IBelieve Me

On the morning of July 26, 2012, Mario Draghi stood before a room of investors at the Global Investment Conference in London and gave the kind of speech central bankers give: measured, technical, a little dull. The euro was in its third year of crisis. Spain’s ten-year bonds had been yielding above 7 percent, a level at which a country begins to wonder how long it can borrow. Then Draghi said there was another message he wanted to deliver. “Within our mandate,” he said, the European Central Bank was “ready to do whatever it takes to preserve the euro.” And then: “And believe me, it will be enough.”

He had reportedly not cleared the sentence with the bank’s Governing Council. Der Spiegel later reported that some of its members “had heard nothing of such plans until then.” The plans came afterward. In August the bank announced, in principle, a program to buy the short-term bonds of countries under attack, and in September it published the details and a name, Outright Monetary Transactions. No country ever asked to use it, and the bank never bought a bond under it. Yet by December, Spanish and Italian ten-year yields stood roughly a point and a half below their July levels, and an ECB study later attributed a fall of about two percentage points in Italian and Spanish two-year yields to the announcements. A program that never ran had done its work by being described.

Ten months before Draghi spoke, another central bank had made another promise. On September 6, 2011, with investors crowding into the Swiss franc as a refuge from the euro’s troubles, the Swiss National Bank set a floor: the franc would not be allowed to trade stronger than 1.20 to the euro. The bank said it would enforce the floor “with the utmost determination” and was prepared to “buy foreign currency in unlimited quantities.” For more than three years the floor held. On Monday, January 12, 2015, the bank’s vice chairman, Jean-Pierre Danthine, told Swiss television that the floor must remain the cornerstone of the bank’s policy. On Thursday the bank abandoned it. Within minutes the franc had jumped almost 30 percent against the euro. It closed the day about 15 percent higher.

Both banks promised the unlimited, and the pairing is exact rather than lucky. A central bank can create its own currency without end. The Swiss bank never lacked the means to keep printing francs and selling them. Its own explanation, on the day, was that the euro had weakened considerably against the dollar, so that enforcing the floor was “no longer justified.” The means remained; by the bank’s own account, the reason to use them did not. The franc floor was not a promise that exceeded its maker’s power. It was a promise its maker could reconsider, and did. Draghi’s promise held because no one called it. The Swiss bank’s broke because, in the end, the bank called it itself.

On October 12, the Royal Swedish Academy of Sciences awarded this year’s prize in economics to Robert E. Hall of Stanford and Michael Woodford of Columbia “for microeconomic foundations of macroeconomic stabilisation.” John Hassler, who chairs the prize committee, said their work had provided “a stable theoretical foundation” for the models that central banks and governments now use. The tributes this week have told, rightly and well, the story of how those models were built. Their deeper subject is the one Draghi and the Swiss bank enacted from opposite sides: an economy in which tomorrow is already present in today, and in which a central bank’s strongest instrument is not a rate or a balance sheet but a sentence. That sentence works only when it is believed, and it is believed only when breaking it would cost more than keeping it.

IIThe Menu

When Arthur Burns was sworn in as chairman of the Federal Reserve in 1970, Richard Nixon offered a sentence of his own. “I respect his independence,” the president said. He went on to say that he hoped Burns would independently conclude that the president’s views were the ones to follow. Over the next two years, as recordings later published by the economist Burton Abrams show, Nixon pressed Burns for easier money ahead of the 1972 election.

The president had reason to think pressure would pay. Postwar economists had found what looked like a menu. The Phillips curve, named for the economist A. W. Phillips, traced an inverse relationship between inflation and unemployment: accept a little more of one and get a little less of the other. A government that wanted jobs before an election could order them.

Two economists had already warned that the menu was a mirage. In his presidential address to the American Economic Association in December 1967, Milton Friedman argued that any such trade-off was temporary, and Edmund Phelps, working separately, made the same argument in 1967 and 1968. Once people came to expect inflation, they would build it into their wages and prices, and unemployment would drift back to where it had been, now with inflation on top. The 1970s, a decade of rising prices and recurring recessions, were read as their vindication. Phelps, who received the prize in 2006, died in May, five months before this year’s was announced.

In 1976 Robert Lucas gave the warning its general form. The relationships economists measured were the result of choices people made under a particular policy. Change the policy and the choices change, so that “any change in policy will systematically alter the structure of econometric models.” A year earlier, in a paper for the Reserve Bank of Australia, Charles Goodhart had observed that any statistical regularity “will tend to collapse once pressure is placed upon it for control purposes.” The audience had read the script, and a play that depended on its not knowing the ending could not be staged twice.

The profession’s answer was to rebuild macroeconomics on the behavior of individuals, and to assume that the people inside the models understood the economy as well as the economists who built them. The assumption was called rational expectations. It was a convenient fiction, and the two economists honored this week spent their careers finding out what it implied and where it broke.

IIIThe Narrator

On September 20, 2010, a committee of economists at the National Bureau of Economic Research announced that the Great Recession was over. It had ended in June 2009, fifteen months earlier. The same committee had announced the recession’s beginning, in December 2007, on December 1, 2008. In July 2021 it announced that the pandemic recession had ended in April 2020, and that it had been “the shortest US recession on record.”

From 1978 until 2024 the chair of that committee was Robert Hall. For forty-six years the official word on when an American recession began and ended came from a room over which he presided, and it always came late, because the committee waits for the data to settle before it speaks. Hall was the economy’s narrator in the most literal sense the economy allows, and like most narrators he spoke after the events he described.

His most famous paper, published in 1978, the year he took the chair, pointed the other way in time. Hall asked what it would mean for people to plan their spending sensibly over their lives. If they did, they would already be using everything they knew. Anything predictable about next quarter would already show up in this quarter’s spending, so the change from one quarter to the next should be a surprise, unpredictable from anything in the past. He tested the idea against American data. Last quarter’s income, the variable on which the older models leaned, told him nothing about how spending would change. Stock prices had some small predictive power, enough to show that the idea was not the whole truth and too little to rescue the old models.

The finding sounds dry, and its implication is not. If households spend today according to what they expect tomorrow, then tomorrow is already inside today, and the present is a running estimate of the future. A policymaker who can change what people expect about the future can therefore change what they do now. The man who for forty-six years announced the economy’s past had shown that its present is made of its future.

IVAppropriate Circumstances

At a press conference on June 17, 2015, Janet Yellen was asked about the dot plot, the chart the Federal Reserve has published since January 2012 in which each member of its rate-setting committee marks where interest rates should go. Markets read the dots as a schedule. Yellen corrected them. “Now, that’s not a promise,” she said, “it’s conditional on their economic forecasts.” Nine years later Jerome Powell was still making the point: the projections “are not a Committee plan or decision.”

Their caution states this year’s prize backward. Three years before Yellen spoke, at the Kansas City Fed’s symposium in Jackson Hole, Woodford had argued that guidance about future policy, if it is to work, “does need to offer a ‘promise’ and not merely a ‘forecast.’” The laureate said a central bank’s words about the future must be promises and not forecasts. The Fed has spoken in something close to promises when it chose to. In August 2011 it said conditions were likely to warrant exceptionally low rates “at least through mid-2013,” and in December 2012 it tied them to a threshold, holding them low “at least as long as the unemployment rate remains above 6-1/2 percent.” It knows the difference, and it files the dots on the forecast side deliberately. Markets, for their part, have gone on reading the dots as promises four times a year. The space between the laureate’s sentence and the Fed’s is where central banking now lives.

Why a promise is hard to make had been established in 1977 by Finn Kydland and Edward Prescott, in a paper called “Rules Rather than Discretion.” A central bank that can decide afresh in every period will be tempted, once people have acted on its word, to do whatever is best from that moment on, including breaking its word. People know this and discount the word in advance, so a promise is worth only as much as its maker will still gain by keeping it. The Swiss franc floor was that paper enacted. The Swiss bank had the discretion to stop, and in January 2015 it used it. Kydland and Prescott shared the prize in 2004.

A philosopher had described the same act from the other side. In lectures at Harvard in 1955, published in 1962 as How to Do Things with Words, J. L. Austin distinguished sentences that describe the world from sentences that act on it. “I promise” is a sentence of the second kind: to say it, in the right setting, is to do it. Austin was precise about the setting. “The circumstances in which the words are uttered” must be, in his word, “appropriate.” The speaker must have the standing, and the procedure must exist. Draghi’s sentence met both conditions in public. The procedure became Outright Monetary Transactions. The standing was in the first words of his promise: “Within our mandate.” That clause was tested in court. Germany’s Constitutional Court referred the program to the Court of Justice of the European Union, which upheld it in June 2015. It is the rare promise whose speaker’s standing a judge has ruled on.

Woodford’s achievement was to put this logic at the center of a working model. Economists such as Stanley Fischer, John Taylor and Guillermo Calvo had explained, in the late 1970s and early 1980s, why prices and wages adjust slowly. In a 1997 paper with the late Julio Rotemberg, and then in Interest and Prices (2003), Woodford joined those slow-moving prices to Hall’s forward-looking households and to a central bank that sets interest rates by a rule. In that model what matters most is not today’s rate but the expected path of rates to come, which is to say what people believe the bank will do. At Jackson Hole he drew the practical conclusion: the most effective guidance “involves advance commitment to definite criteria.” He was skeptical that large purchases of bonds did much except as a signal of such commitment.

The Fed’s manner changed along with the theory. Alan Greenspan, who died in June at 100, reportedly quipped in 1987, his first year as chairman, “If I seem unduly clear to you, you must have misunderstood what I said.” In February 1994 the Fed for the first time announced a decision the moment it was made, in a statement a Fed research note later described as “a mere 99 words in 4 sentences.” Every statement from March to September 2014 ran past 800 words. The Fed’s balance sheet is counted in trillions of dollars, and its instrument, more and more, in words. Central banking had become a literary practice: the drafting of sentences meant to be believed by readers who are paid to doubt them.

VThe Beauty Contest

In 1936 John Maynard Keynes compared professional investing to a newspaper competition in which readers choose the prettiest faces from a page of photographs and win if their choices match those of the other readers. The winning entrant does not pick the faces he finds prettiest, or even those he thinks others find prettiest. He devotes himself, Keynes wrote, to anticipating “what average opinion expects the average opinion to be.” Some, he added, go to the fourth and fifth degrees.

This is a theory of belief too, but a different one from Woodford’s. In Woodford’s model everyone holds the true model of the economy and expects what it implies. In Keynes’s contest no one needs the true model, only a model of what others will think. Robert Shiller, in his 2017 presidential address to the American Economic Association and in Narrative Economics (2019), carried the idea further: economic stories spread like contagions, and the popular story, true or not, moves spending, saving and prices. Belief, on this view, is less rational than social.

Draghi’s sentence worked in both registers at once. To a rational investor, a central bank that can create euros without limit and promises to buy a country’s bonds makes betting against those bonds a losing trade, and the promise removes the reason to run. To the crowd in Keynes’s contest, “believe me” was a story, and investors told it to one another until it was what everyone expected everyone else to expect. The Swiss bank lost in both registers at once. Its promise was rational only while the bank’s will held, and the story of the floor ended the moment the bank stopped telling it.

If belief can be social, the stories that move economies are not told only by central banks. Economists tell them too, including stories about themselves.

VITransitory

On November 30, 2021, Jerome Powell told the Senate Banking Committee that the Fed would stop calling inflation transitory. “I think it’s probably a good time to retire that word,” he said. For most of that year the Fed’s most important forecast had been that rising prices would fade on their own. Markets had come to doubt it, and now the Fed withdrew it.

What followed is the episode the laureates’ admirers hold up as their theory’s acid test. Consumer prices rose 9.1 percent in the twelve months to June 2022, the largest increase since 1981. The Fed raised rates quickly. By January 2023 inflation was 6.4 percent, and by June 2023 it was 3.0 percent. Unemployment, which every previous great disinflation, Paul Volcker’s above all, had pushed up, stayed near half-century lows: 3.4 percent in January and again in April 2023. Analysts had begun to speak of an “immaculate disinflation” in the fall of 2022, and by the spring of 2023 Paul Krugman was among those using the phrase for what seemed to be happening. Noah Smith, in his tribute to the laureates, gives the admirers’ reading: once businesses saw that the Fed would do whatever it took, they stopped raising prices.

Any account that credits belief has to explain how belief survived 2021, a year in which the Fed’s central forecast was wrong and publicly retired. One answer is that credibility is not built by sentences alone. Volcker built the Fed’s the old way, by pushing its benchmark rate to a record 20 percent and accepting a recession that drove unemployment to 10.8 percent at the end of 1982. Promises come cheap when the promiser has recently proved expensive, and for forty years the memory of Volcker may have been doing some of the work now credited to words.

Other accounts need no appeal to credibility at all, and the economists who offer them disagree with each other. Ben Bernanke and Olivier Blanchard concluded in 2023 that most of the surge “was the result of shocks to prices given wages”: energy, food and shortages in particular industries, rather than an overheated labor market. As the shocks faded, inflation faded. Pierpaolo Benigno and Gauti Eggertsson argued the opposite about the cause. The surge, they wrote, “was mostly generated by a labor shortage,” at a time when job openings outnumbered the unemployed and the old trade-off had become unusually steep, so that a modest cooling of the labor market could bring inflation down fast without much rise in joblessness. The two accounts cannot both be the whole story. What they share is that neither requires anyone to have believed anything in particular for inflation to fall.

The theory’s own foundations have been tested as well. Hall’s random walk does not describe everyone: in 1989 John Campbell and Gregory Mankiw estimated that households who simply spend what they earn receive “about fifty percent of income.” In 2012 economists at the Federal Reserve Bank of New York named a “forward guidance puzzle.” Standard models, they found, “grossly overestimate the impact of forward guidance on the macroeconomy.” In those models a promise about interest rates years away moves the economy today far more than seems possible, because the people in the models believe the promise completely and look forward without limit.

The most telling response came from the laureate himself. In the years after Jackson Hole, Woodford began building a listener who believes less. A 2019 paper with Mariana García-Schmidt carried the subtitle “A Paradox of Perfect-Foresight Analysis.” His study of finite planning horizons, published the same year, imagines decision makers who “look ahead only a finite distance into the future,” and it tames the puzzle his own framework had produced. The economist honored for the believing listener spent the 2010s qualifying that listener.

The skeptics’ corner holds an irony of its own. In 2014, in an email quoted by The New York Times, Edward Prescott wrote that the Fed’s bond buying “is as effective in bringing prosperity as rain dancing is in bringing rain.” He is the same Prescott whose 1977 paper with Kydland showed why a central bank’s promises are hard to keep, and so why a theory of credible promises was needed at all.

None of this refutes the laureates. Belief may well have helped in 2022 and 2023, and a Fed that had lost its credibility might have needed a deeper recession to get the same result. The point is narrower and harder. The disinflation can be told as a story about credibility, about fading shocks or about a labor market cooling along a steep curve, and the evidence does not yet choose among them. A theory that says stories move economies cannot exempt the story it tells about its own success. To call 2022 an acid test passed is itself a sentence meant to be believed.

VIIThe Perfect Listener

In the late 1990s, on the mornings of Fed meetings, the CNBC anchor Mark Haines would study footage of Alan Greenspan arriving at work and report on the thickness of his briefcase. A fat briefcase, the theory went, meant the chairman had been working on something, and that meant a change in rates. The “briefcase indicator” was a joke that markets half believed. It is also a fair picture of the listener central banks once had: people reading a man’s luggage because his words were not yet worth reading.

The listener has changed. On September 18, 2013, the Fed surprised markets by announcing that it would not yet slow its purchases of bonds. The statement was released in Washington at 2:00 p.m. According to data from the market-data firm Nanex, reported by CNBC, buying in futures contracts in Chicago began three milliseconds later, faster than a signal could travel from Washington along any real route. The Fed reviewed how it released its statements to the press. In December 2024, Federal Reserve staff reported a test of eleven generative AI models, which were fed sentences from the minutes of the Fed’s policy meetings and asked to label them. In a quarter century the reading of the Fed went from studying a briefcase to parsing a sentence, and from parsing a sentence to trading on it in three milliseconds.

The models honored this week assumed a particular listener: one who holds the economist’s model of the economy, has read every statement the central bank has made, and expects exactly what the model implies. For most of the theory’s life that listener was a convenience, and the forward guidance puzzle was the cost of assuming her. Woodford, late in the theory’s life, gave her a shorter horizon. Software that parses every past statement, and trades on the next one within milliseconds, has no horizon problem of that kind and no need to hear a story twice before acting on it. The listener the theory assumed, and then had to qualify, may be arriving in part as a machine.

What such a listener does to a promise is not settled. It might make the right sentence more powerful than ever, the forward guidance puzzle running in reverse, because its readers act on the words as completely as the people in the models did. Or it might make every promise brittle, because every past promise is on the record, every inconsistency is found at once, and the discretion that Kydland and Prescott warned about is priced before the speaker finishes. The Swiss bank learned in a few minutes on a Thursday in January what a market that has read the whole record does with a promise withdrawn.

If the listener a central bank speaks to has read every promise it has ever made, what is a promise still worth?

Draghi did not tell the room in London that the program would be enough. There was no program yet. He said, “believe me.” The theory honored this week explains why those two words could do the work of a policy, and why a bank’s word is worth what breaking it would cost. It does not yet say who, or what, will be doing the believing.