Thursday, 2 April 2009

Self-feeding economics

I am hopeful about the results of the G20 summit today. A few months ago, I hypothesised that political leaders were deliberately driving economic confidence off a cliff so that we'd enter the recession sharply, in the hope of a fast bounce. Once recovery starts (in whatever form) I believe it will continue and accelerate.

So many aspects of economic performance and perception are self-fulfilling. Stockmarket valuations are based on predictions of future returns. A recovery that starts now instead of next year and runs at 3.2% instead of 1.5% for a couple of years will create about 10% more total return than the counterfactual. If investors believe that's going to be the scenario, stocks today will be worth 10% more. This will increase the profits and capitalisation of financial companies, possibly saving some from bankruptcy and certainly allowing them to lend more. This in turn will boost industrial activity, employing more people and leading to exactly the potential recovery that started the cycle.

Exactly the same effect works for personal income and spending.

Some dynamics are different - for example inflation, the money supply and interest rates have a more complex relationship which operates more like a self-correcting equilibrium.

The distinction between these two types of economic effects is one of the most important features of macroeconomic theory, and I am investigating what difference knowledge economics and behavioural models make to them. Classical economic theory doesn't really account for self-feeding behaviour at all (and can't even properly explain economic growth) so there must be an important role for knowledge and behaviour in explaining these features of the world.

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