Buttonwood
Bribing the markets
Oct 29th 2009
From The Economist print edition
The impossible task of eliminating uncertainty
llustration by S. Kambayashi
LORD SKIDELSKY’s excellent new book, “Keynes: The Return of the Master”, makes one striking claim about the economist’s work. “The centrepiece of Keynes’s theory”, he writes, “is the existence of inescapable uncertainty about the future.”
Uncertainty is different from risk, as Frank Knight, an economist, first pointed out in 1921. A poker player can figure out the odds of success when holding a pair of kings. But when dealing with macroeconomic events or forecasting stockmarket movements, you do not know the potential distribution of outcomes. There are an awful lot of jokers in the pack.
Most people face a future that comprises a combination of Donald Rumsfeld’s known and unknown unknowns. Choosing to buy a house, for example, involves a series of bets on land prices, interest rates, taxes, job prospects, future planning decisions in the area selected and the structural soundness of the property concerned. It is impossible for any buyer to be confident about so many variables. Any decision must be a guess.
Buyers usually accept this constraint and make the best guess they can. But when uncertainty increases substantially, the temptation is to freeze—to do nothing until the situation becomes clearer. Consumers delay their spending plans; companies halt their capital expenditure. In Keynes’s words, “animal spirits” are depressed. That was one reason he believed there was a case for government intervention: to act as the spender of last resort.
But uncertainty also has another impact. The stockmarket is used both as a barometer of investors’ risk aversion and as a lead indicator of economic health. When investors are uncertain (risk-averse), they have a preference for holding cash and the price of shares falls. That in turn feeds back to the economy through a further downward effect on confidence.
Over the past 25 years, the authorities have had a tried-and-trusted method for bringing a halt to this vicious circle: cutting interest rates. The bigger the crisis, the faster and farther they have to cut. That is why British interest rates are lower than they have been in the 300-year-plus history of the Bank of England. Traditionally, 2% was seen as the floor for short-term rates.
So you could see low rates as the “price” of uncertainty. The authorities have been forced to push interest rates close to zero in order to give investors a one-way bet. Any asset offers a higher yield than cash. Equity and corporate-bond markets have duly responded, rallying strongly this year.
But it is all rather reminiscent of Ethelred the Unready, an 11th-century king of England who paid Danegeld to buy off Viking invaders. The result was that the Danes demanded ever-bigger payments.
The price of these bribes is being paid by the cautious, such as elderly people who do not want to trust their modest nest-eggs to the vicissitudes of the stockmarket. Their income has been slashed. Keynes, who talked about the “euthanasia of the rentier”, might have approved. He wanted interest rates kept low to discourage the hoarding of money and encourage consumption and, by extension, full employment.
But penalising the prudent and rewarding speculators can, at best, only be part of the process. The real “animal spirit” that needs lifting is the willingness of banks to lend to businesses (and of the latter to borrow). So far, that process has been a failure. Figures from the European Central Bank this week showed that lending to the private sector declined by 0.3% year on year in September, the first drop since records began. In America the annualised rate of broad-money growth over the past six months has been just 0.2%. The very largest companies have been able to raise capital in the bond markets, but that has not helped smaller firms (which are the ones most likely to generate new employment).
At the heart of this failure may be two other kinds of uncertainty about the future direction of government policy. Instead of lending more, banks would rather boost their capital ratios to hasten the day when governments get off their backs. Companies may not want to borrow to invest, for fear that stimulus programmes will be followed by tax rises as governments strive to tackle their deficits.
Indeed, the final uncertainty is whether all this fiscal and monetary stimulus will work. It may do so in economists’ models, but the main practical example (Japan over the past two decades) is not encouraging. Perhaps uncertainty follows the “waterbed principle”: try to flatten it in one place and it simply pops up somewhere else.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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