Zombie Economics by Quiggin John;

Author:Quiggin, John;
Language: eng
Format: epub
Publisher: Schwartz Publishing Pty. Ltd
Published: 2012-04-16T00:00:00+00:00

What specific features of a more general and realistic model of choice under uncertainty might contribute usefully to a renewal of Keynesian macroeconomics? There are at least two obvious examples. First, there is the problem of unknown unknowns, which is also, and not coincidentally, a critical problem for the Efficient Markets Hypothesis. An obvious feature of economic crises is that people are forced to consider contingencies they might previously have disregarded, such as the possibility that their employer or their bank might fail, or that currency might rapidly lose its value. When such a contingency suddenly enters the minds of many people, large macroeconomic shocks may result.

Second, as I’ve already mentioned, although people fail to consider some low-probability extreme contingencies, they tend (perhaps in compensation) to overweight those they do consider. In the macroeconomic context, the “normal” situation is one in which people disregard or at least do not account for the risk of a serious recession. In a crisis, the normal outlook may suddenly be replaced by a far more pessimistic outlook in which the same people place a high weight on the possibility of total economic collapse.

Unsurprisingly, such a change in “animal spirits” may represent a self-fulfilling prophecy. If a lot of people expect a recession and try to increase savings and reduce investment, these defensive actions may bring about the recession against which they are designed to guard.

Of course, awareness of this fact will do nothing to moderate the potential impact; if anything the reverse. People who are suddenly worried about a recession will not, if they are looking to their own well-being, keep spending in the hope that others will do likewise and thereby keep the economy afloat. Rather they will reason that others are likely to think as they do, and that a recession is even more probable than the objective evidence would suggest.

Keynes’s idea of “animal spirits” has been revived by George Akerlof and Robert Shiller in their recent book of the same name. Akerlof and Shiller consider five deviations from the standard model of rational maximization (confidence/trust, fairness, corruption, money illusion, and stories) and argue that some combination of these can be used to explain a range of economic outcomes inconsistent with the standard model. Their discussion makes a compelling case that macroeconomics needs new, and more realistic, foundations.

If the prospects for a macroeconomic analysis based on alternatives to expected utility theory are so promising, why has so little work been done along these lines? In part, perhaps, this simply reflects the effects of specialization. Decision theorists focus on individual choices, and when they seek economic applications, this leads them naturally to look at microeconomic problems.

But there is a more fundamental problem. Individuals who satisfy the conditions of expected utility theory display a property called “dynamic consistency” which, as the name suggests, is of fundamental importance in DSGE models. Dynamically consistent economic agents never change their view of the world in any fundamental way. They respond to new information by changing their subjective

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