditional expectations matter too in New Keynesian macroeconomic models.
Even if you think about monetary policy as New Keynesians do, as setting a counterfactual conditional feedback rule for the nominal interest rate, this does not mean that monetary policy cannot be loosened at the ZLB. If people expect that at some future time, however distant, the economy will escape the ZLB and the central bank will want to raise interest rates to prevent the inflation rate rising too much, monetary policy can still be loosened today. The central bank can commit to delaying the time at which it would otherwise increase the nominal interest rate. It could commit to keeping interest rates "too low for too long". A better way to communicate that commitment might be to commit to a higher price level or NGDP level in the future feedback rule for monetary policy. And it might be better still to stop talking about monetary policy in terms of interest rates, and describe the monetary feedback rule in terms of a setting for some asset price as a function of an NGDP target.
I don't have great hopes for this post persuading people to change their perspective on expectations. But one can only try.
Worthwhile Canadian Initiative 
… the fact that governments issue long bonds and honor them cannot be derived from any simple premises. It’s a fact about the world, that could be otherwise.
I agree JW. But I believe the US has a track record of paying its debts, going all the way back to Hamilton. So it has hard won credibility, and every time it pays another debt it invests further in that credibility.
There are theses things called government bonds, where the government makes a commitment to pay a certain amount to whoever owns them, sometimes 30 years in the future. Some of those bonds are even supposed to be indexed to inflation!!! I can’t see any reason why anybody would believe that commitment. Would it actually be in the government’s interest to do what it said it would do, 30 years previously?
Congress passes laws allowing the government to formally issue a debt obligation. That debt obligation is backed by “the full faith and credit of the United States”.
When a Congress person loses his seat, the law remains, as does the obligation.
There is a big difference between a financial obligation made into law and backed by the full faith and credit of the U.S. government, and the announcement of a policy stance by someone who will be replaced with possibly a different policy stance.
Nick, don’t you see the difference between a debt obligation of the government written on paper and owned by someone with a legal right to redeem, and a “policy” obligation? The current sitting session of congress can force the U.S. to incur a debt obligation, but it cannot force future sessions of congress to incur policy obligations. There is no mechanism to constrain future legislators this way, and if there was, it wouldn’t make sense to prioritize one session of congress of another, reserving policy making rights to only one period of time.
Or, put another way, in 20 years, our knowledge of how the economy works will be different. We will, hopefully, understand that the central bank does not control the money supply! (had to get that jab in).
But whatever that knowledge is, it will cause policy to change. Policy will always change. We will not adopt a bad policy in 20 years in order to fulfill a “policy debt” set today. But we will continue to service our debt. We are not know debating not servicing our debt. We are now debating adopting a new policy. One of these is a policy variable, while the other is a real obligation that people can count on being fulfilled.
rsj: “bonds” are just ink marks on paper. Is it magic ink and magic paper? Laws are more ink marks on paper. Only superstitious people believe they have any magic power. “Bonds” and “laws” are just the government’s communications strategy. They only work if we believe they work. They aren’t concrete steps to anywhere.
Everything rests on fairies. It’s fairies, all the way down.
Nick, this is why economics, try as much as it might to pretend otherwise, is a social science. We have rules. The rules change. The models need to capture the rules. The models need to change. So everything is either subject to the Lucas critique or vacuous, because the rules themselves are changing, and there are no invariants.
In our world, we are debating policies, because policies change. In 10 years, a 10 year bond will be paid in full, but the 10 year old policy promises of central bankers will have only comical value.
And revolutionaries use models to change the way we see the world, and so to change the rules. Will Americans still see monetary policy as interest rates 10 years from now? I don’t know, but I wouldn’t count on it.
“Nick, this is why economics, try as much as it might to pretend otherwise, is a social science.”
I can’t think of an economist who would want to pretend otherwise. (Maybe some would say it’s a branch of biology, but I’m not sure they are mutually exclusive?) Most (all?) economists I know say that economics is a social science. Some say it is the queen of the social sciences. Some say it is the only right way to do social science.
I don’t think this applies much to the issue of debt repayment, but its worth noting that laws are not the same things as conventions, standards, rules or norms. They are rules enforced by sanctions. Governments don’t succeed in getting people to conform, by and large, to the laws simply by communicating those laws. A government is not a mere facilitator of coordination. Governments also communicate their standing commitment to enforcing the laws by punishing violations. And they demonstrate the credibility of that commitment not just by stating the commitment in a firm voice, but by investing massive amounts of resources, day after day, in the apprehension, prosecution and punishment of violators of the laws, and by publicizing these investments and results so that everyone is aware of them. So the proof is in the pudding.
A country’s debt commitments are not really made more credible because it has passed a law binding itself to paying the debt, since it can always change the laws later. But the commitment is made more credible by an enduring track record of repaying debts. Debts can be difficult to pay and there is always at least some incentive for not paying them. So if one sees that a country has a long track record of consistently paying its debts over many generations, one has some evidence that there is something in the institutions and mental habits of the people of that country that seems consistent over time and that the people apparently successfully pass down from generation to generation. It’s by no means an infallible conclusion to draw, but it does grow more solid the longer the practice endures.
Dan: ” Governments don’t succeed in getting people to conform, by and large, to the laws simply by communicating those laws. A government is not a mere facilitator of coordination.”
I don’t look at it that way. Those people we call “Prime ministers”, “presidents”, and “queens”, are usually not any more powerful, in concrete terms, than anyone else. They can only communicate those things we call “laws” to those people we call “police” and “judges”. The people we call “police” usually choose to obey, because they think other police and everybody else will obey too. The “police” are usually a little bit more powerful than ordinary people, but not much. And there are very few of them. But their uniforms and badges are a focal point, so we usually obey them, and they are trained to coordinate on focal points better than a mob of individuals, which helps them win when it does come down to concrete stuff.
Again, it’s fairies all the way down, once you disaggregate “government”.
it’s fairies all the way down
I agree with this, actually.
Nick
When making your purchase decisions without first inferring the objective function of the central bank would be a sign of moral turpitude (or would make woe befall you), I’d agree with this monetary policy and law analogy. Until then, let’s acknowledge that we’re dealing with very shaky territory here.
If one was to believe everything you say, we’re better off searching for the roots of monetary policy in political philosophers and psychologists, proper ones at that. Fisher & Friedman are useless and monetary economics courses should be scrapped or reduced to footnotes in sociology classes.
At the very least, this is sufficient case for subsuming monetary economics under the ambit of public finance.
“How did the fiscal confidence fairy get reified into a cast-iron bond, while the monetary confidence fairy gets dismissed as just Tinkerbell, who only exists if we all believe in her?”
Maybe this has something to do with the source of the institution asking for the confidence. A body like Congress that has very transparent codes, readable and changeable by the people, will necessarily be trusted more than a body which most people understand to have been created in secret ways (on an island off the coast of Georgia), with nefarious intent (to put banks in a special wealth stealing position relative to the electorate). While contempt of Congress is high it doesnt approach the level of contempt for all Central Bankers around the world, and with good reason I think. In the United States at least, they meet regularly, do not openly discuss the specific content of their meetings, CSpan never shows us a blow by blow of the nature of their debates and all we get at the end is a very nebulous five minute proclamation by Bernanke at the end. Most of the time its simply unnecessary words concluded with “We intend to keep rates at x for the forseeable future”. CBs are the least trusted people on the planet, so regardless of their intent and abiliites to affect things, everything they do which requires a level of coordination with and trust from the general population will be negatively affected. There is really not anything of importance in this world that doesnt require a significant amount of collective will to get accomplished and collective will requires thoughtful and trusted communicators (maybe not first and foremost but certainly important to the process). Sorry to burst your bubble Nick but most people see CBers as scheisters.
We all know thtat CBs are FOR the banks first and public purpose is waaaaaaay down the list if even on the list.
Nick, the difference between the government and the fed is the government is a legally mandated monopoly that has wide spread support. Are you suggesting that the fed should have greater monopoly powers? Should the American government outlaw the acquisition of gold or currency exchange?
Again, it’s fairies all the way down, once you disaggregate “government”.
Isn’t that a little bit like saying, “It’s atoms all the way down, once you disaggregate nuclear bombs”?
The motives people have for conforming to laws are very different from the motives they have for conforming to norms articulated by a facilitator.
Suppose we had a norm which said: “you must do X, and you must punish those who do not follow this norm”. (please note the infinite regress due to the self-referential bit, so the norm says we punish those who do not punish those….who do not do X.) If people actually follow that norm, we call it a law.
Some people do try to analyse this sort of stuff. They come from lots of different disciplinary backgrounds, economics included. My guess is that sociology and psychology are if anything under-represented in this field. But when you read this sort of stuff, it’s often very difficult to guess the author’s disciplinary background.
Ian: “…the government is a legally mandated monopoly…”
At least, that’s what the government says it has. But that’s just another way of saying that there’s a bunch of people who call themselves “the government”.
“Are you suggesting that the fed should have greater monopoly powers? Should the American government outlaw the acquisition of gold or currency exchange?”
Nope. I have no idea why you might think I’m saying that.
Suppose we had a norm which said: “you must do X, and you must punish those who do not follow this norm”. (please note the infinite regress due to the self-referential bit, so the norm says we punish those who do not punish those….who do not do X.) If people actually follow that norm, we call it a law.
Few such norms exist. That describes life in something not far removed from a Lockean state of nature with the private enforcement of justice.
In our society, we have professional classes of punishers. They punish people because it is their job to do so; and like most people, they do their job not because it is part of a broad social convention, but because they are incentivized to do so.
Dan, I think Nick is right here. “Laws” and “incentives” are just conventions. The only reason laws have moral force and are obeyed, is that they are widely believed to have moral fore and to be obeyed. On a formal, abstract level there really is no difference between changing a law and changing an expectation of future policy.
The difference is the practical one. In a modern liberal society, the belief that the law will be followed is very strong, so that it can be a convenient shorthand to just say “people have incentives” as if it were a physical fact, like “people have two kidneys.” But it isn’t really. On a fundamental level, there really is no difference between central bank guidance and law.
But there is a very big practical difference. People actually do hold very strongly rooted expectations that law will be obeyed, that debts will be paid, etc., in a way they do not about central bank announcements changing the expected economic conditions years from now. That’s a contingent fact about the world — it’s perfectly possible that after years at the ZLB, and a big intellectual victory by market monetarists, etc., announcements about policy N years from now would become a main tool of central banks, and experience would eventually confirm that you should make economic choices today based on what the central bank says policy will be five years from now. There’s no reason in principle why that could’t be the case. It just doesn’t happen to be the case now.
I don’t know if you identify as an MMTer or not. But my criticism of MMT has always been that they take a set of true, and important historical-empirical claims, and then mistakenly try to derive them deductively.
Just to make the grounds of substantive agreement with Dan K. clearer, here’s Gillian Tett in today’s FT, reporting that on a recent survey of CFOs that finds the vast majority of businesses would not change their business plans at all even if interest rates fell by as much as two percent. But “optimists add, QE3 also provides a wider general psychological boost. … The crucial problem … is that the psychology of this is still so uncertain. With anything between $2,000bn and $4,000bn of unused liquidity now swirling around the US financial system (depending on how you measure it), consumers and CFOs alike can sense that monetary policy is becoming less effective.”
As a practical matter, QE is not expected to work, which means that if it depends on the expectations channel, it won’t.
(link fail, sorry.)
The quote is from Gillian Tett in today’s Financial Times.
Link fixed.
JW
“On a formal, abstract level there really is no difference between changing a law and changing an expectation of future policy.”
Correct, with an important caveat. Changing expectation of future policy is equivalent to successfully changing the law.
Every year in India, thousands of female foetuses are aborted, despite strict laws banning sex determination of pregnancies. Every year in India, billions of rupees are demanded and offered as daughters’ dowries, despite strict laws banning this as well. Every year in India, we are reminded of how little the government can matter for social conventions.
Every year, economists write thousands of articles about how this or that government policy failed because it failed to take into account people’s tastes, preferences and incentives.
The question is, are nominal macroeconomic expectations as fluid, as well understood and as effortless as the effortless switching of clocks during DST, or are they more analogous to the rigid social conventions and private preferences over which non-despotic fiat regimes have relatively little power.
Nick somehow believes that the answer is clear. I’m not sure what gives him this confidence.
JW: what that FT article missed is this: suppose only 9% of firms respond to the interest rate cut. But another (say) 9% of the firms (or their customers) respond to the increased demand from that original 9%. And so on. Good old fashioned Old Keynesian multiplier analysis. Now the central bank announces a focal point to help the firms solve the very short run coordination problem. All you need is one firm.
Ritwik: people used to think of monetary policy in terms of the gold price. Then they thought of interest rates. Now they think of inflation targets. What gives me confidence? Roosevelt did it.
“Nope. I have no idea why you might think I’m saying that.”
You are making an argument for the reputation of the federal reserve and its ability to stick with its comittment are you not? People view government debt with high levels of trust because when it comes time to pay the debt off, the government can force people to pay it. If the fed commits to inflation its a lot less obvious what is going to happen since it is hard to force people to support the decisions of the fed, the only way would be to outlaw gold or currency trading.
Of course, in the long run government collapse all the time but the long run to government collapse is much longer than the long run to monetary regime collapse.
“But there is a very big practical difference. People actually do hold very strongly rooted expectations that law will be obeyed, that debts will be paid, etc., in a way they do not about central bank announcements changing the expected economic conditions years from now. That’s a contingent fact about the world — it’s perfectly possible that after years at the ZLB, and a big intellectual victory by market monetarists, etc., announcements about policy N years from now would become a main tool of central banks, and experience would eventually confirm that you should make economic choices today based on what the central bank says policy will be five years from now. There’s no reason in principle why that could’t be the case. It just doesn’t happen to be the case now.”
The difference is that it is harder to enforce inflation on people without completely monopolizing the currency within a geographical area in a similar way that our legal system does. If it becomes a custom then you dont have to enforce it, laws are not customs since they are enforced on those that disagree with them.
If people have reason to believe that policy announcements will have beneficial outcomes in the future then it might become customary for policy announcements to affect current economic conditions. If NGDP targetting policies require everyone to share the same customary expectation for it to have an effect on current economic conditions then it is hard to see how you are going to get millions of people to agree on policy without enforcing it onto large groups of people.
“Dont steal other peoples stuff” is a lot easier to agree upon then “Lets inflate away your savings”. The government has broad support for the former but its hard to see how a central bank will be allowed the later through a democratically elected government.
laws are not customs since they are enforced on those that disagree with them.
What Nick keeps saying, which seems completely clear to me but apparently not to others, is that enforcement is itself just a custom.
JW: you said it clearer than I did. That’s perhaps why it wasn’t clear to others.
All you need is one firm.
One interest-sensitive firm plus an arbitrarily large change in interest rates, you mean?
But even if the Fed can genuinely affect both real interest rates and people’s expectations of them, that doesn’t mean it can do so without limit. It’s much more likely that it can establish expectations that inflation will be 3 percent at some point in the future, than that it will be 30 percent. Right?
Also, this is a somewhat separate issue, but the narrower the range of activities that are sensitive to the interest rate, the more changes in the composition and not just the level of activity you get from monetary policy. E.g. it’s a pretty well established argument that if monetary policy operates almost exclusively through the housing market, stabilizing overall output may require booms and busts in housing, with all the disruption that implies. Even aside form all the issues we’re debating here, for monetarism to work as a policy argument, demand for whatever form of liquidity the central bank controls, should be stably associated with the whole range of activity.
(OK, yes, the larger are multipliers, the less of a problem this is. But you can’t assume they are arbitrarily large.)
JW: “One interest-sensitive firm plus an arbitrarily large change in interest rates, you mean?”
No! One arbitrarily small interest-sensitive firm, one arbitrarily small change in interest rates, and a positive feedback parameter greater than or equal to one. Keynesians called that positive feedback parameter the “marginal propensity to consume”. OK, but add in the marginal propensity to invest, plus an additional factor for the propensity for raising prices and so lowering the real rate of interest for any given nominal rate. And it can easily be bigger than one (if the central bank lets it be). And the multiplier is infinite.
This is why I keep yammering on about upward-sloping IS curves.
Yes, it’s all about credibility. I refer to the poker-game model. Do governments bluff? Generally not, or when they do we get an election soon enough and get a more credible player to sit at the table and play better.
Is it wise to bet against the government? Generally not, the consequences are transparent and well-known.
Do central bankers bluff? They do, and people like George Soros call their bluffs. We don’t like central bankers bluffing because we hate making George Soros rich.
All the Concrete Steppes (and why are we stuck in a concrete field in the Ukraine?) people are saying is that when the cards are down, the Central Bank can be shown to be bluffing and lose the hand. So the expectations channel is weak to bluff-calling unless you can magically give the Central Bank an automatic, ever-present ace in the hole.
“What Nick keeps saying, which seems completely clear to me but apparently not to others, is that enforcement is itself just a custom.”
I understand this, what I am saying is that customs that are not enforced (acceptance of fed policy) are not as credible long term as those that are (government bonds). At this moment in time if people adjust their expectations to future output based on policy set by the fed then this is a custom but it is one that is not enforced. If I think the majority is wrong in their expectation I can protect myself from the inflation by investing in other assets. If the government wants to pay back it’s debt then I have no choice but to pay taxes which are enforced by law.
Yes these laws are also customs that can change which is why I asked nick if he was talking about enforcing by law the quality of fed notes. He asked why fed commitment wasnt questioned more than the commitment to pay back government bonds, government bonds are questioned less than fed commitment because we know that other people will be forced to pay them back. The fed can only be committed as long as people continue to voluntarily hold on to fed currency which is hard to believe given the massive number of competitive options currency users have in our modern societies.
No! One arbitrarily small interest-sensitive firm, one arbitrarily small change in interest rates, and a positive feedback parameter greater than or equal to one. Keynesians called that positive feedback parameter the “marginal propensity to consume”. OK, but add in the marginal propensity to invest, plus an additional factor for the propensity for raising prices and so lowering the real rate of interest for any given nominal rate. And it can easily be bigger than one (if the central bank lets it be). And the multiplier is infinite. This is why I keep yammering on about upward-sloping IS curves.
Ah, ok, now I see what your argument is. Huh. I think I still don’t agree, but will need time to formulate a response.
Nick Rowe: “How did the fiscal confidence fairy get reified into a cast-iron bond, while the monetary confidence fairy gets dismissed as just Tinkerbell, who only exists if we all believe in her?”
Isn’t it the other way around?
I was interpreting the monetary confidence fairy as confidence in the CB, not as the nebulous Confidence Fairy who will tap businessmen with here wand.
I was interpreting the fiscal confidence fairy as confidence in the legislature.
JW: “Ah, ok, now I see what your argument is.”
Which makes me realise just how bad I’ve been at explaining my argument.
Min: Yep. Sometimes people talk about the fiscal confidence fairy as the belief that cutting the deficit will increase demand. Here I was talking about the opposite case — the belief that increasing the deficit would increase demand. (Or just the belief that bonds would be paid). I wasn’t clear.
Thanks, Nick. So many fairies, so little time! 😉
“Y = 0.5E(Y) + 0.5X. What people choose to do depends partly on some exogenous variable X, and partly on what they expect other people to do. But there is only one level of Y, given X, at which people’s actions will confirm their expectations of others’ actions. Most static economic models are like that.
“Now lets complicate that model slightly, by introducing time. Y(t) = 0.5E(Y(t+1)) + 0.5X(t). What people do today depends partly on X today, and partly on what people expect people to do tomorrow. Most dynamic economic models are like that. And you need to say something about how people form their expectations in order to solve those models.
“One assumption is rational expectations. People’s expectations are consistent with the model. Taking that same equation and leading it forward one period gives you Y(t+1) = 0.5E(Y(t+2)) + 0.5X(t+1). If people expect that that is how people will choose tomorrow, then E(Y(t+1)) = 0.5E(E(Y(t+2))) + 0.5E(X(t+1)).”
Why should we believe that E(X(t+1)) even exists? After all, X is exogenous.
And the whole system is non-causal anyway.
On this business of laws, I believe the claim that laws are just a particular kind of convention is incorrect.
The most important feature of behavior rule that is a convention, as it is now generally analyzed, is that the reason self-interested people have for obeying it is their belief or expectation that everyone else generally conforms to the rule. The classic example is driving on the right (or left). Suppose there is a country X with no law governing which side of the road one should drive on, but a convention that one is to drive on the right hand side of the road. A self-interested driver Y wants to get from point A to point B with minimum hassle. The fact that Y expects that everyone else in X will drive on the right is, all by itself, a reason for Y to drive on the right.
But now consider paying taxes. Suppose X is a country with no tax laws, but a suggested voluntary tax that everyone in X generally pays. Does the self-interested person Y’s belief that almost everyone else in X will pay taxes give Y a reason to pay taxes? No, not at all. The self-interested person has every reason to defect from the norm of tax-paying. Driving on the left will get Y into trouble if there is general conformity to right-hand driving. Not paying taxes will cause Y no trouble at all. At least, not unless there are sanctions regimes in place.
So suppose there are some enforcers with a known disposition to punish people who don’t pay taxes, and the existence of these enforcers and their general success in punishing tax dodgers is generally known. Should we say at least that among the enforcers, punishing tax dodgers is a a convention? I don’t thing so. Punishing tax dodgers is not some kind of mutually convenient solution to a coordination problem among the enforcers. The enforcers punish tax dodgers because they are also subject to positive and negative sanctions in the forms of rewards and punishments meted out by others.
A system of law depends on network of generally known dispositions to sanction.
Thanks for that FT link, JW.
Queen of the social sciences? IIRC, Marx tried to inject some class consciousness and his work was not well received.
As long as you model people as atomistic individuals who are only trying to maximize their own individual consumption while minimizing their own labor effort, economics will remain the blind step-child of the social sciences.
J.W.
What Nick keeps saying, which seems completely clear to me but apparently not to others, is that enforcement is itself just a custom.
Of course, but I am saying that these customs need to be baked into the models, and changed as the customs change. So federal debts are real obligations — you buy a bond for $1 and get back $(1+r). That goes into the model. But policy promises are not obligations, so that does not go into the model.
If you really believe that economics is a social science, you cant make up whatever customs you want in your model and assume the model has relevance. You cannot invent “policy bonds” and talk about them in the same way that you talk about real bonds, because the repayment of bonds “is just a custom”.
… and a the focusing example here is money, which is itself a social construction. All the pushback against the notion that the CB controls the money is supply is because Nick has his own unique social constructions that are not the general social constructions of our economy. Just as you can’t invent social constructions for policy bonds, you can’t invent constructions for money. You have to get the social rules right in order for the model to be relevant.
rsj: “As long as you model people as atomistic individuals who are only trying to maximize their own individual consumption while minimizing their own labor effort, economics will remain the blind step-child of the social sciences.”
Durkheim said something similar. But then many (not all) sociologists simply assume social propensities, which begs the question. Some of us have tried to tackle the question.
Here is an example from David Friedman.
Here is my own (slightly pathetic) attempt. (But I’m still proud I tried, so please don’t laugh. Friedman is better.)
There are others like that. Those are 20 years old. The literature has moved on since, but I haven’t kept up with it.
David Hume: “As FORCE is always on the side of the governed, the governors have nothing to support them but opinion. ‘Tis therefore on opinion only that government is founded; and this maxim extends to the most despotic and military governments, as all as the most free and popular. The soldan of Egypt, or the emperor of Rome, might drive his harmless subjects like brute beasts, against their sentiments and inclination: but he must at least have led his mamalukes or praetorian bands like men, by their opinion.”
rsj,
“IIRC, Marx tried to inject some class consciousness and his work was not well received.”
Had Marx not personally been a blatant counterexample (among many) to class consciousness, people might have taken the idea a little more seriously.
@Nick Rowe
Nick, this is ad hominem, but in a nice way. 🙂
Fairly often you ask us to suppose that all of a sudden people change their beliefs, desires, or behavior. In a world in which that happens often enough, doesn’t it become difficult for people to form rational expectations, much less expectations far into the future?
Min,
FORMING (implicit) expectations far into the future is easy. Forming CORRECT expectations of what will happen tomorrow seems almost impossible sometimes! Hence saving, hedging, contingency planning etc.
If economics is a social science, then why do we so often use the word ‘social’ to mean ‘not economic’?
W Peden: because we stupidly let our enemies appropriate the word “social”. Which is why my gut reaction, when I hear the word “social”, is to reach for my shovel.
Min: yes. But when I say “what will happen if X changes” that is often shorthand for “what would be different if X were different”.
JW: I really like Hume on this subject. He has another good one somewhere about 2 guys rowing a boat without having made a social contract. Their rowing in time is their social contract. On that particular passage though: even if nobody liked the emperor, no individual would go first to disobey. Or second. Stalin held meetings where he asked people to stand up and say what they really thought. Whoever stood up first was shot. It’s not quite that bad in universities, but it’s usually imprudent to express some views, or not to criticise people for expressing those views, whether you agree or not. Economist Timur Kuran (sp?) has some good stuff on “preference falsification”, with equilibria where everyone pretends to like something they don’t.
Nick Rowe: “But when I say “what will happen if X changes” that is often shorthand for “what would be different if X were different”.
Thanks. 🙂
Actually, that clears a good bit up. 🙂