Episode V: Expectations strike back

Micael Castanheira 14 October 2008



Do you remember Luke Skywalker’s challenge to become a Jedi in The Empire Strikes Back? Luke had to enter a dark,foggy cave and fight evil foes. What Luke did not know is that these foes would be materialisations of his own apprehensions. Empowered by the Force, Luke killed the materialisation of his arch-enemy. But that was not the purpose of the challenge. The real purpose was to teach Luke that the Force lies less in the sword than in the mind. Luke should have turned off his lightsabre and focused his mind. By quelling his own fears, monsters and enemies would have receded. That victory, Luke had to achieve.

These fictional events are the epitome of a self-fulfilling prophecy. It is only because Luke imagines an enemy that the enemy materialises. Bank runs are their very non-fictional equivalent – if every other depositor leaves his cash with the bank, my deposits are safe. But, let me conceive of another equilibrium in which other depositors run to the bank and withdraw their deposits... this would mean that the bank would no longer be safe. Then, I should also run to withdraw my deposits. If the whole herd does the same, the bank goes bust, thereby confirming my expectations. Like Luke with his lightsabre, governments have until now mobilised enormous amounts of energy (and cash) to fight each of these madmen-made foes. These fights have been epic but not sufficient – they only combat the enemies who have already materialised.

So far, the current crisis has proved elusive and unstoppable because it is a test of each chapter of a good economics textbook. All economists have studied multiple equilibria and self-fulfilling prophecies. All of us – and I include here central bankers, as well as stock brokers and traders – studied the weaknesses of the banking system. All of us learnt about the 1929 crisis, the savings and loan crisis, and the Japanese crisis. All of us have the same fears and wonder which will be the victor: the heroic-but-clumsy governments or the traders’ and brokers’ panic? Like in Keynes' beauty contest, each player tries to outguess the other. But we have the same textbooks, and thus the same fears at the same time. Today’s fear is whether this crisis could prove worse and more protracted than in the 1930s. This is not a prediction! Just a fear...

Why could such a fear come true in Europe? After the crisis of the 1970s and 1980s, we developed institutions meant to anchor expectations towards a conservative and sound long-term policy of stability – a safe-and-sound European Central Bank with a heralded conservative policy. The stability pact prevents a re-run of the counter-productive deficit policies of the 1980s. But these institutions are totally inappropriate to stave off present fears. They actually reinforce the expectation that Europe will be unable to adapt its macroeconomic policy. Textbooks say that in 1930 Herbert Hoover increased taxes to prevent a deficit increase, which actually worsened the crisis (see Barry Eichengreen's recent column). Textbooks say that Japan, unable to react quickly, is still suffering from its 1990s crisis. Today, the Belgian government is designing its 2009 budget and yearns for it to be balanced. If we do not coordinate policies away from such misplaced orthodoxy, we may well anchor current expectations towards a worse-than-in-the-thirties crisis.

Today, we thus need to exploit the stability pact in a different way if it is to play its stabilising role. For the next two years, the pact should constrain national governments to significantly increase all deficits, beyond 3% if needed. Textbooks tell us that such a Keynesian policy cannot work for a prolonged period nor when countries face an adverse supply shock. But it might be badly needed to combat the likely contraction in demand that we now expect to take place in 2009. A temporary but aggressive budgetary policy has the potential to rebuild confidence – to anchor expectations towards a moderate and short-lived drop in aggregate demand.

Europe has delayed many important policies because they are costly: energy saving investments to meet CO2 targets, research and development investments to meet the Lisbon agenda, and many efficiency-enhancing but deficit-generating tax reforms. These are genuine investments, which are costly in the short-run but beneficial in the medium or long run. Now is the time to accelerate them and let all deficits increase significantly, to cash in the rewards when growth returns. The purpose is certainly not to abandon the sound policies that have worked in recent years. Yet, to quell present fears, we must anticipate the next textbook chapter and anchor expectations in the right direction – no Luke, such a crisis there will not be!



Topics:  Macroeconomic policy

Tags:  financial crisis, expectations

Senior Research Fellow of the Fonds National de la Recherche Scientifique, Professor of Economics at ECARES and CEPR Research Fellow.