Sayantan Ghosal, Marcus Miller, Leaza McSorley & Ekkehard Ernst

“Welcome to the Age of Anxiety.” W.H. Auden

“There was a Chinese curse which took the form of saying, ‘May you live in interesting times.’  There is no doubt that the curse has fallen on us.” Austen Chamberlain (1936)

Once again, the people of Britain are living in interesting times; and the consensus view that expectations are somehow ‘anchored’ is, arguably, broken.

Recent economic and social developments, it seems, have affected people’s beliefs about the future in disparate ways. These developments include the continued fall-out from the 2008 financial crisis, stagnating wages and productivity growth; the rise in automation and the gig economy; the revival of populism and nationalism; and, of course, Brexit.

These developments can all shift our beliefs about the future, raising anxiety and potential instability in the economy. Indeed the Adult Psychiatric Morbidity Survey (latest survey in 2014) notes that anxiety is the most common named psychological disorder in the UK. Also the rise in mental health disorders for adults aged 55-64 from 2007-2014 has been attributed to the effects of the 2008 recession.

Anxiety influences how we make decisions in an uncertain world. It influences our current payoffs, decisions and overall market outcomes. Like other emotions, anxiety depends on how facts are perceived. Or, as Caplin and Leahy (2001) put it, “Anxiety may respond more directly to possibilities rather than probabilities”.

Breaking out of ‘rational expectations’

This research project, supported by Rebuilding Macroeconomics, examines the conditions under which competing narratives can co-exist, influence (and are influenced by) individuals’ emotions, and their role in shaping individual behaviour and aggregate outcomes.

We build upon past work on expectations as an important factor in explaining behaviour. Akerlof and Shiller’s work on “narrative economics”, for example, highlights how social representations of the future can influence our expectations. Farmer (2010) and De Grauwe (2013) show how different drivers of expectations in macroeconomic models can change the final macro outcome. Recently, Haldane (2018) invoked a similar concept of ‘folk wisdom’, which complements earlier insights from Keynes and Minsky on the conditions under which expectations can lead to aggregate fluctuations.

The traditional approach of rational expectations as a guide to decision-making within economic models relies on the shared knowledge of economic agents. Game theoretic models, in particular, rely on the assumption of “knowing others will do the same” (Basu 2015) and on the concept of “common knowledge” (Schelling 1960).

With competing narratives, expectations will no longer be common knowledge since different people hold different beliefs – especially if there is fundamental uncertainty so there are no objective probabilities to be attached to possible future outcomes.

Accordingly, we will develop a new solution concept for large games and markets which requires only partial consensus on aggregate outcomes generated by the interaction between economic agents.

Stabilising expectations

Given shared or common knowledge there may be more than one economic equilibrium. For example, in the case of banking, viable institutions can be made insolvent if panic causes depositors to run. There is also a substantial literature on coordinating expectations in settings with multiple equilibria – by policy actions or institutional change (such as the Central Bank acting as a Lender of Last Resort or establishing Deposit Insurance, respectively, to avert bank runs).

The distinction between coordinating and stabilizing expectations is clearest in settings with a unique equilibrium. Even where there is only one market equilibrium, expectations that depart from this may lead to macroeconomic fluctuations.

This project investigates whether policy can stabilise such expectations. We focus on ‘lighthouse policies’ – those policies which may have the potential to steer the future direction of the economy by anchoring expectations. Can such ‘lighthouse’ policies establish a sufficiently stable consensus to support a socially desirable outcome that is approximately self-fulfilling?

As a historical case in point, we could cite President Franklin Roosevelt’s Inauguration Speech when he famously said “let me assert my firm belief that the only thing we have to fear is fear itself”. For current times, we may take as an example central bank policies such as ‘forward guidance’ which seek to anchor expectations of future interest rates, or perhaps even ‘quantitative easing’ to provide a floor on expectations of the future values of asset prices.

Empirics and Policy

The dominance of DSGE modelling within the mainstream, with its use of ‘rational expectations’ as a solution concept, essentially rules out the need for such ‘lighthouse’ policies except in extreme cases, such as when a lower bound for the policy rate is reached as in Woodford (2013). By the same token, DSGE modelling cannot account for phenomenon such as expectations-driven fluctuations in business investment and asset prices unless these are assumed to be exogeneous frictions (in the same way that preferences and technology are assumed to be exogeneous) as in Angeletos, Collard and Dellas (2018).

Our idea of ‘partial consensus’ is key to understanding the role played by endogenously determined expectations-driven macroeconomic fluctuations. It provides a rationale for policies such as forward guidance or quantitative easing even when the lower bound for the policy interest rate does not bind.

We will use data on sentiment and beliefs from existing empirical work (generated through new machine learning methods, text analysis and social network analysis) and surveys to quantify the effects of anxiety and competing narratives. We will also examine key channels through which anxiety impacts on aggregate outcomes and welfare and the role of policy.


To read more about this project, click here.

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26 April 2019


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