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.