(About the emotional decision making of the Global Economy)
One of the earliest posts of this blog was about policy rules and policy discretion. The original economics model is generally used to provide evidence for how short term optimisation of policy can screw up your long term rules, and thus lead to a sub-optimal outcome. It is an economy level procrastination problem, which - on the individual level - is also well described, by the behavioural economics lot.
A ‘rational expectations’ approach to the rules versus discretion problem, however, changes it a bit. In this form, the economic agents come up with new assumptions about policy rules when they see the policy maker’s short termist behaviour. And thus not only do the originally announced or implied policy rules go out of the window with the discretionary measures, but new rules also emerge. This is especially the case when the policy maker herself does not have any idea what is going on. Which is, incidentally, the situation now…
Given the above, it is striking how little is discussed about the long term consequences of all these semi-random and fully-random and even-more-random policy ‘innovations’ that governments around the world keep coming up with.
Like, what is going to be the long term consequence of a government backed mortgage payment holiday during crisis? How on Earth will anybody be able to come up with any robust probability function for mortgage defaults? Like: if the debtor gets into trouble, she defaults, unless, there are a lot of others, who are also in trouble, and all of these happen to be the constituencies of the ruling political party… Now try to squeeze that into an algorithm…
Or what is going to be the basis for assessing financial risk? Where will bank valuations come from? Will you have to categorise financial institutions into sizes, the big ones being saved for sure? Is it going to be a continuous distribution? Is there going to be a threshold for triggering government action? How many peaks will this distribution function have? E.g., you don’t save the first big one, then save all further big ones, until too many need saving. Or maybe just one or two more… I would shake the hands of the bank equity analyst who can deal with this one in any credible way.
Or countries. What will be the default probability assigned to any country? Now are these lower or higher than before? Lower, for the behaviour of the global governing institutions the past months suggests that no country is being allowed to run into real bankruptcy. But higher, for if these institutions run out of money, or more importantly political capital, then a lot of countries will default at the same time, pulling each other down.
The trouble is that although all of the above can be modelled, but not in any robust way.
Hence the importance of short term discretionary policies re-defining long term rules. Seeing how these novel ‘rules’ come to life is really disheartening. As if we all, as individuals would make our most important, long lasting decisions based on ad hoc emotional impulses.
Which, incidentally, we all do, of course… Life is a mess for everyone, even if you happen to be the Global Economy.