You Can't Handle the Truth

I recently ran across a somewhat disturbing post over at Mark Thoma's 'Economists View'. Thoma is a neo-liberal in the Krugman mould, and in this particular post, he links to a number of prominent economists discussing the notion that we have, from an economic perspective, nothing to fear but fear itself.

This is an argument you'll often see made, that the only reason bad things happen, is because some people are not sufficiently optimistic about the future. If one truly believe this theory, then it makes sense to lie to people to pretend that all is well, since the lie will transform into truth as long as enough people believe it.

First up is Olivier Blanchard who states his thesis up front,

"Were a magic wand to remove uncertainty, the next few quarters would still be tough (some of the damage cannot be undone), but the crisis would largely go away."

...

'Better safe than sorry' is the motto. Unfortunately, while the motto may make sense for individual investors, it is having catastrophic macroeconomic consequences for the world. It is triggering enormous spreads on risky assets, a credit crunch in advanced economies, and major capital outflows from emerging countries.

It affects consumption and investment decisions, and is largely behind the dramatic collapse in demand we have observed over the last three months. Sure, consumers have lost a good part of their wealth, and this is reason enough for them to retrench. But there is more at work. If you think that another Depression might be around the corner, better to be careful and save more. Better to wait and see how things turn out. Buying a new house, a new car or a new laptop can surely be delayed a few months. The same goes for firms: given the uncertainty, why build a new plant or introduce a new product now? Better to pause until the smoke clears.

...

Coherent financial, fiscal and monetary measures are all needed. All three will have direct effects on demand. But, as importantly, they will help reduce uncertainty, lower risk spreads, and get consumers and firms spending again. If policymakers act decisively, private demand will recover sooner rather than later. And, within a year or less, we can be on the path to recovery.

Responding, Esward Prasad takes the argument a little further:

Mr Blanchard asks policymakers to do a lot. But aren’t perceptions of uncertainty malleable and important as well? Don't they have real consequences? Here the media plays a role—it has an inherent bias towards reporting and highlighting bad news, which is especially unhelpful in these difficult times. The drumbeat of sobering news and the screaming headlines that accompany it—Dow Plunges! Exports Collapse! Deflation Looms!—just feed into the uncertainty. Clearly, we must also co-opt the media to turn around confidence more quickly. Perhaps the IMF could do the world a service by setting up a unit to gather and disseminate to the media whatever tidbits of worldwide good news are available. Denial of some realities got us where we are, and perhaps that’s what will help get us out of this hole as well.

Mark Thoma weighs in,

"I want to emphasise the sentence in the article that says, "Above all, adopt clear policies and act decisively", though I would add that clear evidence that the policies work may also be required. The reason evidence of policy effectiveness may be required is the erratic nature of policy to date, particularly from America's Treasury, and the sparse evidence that the policies adopted so far have been successful at stopping the downward spiral of the economy. My hope is that the actions of policymakers to date have not placed us in a Catch-22 situation where policies won't work until people believe in them, and people won't believe in them until they can see with their own eyes that there has, in fact, been progress. If that is the case, if recent policy mistakes mean that people have to see it to believe it, and if it's much harder to see it if they don't believe it, recovery could be a slow process."

Tyler Cowan agrees:

"I agree with Olivier Blanchard that fear and lack of confidence are major problems behind the current economic downturn. I also agree that the banking sector requires recapitalisation and that this is hard to do. But I dissent from his analysis in a few key regards.

First, to the extent that the real problem is fear, this militates in favour of placebo policies. By that I mean initiatives which appear bold and have great symbolic value, but which don't necessarily cost us very much.

...

Most of all, I don't think we are paying enough attention to the placebo idea. It is well known in the medical literature that sometimes placebos work as well as the drugs themselves. "

Alberto Alesino agrees too,

"BLANCHARD'S piece is absolutely on the mark regarding the analysis of the crisis. ... I fully agree with Mr Blanchard that the world is panicking above and beyond what is reasonable. (And incidentally, the comments of pundits who have seized on the crisis as an opportunity to criticise the market economy and spread fear of the Great Depression are adding unnecessarily to the panic.)"

Finally Ricardo Caballero also agrees,

"the main characterisation of the crisis and the policy prescriptions are right on the mark. Following Lehman’s demise, world financial markets have been ravaged by uncertainty and fear.

...

Thus, I believe we can go back to a world not too different from the one we had before the crisis (real estate prices and construction sectors aside), as long as the government becomes the explicit insurer for generalised panic risk."

---

Imagine, for a second, that instead of judging our progress as a society based on how many transactions involving money we undertake in a year, we measured it based on how much time we spent swimming in the ocean. So everything is going along fine, more and more people swim in the ocean for longer each year and the economists are happy until, one day, a couple of people are seen emerging from the ocean with limbs missing.

Suddenly, people become scared to go in the water. There are rumours of sharks. The amount of time spent swimming in the ocean falls and the economists are unhappy.

This brings us to the economists quoted above, who all agree that the amount of time spent swimming won't increase unless the uncertainty about the safety of the water is removed. So they brainstorm about various ways to persuade people it is safe to go back in, most of which amount to having the government guarantee that you won't come to any harm if you go in, and that it will pay your medical bills if any harm does befall you.

Not once do they stop to consider: What if there actually is a shark in the water? After all, something happened to those first victims and it wasn't a lack of confidence. If there is a shark in the water, then isn't the only solution to kill the shark first, and *only then* try to restore confidence?

Back to reality, what if resolving the uncertainty about the economy honestly means admitting that there is a shark in the water? That something triggered this crisis and that something hasn't been dealt with yet?

Could a concerted effort to prevent people from worrying that tech stocks were overpriced in early 2000 have prevented the bubble from bursting and prices coming back down to reasonable levels? Not likely. In the same manner, clapping harder won't undo the massive debt bubble that we have built up over the last 30 years.

Robert Shiller, the best of the bunch on this occasion, says, "Why should anyone trust the valuations banks put on their assets when these vary so much, from less than 50 cents on the dollar to almost 90 in the case of subprime mortgages? Private investors are understandably reluctant to commit more capital when it is unclear whether a bank holds enough toxic waste to render it insolvent."

Of course the reason people are unwilling to put a (true) value on the bank's 'toxic' assets is because doing so would resolve the uncertainty all right, but not in a good way.

If the economists above were really committed to solving the uncertainty regardless of the outcome, then that would be one thing, but it seems like what they are saying is that we should resolve the uncertainty by convincing people that all is well, whether it is or not.

Kind if makes you take every optimistic thing you read from an establishment figure with a grain of salt, doesn't it?

For example, "Bank of Canada Governor Mark Carney said there is little chance of deflation in the world’s eighth- largest economy"

or

"Economy will recover in 2010: Carney"

Not that I'm saying our central bank governor would lie to us for our own good, just that it seems to be a near unanimous opinion among mainstream economists that he should, that's all.