Tuesday, April 23, 2013

The Sorry Demonization of the Confidence Fairy

Why I Believe in the Confidence Fairy 

I developed my economics worldview in relative isolation, because, like most of my peers, I didn't really keep up with current events in college.  In retrospect, that situation was at once dangerous and necessary; ignoring the world is generally not a best practice when forming opinions of the world, but there are so many economics theories, thoughts, and ideas floating about on the internet that even trying to keep afloat requires all of one's mental energy.

Painting by Roy Litchtenstein. #GCB 

Since graduation I have followed a plunge and retreat pattern; every once in a while I binge on the blogosphere, reading, commenting, criticizing, scowling, nodding, noting and expanding, and then I cut myself off and let my natural hatred of twitter, short form argument, and human interaction control my instincts. When I go out into the world, I try to be a sponge and soak up as much as possible, and when I come home I hide in the library and wring myself out, and try to use what I've absorbed to build a boat that can support me next time I go sailing. (The true test of vessel is always whether it can weather the water).

Before the first plunge, I had already decided that the world largely depended on the state of expectation, also known as trust, also known as confidence, also known as the opposite of uncertainty, fear, and pessimism.  In other words, I believe that life is one big self-fulfilling prophecy.  If you believe that your paycheck will come at the end of the month, you'll splurge $15 on the old fashioned at the cocktail bar. If you believe that you'll easily be able to make $100k a year as an orthosurgeon, you'll put yourself $200k in debt to pay for medical school. If you believe that Joe Shmoe can make and sell widgets like nobody's business  then you'll lend him money to hire some people and make widgets. If you believe that none of these things will happen, then there will be no widgets, no doctors, no delicious whisky drinks, and you can sit alone in your room and cry.

Wouldn't you prefer to have a drink? Credits: Paul Kernfeld, Adrian Pio, Max Monn
The problem is that expectations don't always come true. I believe that economic actors make decisions under bounded rationality; they do try to optimize their own happiness, but the information, time, and brainpower they have to make decisions are limited and sometimes they are wrong. Because of unmet expectations, workers sometimes find themselves hard up against their budget constraint at the end of the month, students sometimes find that when they graduate the market is already glutted, and sometimes investors realize too late that nobody gives a damn about widgets.  In addition, factors not traditionally considered economic, like social relations, shame, honor, etc, play large roles in preferences, and what may seem like a mistake in estimation may actually be a perfectly rational, optimizing decision, as when the choice to become a doctor is motivated more by a mother's wish than by economic practicality.

Phew, beliefs stated.

Disillusionment, Confusion, and Presidents with Wings 

During one of the plunges last year I encountered an interesting phrase: "confidence fairy." Now mind you, I devoured more than my fair share of preteen fantasy lit in that awkward period after picture books and before Charles Dickens, and I fondly remember the fair folk as pseudo-elemental, pseudo-spiritual, and very serious creatures  Therefore at first I saw no inconsistency between my belief in the all-importance of expectations and its personification as mythical but symbolically important being:

Wise, isn't she? 

I also generally consider myself to be quite progressive monetarily, fiscally, and socially, (although I'd rather avoid direct regulation where possible,) and would rather pile taxes and QE to the moon than see a 5% rise an unemployment.  Thus you can imagine my horror when I realized that "fairy" meant "ridiculous," and that it was originally invented by Paul Krugman to lampoon arguments for austerity.

For example, in the 2012 election cycle Mitt Romney, who campaigned on promises of drastic spending cuts, tried to claim that his election would foster confidence and thus growth, saying,
"If it looks like I’m going to win, the markets will be happy. If it looks like the president’s going to win, the markets should not be terribly happy. It depends of course which markets you’re talking about, which types of commodities and so forth, but my own view is that if we win on November 6th, there will be a great deal of optimism about the future of this country. We’ll see capital come back and we’ll see —without actually doing anything — we’ll actually get a boost in the economy."  
Krugman seized the opportunity to call him the confidence fairy, and thus simultaneously aligned my darling sprite with the side of evil, and denied her status as a real player in economic growth. My heart sank.

I was doubly confused because, having read a few of Krugman's academic papers before extensively reading his blog, I knew that he puts as much weight or possibly even more on "confidence" than I do.  More specifically, expectations about future prices are the engine of economic growth in several of his papers, as they are in all New Keynesian models. If expectations are optimistic, the economy grows; if expectations are less optimistic, it doesn't. Sounds an awful lot like confidence, right?

I had also seen Gauti Eggeretsson, Krugman's primary coauthor for the last few years, stand up and deliver a presentation where he claimed that FDRs announcements about changes in monetary policy, not his actual implementation of policy, but his announcements, could explain huge volatility in stock markets and price levels.  Perhaps they just disagree, but coauthors don't tend to go on coauthoring when they differ on something so fundamental. 

This is a real life Gauti Eggertsson slide I found after about two seconds on the google image search, I believe from a presentation about his 2008 paper, Great Expectations and the End of the Depression.

So....FDR is the confidence fairy? 

What's going on here? 

How the Confidence Fairy Was Kidnapped by the Right

To understand how the confidence fairy came to be cast as a counterproductive sidekick to Mitt Romney, we have to go back in time. We could trace the history of confidence in political economy as far back as ancient Greece, but in the interest of brevity I'll start just 100 years ago, at the dawn of World War I. 

In the 19th century governments spending was small and inflation kept in check by the global supply of gold. It was the Gilded Age of liberalism, when commerce moved briskly and the world looked infinite and rosy--to those on top. But the illustrious peaks rose over deep and jagged gorges; if you fell, no safety net would catch you. World War I changed this by placing unprecedented demands on government budgets. To beat the Germans the Brits had to resort to extraordinary measures; they excised special taxes on the British public, they took ruinous loans from the Americans, and suspended convertibility to gold, code, in 1914, for printing money. 

After the war most politicians wanted to return to small government and the gold standard, and used austerity to appreciate the currency and cut away at spending and debt.  However, the relative success of the extraordinary measures taken during the war and the pain of austerity encouraged opposition to the main line.  This new school of thought believed that government spending and inflation could be used as a tool to foster economic growth.  The most vocal and adamant member of this new school was John Maynard Keynes, who argued against return to the gold standard in a series of articles in the 1920s. 

Keynes won many to his cause, but still "Sound money" became the rallying cry for the British, French, and American citizens who wished to see the international monetary system return to what it was. If businessmen were to invest, if banks were to lend, and if capital was to flow across boarders as it had before, there had to be confidence that the currency and the exchange rate would not rapidly depreciate.  

In the late 1920s and the late 1930s the sound money view was buttressed by the Treasury View, the &quote wikipedia belief that "Any increase in government spending necessarily crowds out an equal amount of private spending or investment, and thus has no net impact on economic activity." According to the Treasury View, not only did uncontrolled spending increase the risk of hyperinflation, it was also contributed nothing to economic growth. 

A Cartoon criticizing government spending, Chicago Tribune, 1934
Thus, but the time Keynes published his magum opus, The General Theory of Interest, Employment and Money, in 1936, the conservatives had already claimed confidence for austerity.  Keynes, however introduced a new type of confidence, something he called "the marginal propensity to consume." The propensity to consume is the percentage of each additional dollar of income spent; when the average propensity to consume is high, Keynes argued, the economy grows quickly, and when low, it slumps.  Today, most people know the average propensity to consume by a simpler name: consumer confidence. 

Further, Keynes argued that by redistributing money to those with the greatest marginal propensity to consume, ie, the poor, fiscal policy might actually be able to increase the total marginal consumption, and that even if it can't, fiscal policy is still a band-aid necessary to keep up effective demand when the propensity to consume is low.  Inflation, Keynes argued, is  not a cure-all but also not a problem, because a constantly eroding currency encourages current spending, ie, raises the propensity to consume.  

And so by the start of WWII the confidence fairy was caught in a tug of war between two sides; the right, who claimed her influence on investment, and the left, who claimed her influence on consumption.  Most of the time, neither side called her directly by her true name, preferring to fight with epithets such as "fiscal prudence" and "inflation-employment tradeoff."  Pixies are notoriously elusive.  

All custom images in this post were created in powerpoint. I have neither the patience nor the budget for photoshop.
The Keynsians were winning the tug of war for quite sometime, until a new set of heavyweights began to pull for their right. Their names were Milton, Muth, Barro, Sargent and Lucas, and they had had very particular ideas about expectations. At a 1968 American Economic Association dinner, Milton proposed something called "adaptive" expectations, arguing that after a while consumers adjust to the money supply and that inflation can have no long run effect on employment. In 1979, Barro wrote a paper noted that, if consumers were perfectly rational, they should realize that government spending today means taxes tomorrow, and adjust their spending accordingly. This "Ricardian Equivalence," essentially an update of the Treasury View, denied the ability of government spending to increase or even compensate for a low propensity to consume.  Adaptive expectations and Ricardian equivalence flipped consumer confidence from an argument for spending to an argument for austerity, and trapped the confidence fairy in a blood red box.

Why the Left Let Them Have Her

The coup of rational/adaptive expectations was a great blow to liberals everywhere, and, combined with an uncomfortably severe period of inflation, it essentially sent Keynsianism to the grave. The Keynsian economists put their tails between their legs and hid behind increasingly robust econometrics in the hallowed halls of Academia. They reconsidered, compromised, and regrouped, and reached deep back into the General Theory to rebuild their models on sticky prices, another of Maynard's insights. They came back toward the end of the 20th century with an awkward, watered-down model of underconsumption: the Dynamic Stochastic General Equilibrium.

The liberal who has tried hardest to use DSGE modeling to defend spending and inflation is of course, Paul Krugman. He studied Japan's "lost decade" and found that when interest rates are near zero, the only thing that matters is expected nominal future income. In other words, when the economy is depressed, deficit spending and inflation are fine, because both increase expected income.  The terms of his paper on the subject, including "interest rate zero bound" and "liquidity trap" pepper his NYT posts.

These charts clearly show how the economy behaves in a liquidity trap. Yeah, they're pretty painful. 

Essentially, Krugman argues that sometimes, especially after financial crises, low expectations of future income present the greatest obstacle to recovery. Consumers expect to earn LESS in the future than they do today, and therefore prefer to sit on their money than go spend it.   Why make widgets if you believe they'll stay on the shelves?  Why go to med school if you think you'll make diddly squat? Why buy cocktails if you're afraid you'll lose your job? (Vodka from a plastic bottle is much cheaper). Only a heady dose of inflation or government spending can shock consumers out of their pessimism, increase expectations, and return spending. This is what FDR did in the 1930s, and why Gauti Eggertson (metaphorically) gave him wings.

He's talking about confidence, and he knows it. From a September 23rd 2012 post:
Some readers have asked whether there isn’t an inconsistency between my view that the Fed can promote economic recovery by changing expectations about future policy, and my ridicule of austerity proponents who invoke “confidence” as a reason to believe that austerity will actually be expansionary. But there isn’t really any inconsistency; it’s an orders of magnitude thing.  What the expansionary austerity types are claiming is that the indirect effect of austerity on confidence will outweigh the large direct depressing effect of cutting government spending now. 
He goes on to explain why, right now, the positive effects of government spending and inflation on expectations/confidence outweigh the negative effects of government spending and inflation. I won't go into that now. Suffice to say that the current economic debate is not about the importance of confidence, it's about the effect of policy on confidence. 

Here's one way to look at it: there are two confidences, the "up and the air" confidence, influenced by discount rates, policy shocks, state solvency, etc, and the "obvious" confidence, determined by the size of the paycheck you expect to get next week.  The two confidences don't always push in the same direction.  For example, both my parents work for the federal government.  Right now they have very little "up in the air" confidence, and keep sending me invitations to "fix the debt" initiatives that, in the name of greater long term welfare, aim to introduce austerity measures (facepalm).  However, because their paychecks are not directly affected by the sequester, their "obvious" confidence is strong and they haven't reduced their spending, despite the anti-debt rhetoric.  Ironically, if fix the debt measures succeeded to the degree my parents would like, they are more likely to suffer a pay cut and decrease spending to compensate.

Sometimes you miss what's right under your nose. 
The "obvious" confidence is in almost every case more important, but it's not usually called by the name  "confidence." Krugman has found it easier to keep using "confidence fairy" to criticize austerity advocates who place too much weight on "up in the air" confidence and his wonkish vocabulary to defend "obvious" confidence then to try to create new connotations.  I sympathize. A good phrase can be powerful, and even if "confidence fairy" is misleading, it may convince people that austerity is a bad idea. "Invisible hand" has certainly done a lot of damage.

However, I do regret the confusion it causes. For the non-academic reader, the demonization of the confidence fairy is a step backward, not a step forward, towards understanding how the economy really works. What's more, for some readers it may actually be counterproductive. It's easy to read one of Krugman's anti-confidence fairy posts and decide that he is deliberately ignoring something important. He's not, and a deeper look makes that clear, but to understand why you have to jump over a whole lot of wonk.

Arguments built on shaky foundations are always eventually be torn down, even if they're the right arguments. Luckily right now popular favor seems to be turning against austerity, but if today's rhetoric doesn't improve,  I'm quite sure austerity will be back. Besides, I like fairies, and I'd rather treat them with respect.

This doesn't really apply to this post but it's always good to throw in some wisdom from wise fairies:

If we shadows have offended,
Think but this, and all is mended,
That you have but slumber'd here
While these visions did appear.
And this weak and idle theme,
No more yielding but a dream,
Gentles, do not reprehend:
if you pardon, we will mend:
And, as I am an honest Puck,
If we have unearned luck
Now to 'scape the serpent's tongue,
We will make amends ere long;
Else the Puck a liar call;
So, good night unto you all.
Give me your hands, if we be friends,
And Robin shall restore amends.


  1. I apologise for going off topic, but it was prompted by the title of your blog.

    If you don't mind me asking, Melanie Friedrichs, have you read both The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations?

    I haven't finished reading both myself. But I do believe that you might find the following paper to be of great interest - it compares and contrasts Adam Smith, John Maynard Keynes, and Jeremy Bentham.


    Gavin Kennedy, a historian of economic thought specialising in Adam Smith, has recommended people to read the aforementioned paper on his blog.


    Finally, have you seen this 2010 conversation between Robert Skidelsky and Nicholas Philippson at the LSE on Smith and Keynes? I think you'd enjoy it.


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