Post-Keynesian Observations

Understanding the Macroeconomy

2. UNCERTAINTY and ANIMAL SPIRITS

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[NOTE: Be sure you have read part 1 first!  This is a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

The expectations of entrepreneurs and bankers play the key role in determining whether or not you can afford a new Xbox360, an upgrade to HD cable, a new car, a house, dinner, etc. Their forecasts decide whether or not loans are made (as explained in part 1 of this series), employees are hired, inputs are purchased, factories are built, etc. It is necessary, therefore, to understand how those forecasts are created.

First and foremost, they are made in an environment of what Keynes called “uncertainty” (Keynes’ master’s degree was in statistics and his thesis was a study of logic of decision making). By that, he meant that bankers and entrepreneurs lacked an objective basis for their expectations because they did not have, nor could they have, sufficient knowledge about the relevant circumstances. Roulette is not uncertain in that sense, it is “risky.” This is because you know all the possible outcomes and the odds of each. You can therefore make objective decisions since you have a mathematical basis for doing so. You can’t know for sure whether 18 or red or 00 will come up, but you can calculate the probabilities and use that and use the casino’s payout to decide whether or not you should place a bet.

Not so in the real world. Particularly when making long-term forecasts, Keynes says that we simply do not know. When a firm is considering building a new factory or an entrepreneur a new restaurant, they operate under the assumption that their enterprise will be in existence for five, ten, maybe twenty years into the future. They *might* have a decent sense of how events will unfold over the next year, but beyond that (and certainly past three or four years) it’s really not much more than a guess.

So why would anyone in their right mind put money down at a game where they had no idea of the odds? Because our “animal spirits,” or exaggerated sense of our chances of winning, make us say, “But it won’t happen to me–my restaurant will do great!” And thus at any given moment it is the precarious balance between uncertainty and our animal spirits that determine whether or not U.S. corporations are opening new facilities or laying off workers. Note that Federal Reserve policy in moving interest rates, which makes so many headlines, is of little consequence in this world. When firms are enthusiastic (and banks along with them), they will happily invest in new physical capital regardless of what they have to pay; but, when they are depressed, no amount of interest rate cutting will spur new spending. Firms would obviously prefer lower interest rates, but expectations are the key, not the federal funds interest rate.

This is not to say that recessions are simply the result of bad moods and could be solved by giving executives and bankers Prozac. There are underlying, real reasons for them to become depressed and these arise cyclically and are built into the way we have designed our system. Those reasons are the subject of part 3 of this series.

Next stop: Durable Goods!

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Written by rommeldak

January 9, 2009 at 8:09 am

Posted in Uncategorized

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