Confidence, Credibility and Macroeconomic Policy.
New York: Routledge, 1995. Pp. 169. $65.00.
You tell your child, "If you do not stop pestering your brother, you will be in time out for 10 minutes." If the activity continues and you do not put your child into time out, then you lose your credibility with your child. To regain that lost credibility, to regain that lost authority is a very difficult task. This parent-child parable can be retold in terms of a government-private sector setting. This book is about what governments can do to regain the credibility that they have lost with the private sector over the issue of activist macroeconomic policy.
The first three chapters examine the policy irrelevance theorem: In the long-run, activist macroeconomic policies are neutral with respect to real output and employment and nonneutral with respect to the rate of inflation. Chapter 1 states that government expenditures may be funded by taxes, bonds, printing money, or some combination thereof. Any attempt to cover expenditures that are not credible in the eyes of the private sector leads to inflation. Chapter 2 presents a brief summary of the Ricardian Equivalence Theorem and a classroom experiment that illustrates the principal conclusions of this Theorem. In particular, this chapter is concerned with what happens when a government switches from the use of taxes to the use of bonds as the primary means of funding its deficit. Chapter 3 presents a brief summary of Lucas's "Islands Model" and a classroom experiment that illustrates the principal conclusions of this work. In particular, this chapter is concerned with what happens to private sector expectations when the government changes its monetary policy regime.
The next three chapters review three historical instances where governments have funded their deficits by printing money. Chapter 4 reviews the case of hyperinflation that occurred in the Confederacy during the Civil War. During the early stages of the war, the rate of inflation was significant but not unexpected given a war-time economy. After the battle of Sharpsburg in 1862, however, hyperinflation occurred because the Confederate government's policy of funding its war-time expenditures primarily by printing money was not credible in the eyes of the private sector and therefore a flight from currency took place. Thus, by April 1865, the Index of Quarterly Wholesale Prices (April 1861 = 100) had increased to 9211. Chapter 5 reviews the case of hyperinflation that occurred in Germany following the First World War. The authors suggest that the Peace Conferences had the same effect on the German private sector as the military defeats had on the Confederate private sector, namely, the German private sector did not believe that the government's policy of funding its current expenditures principally by printing money was a credible policy, and a flight from currency began. Thus, by 1923, Germany's annual rate of inflation (Wholesale Price Index, 1913 = 100) reached 481,068, 520%. Chapter 6 examines the question: Does membership in the European Monetary System (EMS) automatically mean that member governments' policies are credible in the eyes of the private sector? Using a variety of statistical tests, the authors arrive at a preliminary conclusion that such is not the case. Anecdotal historical evidence lends support to their conclusion. Witness the successful assault on the British pound undertaken by George Soros.
There is, however, one aspect of the authors' argument to this point that is asymmetrical: A flight from currency occurred in the Confederacy and Germany but not in Britain. In each case, the private sector found its respective government's policy not credible and acted on that information. The missing element from their credibility thesis, at least in these three historical examples, is that credibility may be a function of the governed's belief in the durability and long-term stability of its government. A flight from currency occurred in the Confederacy and Germany because the governed believed that their respective governments would be radically restructured in the near future. Since no such belief existed in Britain, a general flight from currency and hyperinflation did not occur.
A second aspect of the authors' argument to this point, which is a cause for concern, is the end of the hyperinflation in Germany. If hyperinflation is the result of the private sector acting on its belief that the funding of the government's current expenditures by printing money is not a credible policy, then the end of the hyperinflation must be in some way linked to the private sector's belief that the government's new policies for funding its current expenditures are credible. The three provisions of the Dawes Plan - the reasonable reparation payments, the mandatory currency reform, the removal of the Reichbank from German control - and the General Election of 1924 allowed the private sector to renew its faith in its government, and the flight from currency abruptly ended. While Chapter 2 does contain a brief discussion of the private sector's reaction to the government's attempt to regain credibility in the area of monetary policy, an extended examination of the monetary stabilization process in Germany following the hyperinflation would have strengthened and foreshadowed the authors' primary point: the introduction of consumer confidence into macroeconomic models.
The final three chapters of the work examine the role of consumer confidence in determining the credibility of a government's macroeconomic policies. The authors suggest that, in most New Keynesian and New Classical models, information is imperfect and asymmetrical. By including data about consumer confidence, as it affects consumption and investment expenditures, the quality of information contained in these models can be improved.
The authors present a model that incorporates an index of consumer confidence, similar to the one compiled by the University of Michigan, into the equations for aggregate demand and aggregate supply. In this model, if the economy is in equilibrium at less than full employment, the government could implement a set of macroeconomic policies designed to restore the system to full employment. The level of real output increases because both aggregate demand and aggregate supply shift to the right. This shift in the aggregate demand and aggregate supply curves is consistent with New Keynesian macroeconomics - that expansionary fiscal and monetary policies are nonneutral with respect to real output, employment, and prices - and with the fact that increases in investment expenditures increase aggregate demand and, once the investment project is completed and comes on line, increase aggregate supply as well. Eventually, however, the private sector no longer believes that the government's expansionary policy is credible. Real output ceases to increase and the rate of inflation begins to increase. This reaction on the part of the private sector is consistent with New Classical macroeconomics - that the aggregate supply curve is vertical and that expansionary fiscal and monetary policies are neutral with respect to real output and employment and nonneutral with respect to prices. Thus, the authors ". . . offer a reconciliation of the work of the New Keynesian school with that of the rational expectations 'policy irrelevance' school by introducing endogenised confidence terms" (p. 168). This is an innovative theoretical solution to the problem discussed in the long running 'Keynes and the Classics' debate.
I highly recommend this very thought-provoking book because (i) the arguments are presented in a very readable and logical manner, (ii) the classroom experiments are elegant illustrations of complex theoretical propositions, and (iii) the authors' thesis is a reasonable, thoughtful, and pragmatic merging of the essential policy conclusions of the New Keynesian and New Classical schools of thought.
Tom Cate Northern Kentucky University
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|Publication:||Southern Economic Journal|
|Article Type:||Book Review|
|Date:||Apr 1, 1998|
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