Policy Uncertainty Creates a Low Level of Confidence Leading to a Prolonging of the Economic Slump

My ‘Austrian’ explanation of the long slump will be that policy uncertainty has created a low state of confidence and a corresponding slump in investment. The ‘state of confidence’ has a long history in economics, as I will show. Economists today are more likely to speak of ‘animal spirits’ than ‘confidence’ to identify the same supposed dispositions, expectations and emotions of business investors. Whatever the label, it is an important topic. And yet there has been relatively little attention to the theory of the state of confidence. Drawing on Higgs (1997) and Koppl (2002), I will outline a theory of confidence that explains the long slump, a theory that fills in the something that has inhibited economic adjustment after the boom.

In brief, the explanation is as follows. Interventionist policies create uncertainty, raise the costs of financial intermediation and discourage investment. I might almost say that the problem is not that the government has done too little, but that it has done too much. That way of putting it, though, may seem to suggest that I am an ‘austerian’ who wants to heat up the economy by freezing government spending. The problem, however, is not the level of government spending. The problem is changing rules, uncertain regulations, shifting Fed policy. The problem is the variability and unpredictability of government economic policy.

In the theory I lay out below, the state of confidence is more likely to be arbitrary and self-referencing the more precarious our knowledge of the future. Investor expectations are never certain (by their nature) and never a total blank. Where we are between the poles of ignorance and prescience depends on the policy regime affecting investors. I will emphasise two aspects of the policy regime: whether the rules of the game are uncertain and whether there is ‘Big Player’ influence.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 13-14.