The Confidence Fairy and Formation of Demand Expectations Under Uncertainty

From a broadly Keynesian viewpoint, output is demand determined. This suggests that fiscal policy, by affecting demand, can affect output and employment. At the same time, however, many Keynesians emphasize fundamental uncertainty. Firms’ output decisions depend upon expectations of future demand, and these expectations must be formulated under conditions of uncertainty. It can be wondered how the efficacy of fiscal policy squares with the presence of uncertainty.

In the aftermath of the global financial crisis of 2007 and the ensuing Great Recession, some opponents of expansionary fiscal policy invoked the notion of uncertainty to claim that such policy is self-defeating. One prominent line of attack was that such measures undermine business confidence.

By now, most economists appear to reject such claims. There seems to be fairly wide consensus that expansionary fiscal measures, when and where adopted in the aftermath of the crisis, have been effective.

Even so, the devil’s advocate might wonder whether critics just happened to be unlucky in their predictions. Perhaps it could be argued that uncertainty – especially if conceived as fundamental uncertainty – means that pretty much anything could happen in response to just about anything?

Arguably, Keynes himself may have left this possibility open. (For a very entertaining blog series on this topic, see ‘The Horror of the Confidence Fairy‘.)

Whatever Keynes’ own view on the matter, I think there are good reasons to expect expansionary fiscal policy to be effective.

As Keynesians have often emphasized, the presence of uncertainty encourages recourse to conventional behavior and the adoption of rules of thumb. Recent experience and anything that is readily verifiable in the present will tend to guide action. This applies to the task, faced by firms, of anticipating demand when setting their production levels.

In broad terms, how might these demand expectations be formulated?

One relevant consideration is the government’s fiscal policy along with other major economic policy announcements and signals. In its annual fiscal statement, the government commits to a level of spending, composed of various components, to accompany various tax measures.

Expenditures specified in the government’s fiscal statement will:

  1. Broadly indicate a level of public-sector wage payments, which can be expected to induce private consumption expenditure.
  2. Provide information concerning government orders to be placed with private enterprise.

The level of public-sector wage payments in 1 provides information for firms supplying consumption goods. This will help to inform production and employment plans in these firms.

The orders implied by 2 indicate a certain level of output that can be realized through sales to government by those winning the contracts. This has implications for the level of employment and wage income in the contracted firms.

The production commitments of firms directly enticed into action by 1 and 2 will, in turn, imply orders that need to be placed with suppliers. In other words, various suppliers of equipment and raw materials will receive orders from firms responding to factors 1 and 2, indicating further output that can be realized in exchange.

These orders and the production implied will also call for additional employment and so bring about additional wage income.

In general, a government’s decision to place orders with various firms and employ workers has implications for enterprises making investment and production decisions.

Similarly, the private investment decisions of firms, once acted upon through the placement of orders, also introduce a degree of predictability to demand. When orders are placed for investment goods, this indicates a level of output that will in all likelihood be realized in exchange.

Just as with the placement of government orders, the placement of private investment orders has flow-on effects along the relevant supply chains. Firms producing investment goods are induced to place orders with their suppliers, and so on.

The announcement of government expenditure plans and the placement of private investment orders then, of course, imply multiplier effects that will ripple through the economy. Firms producing consumables will adjust output as best they can to this additional demand induced out of income.

In short, few businesses are likely to cut back their own production in the face of visibly rising demand for their own output, no matter how false their beliefs might be concerning the supposed adverse macroeconomic consequences of fiscal deficits and the “national debt”. Any firm foolish enough to do so will probably just lose market share to competitors.

None of this is to deny the presence of uncertainty. It is simply to suggest that, despite this uncertainty, firms that are guided both by recent experience as well as the immediate reality of orders placed by customers and policy statements of governments are likely to respond to fiscal measures in a way that a broadly Keynesian analysis would predict.

The reason for this is essentially that economic actions occur through time. There is a sequence of events in which production decisions are made in succession. At each step in the sequence, decisions are guided by decisions made at an earlier step.


7 thoughts on “The Confidence Fairy and Formation of Demand Expectations Under Uncertainty

  1. Great post, Pete (and thanks for the links).

    There is an observation, though. Consider this:

    The level of public-sector wage payments in 1 provides information for firms supplying consumption goods. This will help to inform production and employment plans in these firms.

    I completely agree that the pubic sector in general, through either 1 or 2, provides firms with information, which they can use to decide on investment levels. It may not be precise, quantitative, information, but it is information, nonetheless. It’s not like Keynes believed that “entrepreneurs” take decisions in the dark, based on what their guts tell them.

    To put an example, perhaps simplistic: when Kevin Rudd announced the pink batts scheme (sorry, the Energy Efficient Homes Package) I doubt anyone thought “this should increase private investment by X%, which considering the multiplier, should increase GDP by Y%, with a probability of Z%”. More likely, those potentially able to take advantage thought something like “geez, maybe I could get a cut from that money”.

    That, in my opinion, is what Keynes and the Keynesian literalists fail to understand due to their obsession with subjectivism and an idealised view of capitalists.


    In fact, I’d bet you are probably thinking along a similar line:

    In general, a government’s decision to place orders with various firms and employ workers has implications for enterprises making investment and production decisions.

    Capitalists understand those ** implications **. And they should be enough to induce investment. That’s what Keynes didn’t like: “entrepreneurs” become predictable.

  2. Thanks, Magpie. Yes, your example of the pink batts scheme is a very nice illustration of what I had in mind.

    Actual placement of orders provides firms with direct information. And, as you say, the likely response of a business that thinks it can get a piece of the action is pretty predictable.

    The guidance provided by policy pronouncements is more likely to be consciously factored in at the level of large corporations who will either pay for economic forecasts and analyses or conduct their own research.

    Banks’ assessment of policy and the economy in general can have implications for credit conditions faced by firms (including small firms).

    Even so, credit creation appears to be largely reactive, induced by levels of activity.

    Also, an increase in realized profit enables higher investment out of retained earnings, even if credit conditions happen to tighten somewhat.

  3. Isn’t this approach a version of what used to be called “Indicative Planning”?
    The 1965 UK National Plan was abandoned largely due to foreign exchange crises under a “fixed” exchange rate. However a new plan might work today work given a floating exchange rate and sufficient political determination.

  4. Hi Kingsley. Interesting thought. There probably are implications for the efficacy of various policy regimes. I wasn’t so much looking at that here. I was just considering likely impacts of fiscal policy within the current institutional framework, taking into account fundamental uncertainty

  5. I’m not following the concern here. Uncertainty is always a consideration for a business. It would seem that, aside from product desirability, consumer income and direct government spending are the overriding drivers of demand and the most significant inputs to a risk equation. What am I missing here? Seems obvious.

  6. Hi Paul. For context, see the links to Magpie’s blog provided in the post. I agree, of course, with your depiction of how government spending is likely to impact on the economy. The point is about ‘fundamental uncertainty’ and how an emphasis on this notion squares with Keynesian policy prescriptions. For instance, here is Skidelsky (biographer of Keynes), quoted in one of Magpie’s posts:

    As a Keynesian, I firmly believe that market economies need to be stabilized by policy. But Keynesians have to face the uncomfortable truth that the success of stabilization policies may depend on the business community having Keynesian expectations. They [i.e. Keynesian economists] need the confidence fairy to be on their side.

    During the Great Recession, some vocal critics of expansionist fiscal policy claimed that it would harm business confidence.

  7. Just one comment, Pete.

    When Skidelsky wrote that he was basing himself on Keynes’ writing! The confidence fairy is just another name for animal spirits.

    Brad DeLong agrees that the confidence fairy is not obviously absurd, also on theoretical grounds.

    Paul Krugman gave the answer to Skidelsky’s position: Keynes wrote many things, not all of them consistent with each other.

    His answer sounds perfectly legitimate to me, but I’m sure it does not sound so legitimate to some post Keynesians. Further, if Keynesians dismiss the confidence fairy, then they need to dismiss animal spirits, too. But animal spirits is their explanation for recessions.

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