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November 30, 2011, 8:49 AM

Questions Of Confidence

Some readers have asked why, given my scornful discussions of the “confidence fairy” story about fiscal austerity (will that be my lasting contribution to economic discourse?), I’m willing to take seriously the idea that ECB rate hikes had a huge impact via expectations.

That’s a good question, but I do have answers.

First of all, the ECB story is about the bond market; the expansionary austerity story isn’t. Instead, to believe that fiscal contraction will lead to higher consumption and investment spending you have to believe that consumers and firms will make major changes in their current behavior based on perceptions about taxes and spending years in the future. And that’s just a lot less plausible. The likes of Pimco are out there trying to figure out the implications of ECB behavior, and investing accordingly; how many families do you know deciding on holiday purchases based on expectations of tax policy in 2014?

Second, the monetary story is a lot more concrete. The ECB’s readiness to raise rates despite low core inflation and high unemployment tells you a lot about the likelihood that it would choke off the modest rise in inflation needed to make the eurozone adjustment feasible. Do Cameron’s budget cuts convey any comparable information about future UK taxes and/or solvency? I don’t think so.

Finally, the whole euro situation is fraught with multiple equilibria and the risk of self-fulfilling panics — which means that there can sometimes be disproportionate responses in a way that doesn’t make sense when we’re talking about budget cuts.

So yes, expectations can matter; but some expectational arguments are more equal than others.