Roubini’s paper from 8th February makes an intriguing point. In his list of reasons why the Fed cannot save us this time, the final one is that the entire system is in “a crisis of financial globalisation and securitisation” and so a recession cannot be prevented within the current framework. The implication is that quantitative policy actions will not solve the problem, but systemic reform or qualitative changes are required.
While the actions proposed by Sachs and Wolf seem reasonable and well thought out, it is unclear that they will be convincing to market participants. This argument is borne out when we look at the situation from the angle of behaviour and incentives instead of just the figures.
Decision-making behaviour is in theory guided by what people believe the future will hold, not what happened in the past. Of course if they believe the future is going to be like the past, they will use past evidence to make future decisions. Future economic performance is in turn driven by the decisions people make now.
And so, for any policy intervention to work, it is crucial that it be a credible break with the past. Whether the policy is genuinely different is sometimes less important than whether people believe it is.
This is why the fiscal rules of Gordon Brown in 1997 and, before that, the Maastricht rules of 1992 were successful. They gave people a reason to believe that the future would be different, and to take actions accordingly. As it happens, Roubini himself wrote a paper on these rules in 1992 – co-authored with Willem Buiter – suggesting that the debt condition of the Maastricht rules (public debt to be under 60% of GDP, fiscal deficit to be under 3%) should be suspended in the runup to EMU. Whatever the merits of the rules themselves, their believability is the most important issue.
As John Kay’s column of 3 September said, “The appearance of prudence, not prudence itself, was sought and rewarded”.
What support is there for this viewpoint? First is the evidence that, in recent months, no matter what level of liquidity and fiscal stimulus has been announced, the economy has not responded as intended. Perhaps interbank rates are finally coming down, but the taps in the real economy have not opened yet.
Second, we see the totemic importance in the public narrative of redefining the rules. Alistair Darling avoided proposing new fiscal rules for the UK in his Mais speech of 29th October, but there is clear pressure to produce them [this response was written some time before the PBR]. Gordon Brown’s article in the Telegraph last weekend also started to hint at new rules for guiding the behaviour of the market in general, and commentators across both economic and mainstream publications are hunting for new frameworks for all sorts of things.
Third, we can refer to behavioural theory and what we might call the “boiling frog” principle. Quantitative, continuous adjustments tend not to change the behaviour of real agents (as opposed to imaginary, rational economic agents) significantly – the mental cost of changing is greater than the incremental pressure created by the adjustment. A discontinuous change in policy is more likely to cause people to re-evaluate their positions and change their behaviour than simply an increase in the numbers. This is supported both by recent brain research and also by plausible models of bounded rationality.
What kinds of discontinuous actions therefore might have greatest credibility? Those which have an external rationale which discourages further change. For example, if the UK’s fiscal rules are to be rewritten, it would seem more credible to adopt the Maastricht rules (60% debt and 3% deficits) than to choose an arbitrary 55% debt target or 4% deficit rule. By conforming to an existing mental anchor, the resetting of expectations becomes more believable. It also allows for a credible transition period – which may well be needed in the UK, which would probably run 5-7% deficits for a couple of years on the way to the 60% limit.
Future frameworks which people can believe in also go a long way to mitigating the trauma of a collapse in the old framework. If large parts of a “mountain of private debt” do end up defaulting, the damage to economic relationships and confidence will be extreme if there is a vacuum of expectations. Firms and consumers will have no guide for the future except for the memory of the violated promises of past borrowers. However if a new economic model has been defined, and defined credibly, it is much easier to accept pain in the present day – a write-down of current assets – without destroying the incentives for future economic activity.
What form that economic model might take is a subject for another day, but I suspect Nouriel Roubini may have some suggestions.