How The Economy Works

The subtitle of Roger Farmer's book How The Economy Works is 'Confidence, Crashes and Self-Fulfilling Prophecies', and goes a long way towards explaining his mission. This is to set out his synthesis of the presumption in neoclassical economics that people act in their own interest using all available information (that is, rationally) with the Keynesian insight that confidence is all-important for macroeconomic outcomes. There are a number of things I like about the book, and this obviously sensible synthesis –  based on Farmer's academic work in another new book, Expectations, Employment and Prices  –  is one of them.

The book combines two strands. The first is a brief and non-technical history of macroeconomic theories, from Adam Smith to rational expectations. This part is definitely for the general reader – I think it will all be known to any economist. Still, it sets the scene usefully for a discussion of what has gone so badly wrong with the cosy consensus in economics about the 'Great Moderation' (steady growth and low inflation for a decade). This was usually complacently attributed – before the Crisis –  to the success of monetary policy.

The second strand is a non-technical explanation of Farmer's theories about the way the role of expectations in macroeconomic, or collective, performance means there are multiple potential equilibria. Asset prices, including the stockmarket, affect the labour market by affecting wealth, and wealth, Farmer argues, is a far more important determinant than income of the level of demand in the economy. “Low confidence can result in low asset prices and that lack of confidence can become a self-fulfilling prophecy that leads to very high unemployment, potentially for a very long period of time.” (p107) And again: “Confidence selects the unemployment rate we observe.” (p114) This seems a highly plausible claim to me, but I must say I found the non-technical explanation here rather impenetrable, and pined for a few equations explaining what the words mean, at least in an appendix. Perhaps non-economist readers would find this section of the book perfectly clear, but it seems possible that it falls between the two stools of being too complicated for the general reader and too imprecise for the professional reader. Maybe not – this is a hard balancing act – but this is my main reservation about the book.

The role of wealth means the conventional Keynesian policy fix for a recession, a fiscal stimulus, will misfire – just as it did in the 1970s when most western economies ended up with both high unemployment and high inflation. The policy target needs to be wealth, and therefore asset prices, instead, according to Farmer. His conclusion is that the inflation targeting policy followed by central banks before the Crisis was inadequate and needs to be supplemented by asset price targets. He argues that conventional monetary policy – interest rates and/or the money supply – should be set to target inflation, while central banks should use changes in the composition of their balance sheets – asset sales and purchases – to target asset prices. He recommends targeting a stockmarket index.

“The correct response to the crisis is to set in place, in every country in the world, an institution to control the value of the national stockmarket wealth by targeting the rate of growth of an index fund.” (p165)

In effect, this is what quantitative easing policies are doing. But there isn't enough in the earlier part of the book to convince me that this is a good idea. Certainly, I think we've learnt that central banks should call time on asset price bubbles, and will need additional instruments to do so as raising interest rates enough to burst a bubble would harm unduly the rest of the economy. Yet old-fashioned regulatory interventions such as reserve requirements and credit restrictions seem to me more practical tools.

Still, this is an interesting idea, and Farmer's combination of solid theoretical foundations with the obviously important role of expectations and confidence in the economy is appealing. The recommendations made here definitely deserve to be part of the wider debate under way now about lessons for macroeconomic policy and central banking.