The Economics of Mood Control
Last week's financial-market gyrations sent me back to one of my favorite books about the crash. Its wisdom seems freshly relevant.
"Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism" by George Akerlof and Robert Shiller (both Nobel laureates) was published in 2009. (I reviewed it for the Financial Times.) It was mostly written before the recession, but events didn't make it seem out of date -- rather the opposite. The book, I find, only improves with age.
Last Wednesday saw U.S. government bond prices spike and the steepest intraday fall in the Standard & Poor's 500 Index since 2011. Why? Not because of any specific change in economic fundamentals. Against an essentially unchanged background of anxiety about the strength of the global recovery and the future course of monetary policy in the U.S. and Europe, investors surrendered to a moment of alarm. This matters because alarm can be catching, hence self-fulfilling: The results of these fluctuations aren't confined to financial markets.
Akerlof and Shiller examine the ways in which confidence, broadly defined, interacts with the economy. To say that confidence is all that matters might be an exaggeration, but over the span of an economic cycle, other forces do tend to pale in comparison. One of these confidence-driven interactions is salient right now: The role that central-bank policy, and quantitative easing in particular, play in shaping the economy's mood.
That might seem an odd way to put it. Quantitative easing, or large-scale bond-buying by central banks, is intended to raise long-term bond prices and hence lower long-term interest rates; lower rates then encourage borrowing and spending. This story doesn't rely much on psychology. Experience suggests that the ordinary logic of supply and demand initially works quite well, but its effect lessens with time. After a while, QE is less about quantities and more about mood control. In effect, QE says that the central bank is still willing to take extraordinary measures to support demand. This channel is heavily psychological; and that makes it unreliable.
On Oct. 16, James Bullard, president of the St. Louis Fed, discussed whether the Federal Reserve's QE program should be kept in place beyond its expected termination at the end of this month. It's already been wound down to just $15 billion a month, which Bullard called "not that consequential." One might ask, then why bother persisting? Because it shows, as Bullard put it, that "We are watching and we're ready and we are willing to do things to defend our inflation target." Those things may be inconsequential, but at least they're things. Weirdly, he's almost certainly right: At this juncture, a willingness to do the inconsequential would be consequential.
In 2012 European Central Bank President Mario Draghi said the ECB was ready to do "whatever it takes" to save the euro system. Without knowing, or apparently even caring, what that meant, investors relaxed and the euro-zone crisis abated. Not a great deal happened, policy-wise -- but, again, the inconsequential had consequences. Now, though, the magic has faded. The euro has drifted to the brink of outright deflation and the ECB has let it. Draghi's reassurances are no longer reassuring. Some new inconsequential initiative is needed to change the psychology.
There's an obvious paradox in all this. The more widely these psychological channels are understood, the harder it is for central banks and other policy-makers to exploit them. If investors believe that policymakers are doing nothing but attempting to influence their mood, their mood will be more resistant to influence. Quite possibly, that resistance could increase to the point where even consequential changes in policy no longer have consequences. In central banking, as in most things, the secret of success is sincerity: If you can fake that, you've got it made.
One other insight from "Animal Spirits" struck me with renewed force this past week, and goes a long way to explain why this recovery has been lame. Akerlof and Shiller argue that it isn't enough for policy-makers to shore up demand after a slump -- vital as that may be. They also need to confront loss of confidence in financial markets more directly, with measures to get the credit system up and running normally. The authors argue for a separate policy target for the supply of credit. "The target should not be merely a mechanical credit aggregate, but should reflect the more general condition that credit be available for those who, under normal conditions, would be deserving of it."
Six years after the crash, does that general condition pertain? Earlier this month former Fed Chairman Ben Bernanke told a conference in Chicago that he'd been unable to refinance his mortgage. The tightness of mortgage credit, he said with characteristic understatement, "is still probably excessive." Alan Krueger, former chairman of the Council of Economic Advisers and another bad risk, presumably sympathizes: He told Bloomberg Surveillance that he'd also been rejected for a loan (with a 50 percent downpayment, mind you). No wonder the economy's depressed.
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