“Regime Uncertainty” and “Big Players” Make the Economy More Dependent on “Animal Spirits” or “Confidence” Instead of “Economic Calculation”

The ‘rules of the game’ are the rules of economic exchange. They include tax law, the law of contract and regulations. If the rules of the game are ambiguous or changeable, investors experience uncertainty and ignorance of the future. If the rules of the game are known and stable, investors experience greater prescience. They have greater confidence in their guesses about the future. Irregular and arbitrary taxes, for example, make it harder to estimate the prospective profit of alternative investments; a simple regular and transparent tax code eliminates one source of uncertainty, helping investors to formulate a serviceable, if not perfectly strict, mathematical expectation of prospective yields. Robert Higgs (1997) has coined the term ‘regime uncertainty’ to describe situations in which the rules of the game are uncertain. As we shall see, regime uncertainty discourages investment (regime uncertainty is the cause, reduced investment the effect). 

Big Players are economic actors with three characteristics. Firstly, they are big enough to influence the market or markets in question. Secondly, they are largely immune from the discipline of profit and loss. Thirdly, they act on discretion and are not bound by any simple rules. Activist central bankers are paradigmatic Big Players. A private actor might be a Big Player, but only in the relatively short run or if it is a protected monopoly. As I argue below, Big Players are hard to predict. They reduce the reliability of economic expectations, which encourages both herding and contrarianism in financial markets. Big Player influence drives investors towards greater ignorance and uncertainty. For example, discretionary monetary policy makes it hard to estimate the future purchasing power of the currency and, therefore, the value of alternative investments: a simple monetary rule eliminates one source of uncertainty, helping investors to formulate a serviceable mathematical expectation of prospective yields. Koppl (2002) has developed the theory of Big Players and I will draw on that and related work in this monograph. 

When there is Big Player influence or regime uncertainty investors become more ignorant, less prescient. As they grow more ignorant their investment decisions cannot depend as fully on strict mathematical expectation, since the basis for making such calculations is correspondingly weakened. They are more likely to follow the crowd and to base their decisions on an overall sense of optimism or pessimism rather than independent judgements of prospective yield. In these circumstances, the state of confidence becomes more arbitrary and more self-referential. More or less arbitrary swings of optimism and pessimism are now more likely. Regime uncertainty and Big Players make the economy look more Keynesian as it is more dependent on ‘animal spirits’ rather than economic calculation, which becomes more difficult. As we shall see, there is a sense in which Big Players and regime uncertainty reflect ‘Keynesian’ policies, which suggests the self-defeating nature of Keynesian macroeconomic policy: Keynesian policies tend to create a Keynesian economy.

—Roger Koppl, introduction to From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 14-16.

In “Hydraulic Keynesianism,” the Models Resembled the Mathematical Description of a Plumbing System

The difficulty in understanding the General Theory may have contributed to its success as the founding text of macroeconomics. The book is open to alternative interpretations. In the post-war years, if you wanted to propose interventionist policies to ‘stabilise the economy’ or otherwise improve economic performance, you might well cite the General Theory as the source or context for your proposed policies. Thus, a variety of interventionist systems of thought were labelled ‘Keynesian’.

After the war, one version of economics, described as Keynesian, came to dominate macroeconomics. This breed of Keynesianism would estimate a consumption function, an investment function and other functions intended to represent stable relationships determining the overall levels of output, employment and prices. Changing policy variables such as the government deficit could, it was thought, shift these functions about and give us a better combination of output, employment and prices. Increasing money growth, for example, would inevitably cause some price inflation, but it would also reduce unemployment. This supposed inverse relationship between inflation and unemployment (Samuelson and Solow 1960) is known as the ‘Phillips curve’. Assuming a stable Phillips curve, any event that might increase unemployment could be met with a bit of inflation as a reliable offset.

This sort of macroeconomics is sometimes called ‘hydraulic Keynesianism’. Keynes was claimed as an important source and it was ‘hydraulic’ because the models resembled the mathematical description of a plumbing system. The flow of spending in an economy looked like the flow of water in a system of pipes. And just as we can regulate the flow of water with a few valves, we can regulate the economy with a few relatively simple policy instruments – or so it was thought.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 41-43.

On Robert Lucas’s Expectations, a Central Feature of Modern Macroeconomics, and On His “Lucas Critique” of Hydraulic Keynesianism

The rational expectations revolution, which led to modern macroeconomics, did further damage to hydraulic Keynesianism. Following Muth (1961), Lucas (1972, 1976) articulated what would become the central feature of modern macroeconomics: expectations are formed as if the representative agent knows the true model, and the ‘true’ model is whatever the theorist says it is. The limits of rational-expectations modelling probably seem more important today than they did before the financial crisis of 2007 and 2008. At the time of the rational-expectations revolution, however, it offered a valuable correction to the more mechanical sort of macroeconomics that had previously dominated policy.

Lucas (1976) pointed out a problem with hydraulic Keynesianism. The theory assumes that the different functions being estimated would not change when policy changed. But those functions reflected the plans and actions of people who are trying to understand the economy in which they act. For that reason, the functions may not have the sort of stability required for the theory to work. In particular, the public will sooner or later catch on to the link between expansionary monetary policy and inflation rates. When they do, inflation will no longer reduce unemployment. Anticipating increases in inflation, workers may not imagine that their higher wages represent more purchasing power, suppliers may not mistake an increase in output prices for an increase in underlying demand for their goods, and so on. The public will protect itself from the expected inflation, thereby eliminating the supposedly beneficial effects. This criticism of hydraulic Keynesianism is the ‘Lucas critique’.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 44-45.

Dynamic Stochastic General Equilibrium (DSGE) Models Are Sometimes Described as “Toy Economies”

Kydland and Prescott (1982) and Long and Plosser (1983) were particularly important in transforming the rational expectations revolution into the rigid orthodoxy of dynamic stochastic general equilibrium (DSGE) models. DSGE models are dynamic because they describe the behaviour of an imaginary economy over time. They are stochastic because some of the key variables of the model such as productivity and labour supply are subject to random shocks. Finally, they are general equilibrium models because all markets are considered at once.

DSGE models are sometimes described as ‘toy economies’ to underline how much they simplify real economies. A modern economy has many people and many goods, each different from the others. It changes continuously with innovations and surprises at every turn. DSGE models boil all this diversity down to a few equations representing, typically, one person, the representative individual, choosing how to distribute one good, labelled ‘consumption’, over time given a production technology that can change only when a random shock alters one or more coefficients of the equation linking a few inputs to the output of the one consumption good. Even the more elaborate DSGE models such as the important model of Smets and Wouters (2003) do not exceed about 30 equations.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 50.

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.