Monday, January 26, 2009

The "Confidence" Production Function

I know how to make a cup of coffee. I know how to make a decent economics lecture. I don't know how to produce a unit of "confidence". The micro-econometrics literature has emphasized the importance of accounting for heterogeneity. In a diverse world, how do different policy actions that President Obama, Drs. Bernanke, Romer and Summers may propose affect individuals' "confidence" that the USS Enterprise is flying in the right direction on its way back to prosperity?

When I read Paul Krugman's columns, he seems to be saying that government needs to send a credible signal that it is "on the job" and that everything will be okay. The hope appears to be initialize a self-fulfilling prophecy.

There needs to be some explicit discussions by researchers who work on social networks and social interactions (so the macro guys would be Brock and Durlauf) on how you set off a macro chain-reaction.

For example, suppose that Paul Krugman is an influential person in the sense that if he were to start to write OP-ED pieces saying that the crisis is over that other people (like my mom) would read this and increase her optimism about our short run future.

The math equation here is that my mom's probability of being bullish on America depends on her own views of the fundamentals and what she thinks the influentials (i.e Paul Krugman) thinks.

So we get into an infinite regress here. Under what conditions does Paul Krugman grow more optimistic about our short run future? He clearly would be more optimistic if there was an enormous New Deal. While John Cochrane may not agree with him, suppose we get the New Deal.

Krugman gets optimistic and this causes my mom and her friends to get optimistic. This beneficial contagion spreads and consumer demand rises and factories start to hire again. The banking sector would get unfrozen as ambitious bankers see money flying around again.

In aggregate, the recession ends.

Is this story right? Note that the recession ends even if the Government Big Push achieves nothing but make Dr. Krugman optimistic.

Now I am giving him a very large treatment effect coefficient in this confidence production function but it is up to macro-economists to estimate this equation.

So, my question for macro-economists is whether they need to start to work with sociologists on determining how social-interactions feed into "panic" (the loss of confidence) and who are the influentials for helping to bring back confidence in the cheapest way possible.

Does Obama have FDR clout? What did FDR do to earn that clout? Has Watergate and past wars made us too cynical about Presidents for the new generation of presidents to have this historic clout in boosting our "confidence"?

What did Keynes say about what is the production function of "Animal Spirits"?