Home > Uncategorized > Confidence is an endogenous variable

Confidence is an endogenous variable

Matt Yglesias has two great posts this morning on issues I’ve been thinking about (here and especially here).   That second post is related to a point I’ve really wanted to make for a while now.

First, let me say that I’m a little disappointed in yesterday’s election results in Greece.   Not that I care much for or about Syriza–though I’ve yet to hear why Syriza is supposed to be so frightening to the VSPs of the Eurozone; how exactly is renegotiating a clearly terribly, epically counterproductive austerity agreement supposed to be so dangerous?–but when did the political establishment forget that it was New Democracy (the winner of the election, and to a lesser extent PASOK its former chief rival) that is the primary cause of the seriously-in-need-of-fixing patronage network that the Greeks call a government?   Isn’t the point of the “structural reforms” in Greece to dismantle that patronage network?   How is voting in the architect any kind of solution?

As a related point, why is no one else–Matt excepted–worried that the election (by all appearances) was moved by threats from both the ECB and Germany about the continued existence of Greece as a member of the Euro?   Imagine that Obama threatened to boot perennial economic basket-case Mississippi from the dollar economic zone (i.e. the US)?   In fact, we don’t really have to imagine, because Mississippi did try to leave once, 150 years ago, and the result was a very bloody war.

That being said, the point I really want to make is that we shouldn’t be surprised interest rates in the EU are no longer responding to these “confidence improving” developments.   I’ve been trying to avoid explicit modelling here, but I think this time I might need to introduce a simple mathematical model to make my point.

The issue revolves around this “confidence”.   I’m going to make a somewhat strange case (given the usual debate in the media); basically, there is in fact a “confidence fairy” but she’s very much powerless.    My thinking is this:  each time there is a “bailout” in Europe, there is a temporary reprieve in falling bond prices.   Think about it:   why would that be?   Let’s just take the conventional wisdom as correct.   The “very serious” signal is sent out and the invisible bond vigilantes have been satiated.

Why then do we keep coming back to crisis?   I think that’s clear:  austerity reduces the ability to repay national debt (see  here).    So, all else equal bond investors first “reward” austerity with lower interest rates–but they are doing  so at constant interest rates–yet, as the economy contracts–bond investors don’t internalize GDP growth directly–the supply of money available to purchase bonds dries up, yields eventually rise.   As investors adapt their expectations for the future price of bonds, the “reward” for austerity gets shorter and shorter.

Eventually, “confidence” must come face to face with reality: reducing incomes reduces the ability to repay debts.

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