The role of "confidence" in the truth content of expectations in Keynes's theory

There is a second crucial aspect or dimension of the formation of expectations in chapter 12 that has virtually vanished from Modern Keynesian theory. As mentioned in the previous chapter, because Keynes's agents are aware that they do not know the future, it is difficult for them to have complete psychological confidence that their expectations will turn out to be correct.

The state of long term expectation, upon which our decisions are based, does not solely depend on the most probable forecast we can make. It also depends on the confidence with which we make this fore­cast - on how likely we rate the likelihood of our best forecast turning out quite wrong. If we expect large changes but are very uncertain as to what precise form these changes will take, then our confidence will be weak. The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to dis­cuss it in general terms. In particular it has not been made clear that its relevance to economics comes in through its important influence on the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal effi­ciency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the investment demand schedule.

(CW 7, p. 148-149, emphasis added)

Social and behavioral conventions calm our nerves and "save our faces" as rational economic agents because they create confidence that expectations thus formed have a degree of meaningfulness or validity or truth content sufficient to sustain an investment decision of great moment for the agent. An optimistic forecast of the mec will not induce a firm to undertake a risky long-term investment if the firm has little confidence that their forecast is the truth about the future.

The creation of confidence in the meaningfulness of forecasts or in the "scientific" character of the "conventional wisdom" is absolutely essential to both the growth potential and the conditional stability of the Keynesian model.³ A key reason why agents can sensibly attribute a quasi-objective or quasi-scientific character to conventionally formed expectations is that conventions are socially constituted and socially and externally sanctioned. They are not mere idiosyncratic figments of the isolated individual's imagination. This assumption is reflected in Keynes's assertion, just cited: "Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed" (Keynes 1937, p. 214).

Consider the following example of this assumption. When the col­lective wisdom of "Wall Street" (as reflected in the views of the business and financial press, investor newsletters, television's market analysts, and so forth) is near unanimous in predicting that a buoyant stock market will continue into the foreseeable future, it is not unreasonable for an indi­vidual investor to conclude that this expectation has a solid foundation. After all, the institutions and individuals who constitute "Wall Street" are professionals and insiders, knowledgeable students of the market whose expertise in these matters is richly rewarded by society.

Conventions that inform confidence formation prevent agents from being perpetually confused and perhaps even psychologically immobilized by their comprehension of the extreme precariousness of their economic status. In the end, it is the propensity of agents to believe in the solidity and validity of the conventional forecast and not just "animal spirits" - some innate or genetically transmitted "spontaneous urge to action rather than inaction" - that defeats the forces of ignorance and prevents perpetual stagnation or perpetual chaos in a Keynesian world (CW 7, p. 161). But, as Keynes warned, it "is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points" (CW 7, p. 153). In what Keynes referred to as "abnormal" times, when forecasts of stock market or real-sector booms turn out to be disastrously wrong, confidence in expectations can quickly evap­orate, causing security prices and capital investment to plummet. "The practice of calmness and immobility, of certainty and security, suddenly breaks down" (Keynes 1937, p. 215).

For our purposes in this chapter, we will rely on the simple assumptions that the degree of confidence agents have in their expectations is a positive function of the accuracy of their forecasts in the recent past in normal times, and that confidence can collapse or evaporate in Keynes's "abnormal" times of panic and crisis.