On ‘Rational Inattention’ in Eurozone Crisis and Differences in EU and US Economic Policies

Written by | Monday, March 31st, 2014
Filip Matejka

Exclusive Interview with Professor Filip Matejka (CERGE Economic Institute)

EUBULLETIN has recently talked to Professor Filip Matejka – an expert in macroeconomics, information economics and behavioral economics – about European economic crisis from the point of view of information economics and rational inattention, the role of European households’ expectations about inflation in generating eurozone’s deflation, and also the differences between the EU and US strategies in tackling their own economic crises.

EUBULLETIN: In your research, you focus on macroeconomics, behavioural economics, and information economics – mostly rational inattention. What can you say about the recent European economic crisis from the point of view of information economics and rational inattention?
Prof. Matejka: I think it is safe to say that the following fact has played a significant role. We, e.g., investors, consumers, or policymakers, do not quite follow or understand changes in the complicated world. We like to and need to simplify the complexity surrounding us everywhere, which means that sometimes we do it even when we should not. I’ll put this perhaps too simplistically. The Euro zone was supposed to provide convergence, i.e. simplification of the environment, but perhaps investors believed in the convergence too much, which was then represented by the complete convergence of the bond yields prior to the crisis.
On the other hand, later on it seemed that investors made crude negative generalizations based on geography. For instance, it might otherwise be difficult to explain why Spain and not Belgium should be hit hard by the fiscal crisis. Finally, even the fact that most economists overlooked the troubling fundamentals before the crisis is a big puzzle. But frankly, would you spend your time and study validity of something that must have been looked at and confirmed by many other people? Perhaps this is why we overlooked it. Why institutions, which are supposed to provide such oversight overlook it, that is another question.
EUBULLETIN: What kind of economic phenomena tend to be mostly driven by the fact that individuals are constrained in their ability to process information – which is the fundamental idea behind the theory of rational inattention?
Prof. Matejka: The theory, first formulated by Chris Sims, simply builds on the assumptions that people find it difficult to process all the information and thus they attend to its most important pieces only. Overall, it describes what kind of mistakes (relative to some unconstrained optimizing behaviour) we might be likely to make. This has important implications in situations when perhaps an individual does not have much to gain from processing more information but when no one in the whole society really pays attention, then, in the end, it makes a big difference, such as before the crisis. Or, consider typical elections, how many of us really study platforms that the politicians run on? Few. Putting it cynically, we know we are not likely to change the outcome of the elections, so we might not devote much effort to finding out whom to vote for, to new faces, etc. It is then not surprising that new politicians or parties are not given much chance, and that perhaps most elections are decided by uninformed voters.
EUBULLETIN: Rational inattention in believed to be an important determinant of inflation perceptions. Currently, the eurozone’s rate of inflation is about 0.8 percent, which is far below the ECB’s official target of 2 percent. Do you think that the threat of deflation can materialize?
Prof. Matejka: First, let me point out that the expectations of an average household moved very little in the last few years – most of the time, they are at about two percent, despite the movements in the actual inflation. And as for the threat, anything can happen.  It seems we are in times when both the threat of high as well as low inflation has gone up, and the timing is unclear. Deflation risk is more apparent now, but once the inflation picks up, then those central banks that bought junk government bonds might have real difficulties keeping the inflation down. They will need to increase interest rates, which will make the bonds further devalue, which will make it more difficult for the central banks to sustain the high interest rates paid to commercial banks that would be needed to fight the inflation.
EUBULLETIN: The ECB’s main interest rate is currently at 0.25 points. Some economists believe it should be further lowered in other to get rid of the threat of deflation. Do you think the ECB should further intervene?
Prof. Matejka: Frankly, ECB has lots of very good economists, lots of them know about the data of the current situation much more than I do, so I have no reason not to trust their decision. However, what I think is much more important is to prepare a contingency plan of what to do once things start moving fast in either direction.
EUBULLETIN: You spent a few years in the United States where you obtained your PhD degree from Princeton University. In your opinion, how different is the way Europeans and Americans think of economics and economic policy?
Prof. Matejka: There are several big differences. The striking difference is what people worry about, which is probably just due to different historical experiences. In the US, they worry about high unemployment, which they experienced in the 1930’s; on the other hand, Europeans worry about high inflation much more, which occurred in several European countries in 1920’s. This also affected the institutions we have, while ECB is supposed to manage the price stability only, the FED has a dual goal including the economic activity, too. It will of course be interesting to observe how the new experiences shape the future institutions such as more focus on the real economic activity by the ECB.
EUBULLETIN: It is generally hoped that Europe’s economic crisis is over after the eurozone logged positive growth rates in 2014 for the first time since the end of 2011. The United States, however, started to recover from the crisis much sooner that Europe. What are the main drivers behind this phenomenon?
Prof. Matejka: There are many differences. First, the US acted much faster. What took the US a few days, it took years in Europe, literally. The US was very quick with purchases of the toxic assets, government providing some collateral to the banks and some liquidity to the markets, etc.  Second, the institutions in the US are built very differently. Most importantly, the FED is still part of the American government, with one currency, which makes it almost inconceivable that it would run out of assets. On the other hand, in Europe all governments run their pretty much independent fiscal policies, and the ECB is largely independent, too. While the governments, or the countries’ central banks, would be required to provide the ECB with liquidity if needed, it is not clear at all if they would fulfil it in the end.
And third, and perhaps most importantly, many frictions are simply much larger in Europe. The labour market in most of Europe is much more rigid, minimal wages are higher, protection of each job is higher, mobility of labour force is much lower, etc. Having said all this, the average numbers in Europe are not that bad, and it is not such shame to be behind US economically. What is important now is to prevent or revert large slumps for certain groups of people, e.g. the huge unemployment of young in Spain. If such movements were sustained, then this could result in much bigger problems than just a bit higher unemployment.

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