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Is this a pleb I see before me? Reality and perception in the markets

Andrew Mitchell, the government’s chief whip, remains in some difficulty after his exchange with the police at the gates of Downing Street. At the heart of the incident there is an objective reality. Either he used the word pleb, or he didn’t. Either the police were officious jobsworths, or they were the epitome of politeness.

But, in many instances, perception matters much more than reality. It is perhaps unfortunate for Mitchell that he went to Rugby School, the home of the arrogant bully Flashman in the novel Tom Brown’s Schooldays. This fictional setting, and this fictional character, have played an important role in shaping how many regard the incident.

Perception often matters more than reality in economic policy, also. After allowing for one-offs, UK public borrowing was 22 per cent higher in the April-August period than in the same months last year. So the deficit-reducing Osborne is actually presiding over a sharp increase in government borrowing. Yet the markets continue to believe in him, to have faith that he is committed to deficit reduction.

Further, the objective difference between the policies of Osborne and Labour’s Ed Balls is minute. Osborne wants to achieve his target for deficit reduction in six years. Balls has the radical alternative of getting to the same number in seven years.

The margins of error involved in forecasting public spending and receipts, even one year ahead, are also huge. And the potential error in predicting the projected deficit, the difference between these two numbers, is even larger.

Given the size of this margin of error, to all intents and purposes there is no effective difference between the strategies of Balls and Osborne. Yet Balls struggles to gain credibility in financial markets, while Osborne currently has their confidence. Narrative and perception outweigh reality.

This Time is Different, the monumental study of government debt by Carmen Reinhart and Ken Rogoff, former chief economist at the International Monetary Fund, showed that, when public sector debt to GDP ratios rise above the 90 to 100 per cent mark, there is a sharply increased risk of lower growth and default. The data shows clearly that Germany is hovering very close to this critical value. Yet it is perceived as the epitome of financial stability.

A great deal of economic policy in Europe, at the moment, can be seen as an attempt by various players to get their narrative of events to “go viral.” They want to reassure financial markets, almost regardless of objective reality.

This is the future of macroeconomics. With a real basket case, like Greece, the facts are so glaring they will be hard to ignore. But, in general, as with the Mitchell incident, the truth is usually capable of more than one interpretation. Perception trumps reality.

by Paul Ormerod

As published in City AM on Wednesday 26th September 2012

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