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Why optimism about the economy is so important

The writer is a public policy professor at the University of Cambridge

Economists think people’s expectations are important in shaping their decisions, from whether to invest in expanding a business to buying a house or spending years studying to gain a qualification. Keynes labelled the role of expectations “animal spirits”. Mainstream economics has often assumed “rational expectations”, whereby people do not make systematic errors in foreseeing what will happen.

Whichever theory applies, what we think will happen to the economy in the future determines what we decide today — and thus shapes the future. That is especially important in 2021 as much of the developed world prepares for a vaccinated reopening of their economies.

Yet history also plays its part in economic decisions, and the evidence is that it has a long reach. For example, the road network built by the Roman empire explains much of Europe’s current economic geography and patterns of trade. Similarly, a history of populism in a country is a strong predictor of a populist future. Given such patterns, what are the chances of changing current trajectories?

The economist Paul Krugman argued some years ago that the balance between looking back to the glories of the past and feeling optimistic about the future would determine how fast an economy could grow. Expectations about the economy, whether rational or animal, are self-fulfilling.

So which has the stronger influence, the past or the future? It is a critical question when the outlook is one of radical uncertainty. Looking back to how things were before this pandemic will lead to belt-tightening and gloom. Governments need people to feel optimistic so there will be something for them to be optimistic about. That is why, for example, US Treasury secretary Janet Yellen has urged G7 countries to go big on fiscal stimulus, and the EU is deploying a €750bn recovery fund.

Perhaps it is also why some policymakers have been so positive in their forecasts of growth prospects. Andy Haldane, chief economist at the Bank of England, for instance, has said breakthroughs on vaccines could offset “excess caution and excess gloom” about the economic outlook. Many companies and households in developed economies have piled up their aggregate savings these past 12 months and have a lot of bottled-up intent to spend, goes this cheerful outlook.

It is evidently true that savings have increased enormously for some people. The UK household savings ratio shot up and remains elevated at nearly 17 per cent; the equivalent US figure is 14 per cent. Others have lost income or revenues and run up debts. But the availability of money will not alone determine post-pandemic spending. The challenge is to make people feel upbeat without being an overly optimistic Pollyanna.

Unfortunately, for all the emphasis on the role of expectations, economics does not have great insights into how these are formed, either in individuals or when choices are aggregated taking into account the influence people have on each other. There is some interesting research into the role of narratives in shaping people’s economic expectations, but this is not reflected in most standard economic policy analysis.

Now is the time for this to change. In the UK, when the Victorians built so much of the infrastructure that is still being used, they were feeling pretty optimistic. Look not only at their grand town halls but also at the vast Italianate northern mills or the 150 years’ worth of capacity Joseph Bazalgette built for London’s sewers. How did they do that?

As countries grapple with the pandemic’s economic fallout and plot a path to recovery, we will all have to be persuaded that it is exactly the right time to make massive investments in zero-carbon energy, transport and buildings; in agriculture and food sectors that restore biodiversity and secures supplies of healthy food; in integrated health systems and supply chains resilient to the next pandemic.

Then there is the challenge of levelling up. In the UK, the Roman road network covered most of England so the historical roots of the economic imbalance that we see now between London and elsewhere do not run quite so deep. But the inequalities between parts of many countries — southern and northern Italy, say — are entrenched, worsened by years of public service “austerity”.

The scale of the task that governments in Europe and the US have set themselves is vast. They will have to sound convinced if they are to convince anybody else. And they will need to convince private sector investors, and the public, that spending will be worthwhile if recovery is to succeed. It is a challenge of narrative as well as action.


Source: Economy - ft.com

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