Do Changes in Consumer Confidence Reflect Animal Spirits or Information?

There are two views of changes in consumer confidence, the animal spirits view where causality runs from changes in confidence to changes in economic activity, and the information view where changes in confidence are due to the arrival of new information about future productivity. Suppose, for example, that agents in the economy are able to observe information about future productivity, but the econometrician cannot. In this case, when new information about future output arrives, confidence will change. However, since the econometrician cannot see the information about future output, and instead only sees changes in confidence followed by changes in changes in real activity, if the information view is not considered, then the econometrician will wrongly conclude that animal spirits cause future economic activity. Ultimately, however, which view is correct – the animal spirits view, the information view, or something else entirely – is an empirical question. Here’s an attempt to settle it:

Information, Animal Spirits, and the Meaning of Innovations in Consumer Confidence, by Robert B. Barsky and Eric R. Sims: Abstract Innovations to measures of consumer confidence convey incremental information about economic activity far into the future. Comparing the shapes of impulse responses to confidence innovations in the data with the predictions of a calibrated New Keynesian model, we find little evidence of a strong causal channel from autonomous movements in sentiment to economic outcomes (the “animal spirits” interpretation). Rather, these impulse responses support an alternative hypothesis that the surprise movements in confidence reflect information about future economic prospects (the “information” view). Confidence innovations are best characterized as noisy measures of changes in expected productivity growth over a relatively long horizon.

I. Introduction

In the popular press and much of the business community it continues to be an article of faith that “consumer confidence” has an important role – both prognostic and causal – in macroeconomics. On the other hand, the stance of the rather limited academic literature on confidence is far more ambiguous. The judgments range from the conclusion that confidence measures have an important role both in prediction and understanding the cause of business cycles, to the view that they contain important information but have little role in the assignment of causality, to the verdict that they have no value even in forecasting.

There are, broadly speaking, two contrasting approaches to the role of confidence in macroeconomics.

The first, which we will refer to as the “animal spirits” view, posits autonomous fluctuations in beliefs and consumption that in turn have causal effects on economic activity. In the proceedings of a symposium on the causes of the 1990-1991 recession, both Hall (1993) and Blanchard (1993) regard exogenous movements in consumption as a cause of business cycles.[1] Indeed, Blanchard proposes that the cause of the recession was a powerful, long-lasting negative consumption shock associated with an exogenous shift in pessimism that had a causal effect on consumption and overall aggregate demand. While not fully pursuing the idea in his brief paper, Blanchard proposes that one might be able to test this hypothesis on the basis of the observation that such an exogenous shift in pessimism ought to have only temporary effects on consumption.[2]

The second view of confidence – what we will call the “information view” – suggests that a relationship between innovations in measures of consumer confidence and subsequent macroeconomic activity arises because confidence measures contain fundamental information about the current and future states of the economy. For example, Cochrane (1994b) proposes that consumption surprises proxy for news that consumers receive about future productivity that does not otherwise show up in econometricians’ information sets. His attempt to reconcile VAR evidence with theory closely anticipates the “news approach to business cycles” of Beaudry and Portier (2004, 2006). They analyze models where agents become aware of changes in future productivity orthogonal to current productivity, and argue that stock price innovations proxy for future technological improvement not reflected in current technology. The “information view” of confidence supposes that confidence innovations might contain similar information.

In Section II of the paper, we first show that unexplained innovations in several variables representing survey responses to forward-looking questions from the Michigan Survey of Consumers have powerful predictive implications for the future paths of macroeconomic variables. In particular, within the context of augmented consumption-income VARs, we show that unexplained innovations in the responses to several consumer confidence questions have significant, slowly building, and apparently permanent implications for output and consumption. Confidence is not highly Granger-caused by income or consumption, nor are its innovations highly correlated with innovations in those variables. Responses to little-used survey questions on “news heard” do help to somewhat explain confidence innovations, but with only a very modest incremental R2. These observations point to the conclusion that these measures of consumer confidence are not merely noise, nor are they simply reflections of macroeconomic news reports or innovations in other variables with which they are correlated.

In Section III we attempt to distinguish the hypothesis that these impulse responses indicate a causal channel from sentiment to economic outcomes (the “animal spirits” view) from the alternative interpretation that the surprise confidence movements summarize information about economic prospects known to consumers (the “information” view). To provide a framework for distinguishing these alternative views of confidence, we present a highly stylized New Keynesian model with three kinds of shocks. The first shock is an immediate and unexpected improvement in productivity (a “level shock”). The second is a reflection of genuine news that productivity will grow more rapidly for a substantial period of time into the future (a “growth shock”, also to be referred to as an “information shock” because it conveys information about future productivity that cannot be fully inferred from current productivity).[3] We only permit households to observe a noise-ridden signal of the information shock to technology. We interpret the noise innovation in the signal as an “animal spirits shock” as it is associated with erroneous consumer optimism or pessimism. This shock can be given alternative less structural interpretations, and in equilibrium its implications are similar to those of an exogenous innovation to the Euler equation. Regardless of the particular interpretation, a series of positive animal spirits shocks might capture the putative “irrational exuberance” of the 1920s or 1990s, while a predominance of negative shocks would usher in a period of excessive pessimism.

The model has clear implications for the response of the endogenous variables to each of the three shocks. “Animal spirits” shocks behave as aggregate demand shocks – they are associated with transitory increases in output that attenuate over time, and they produce both inflation and increases in real interest rates. “Information shocks” regarding future productivity and shocks to current productivity are followed by gradual movements in the macroeconomic variables that are not subsequently reversed. Both of these fundamental shocks are also associated with rising real interest rates. Thus, the model yields two primary criteria by which to distinguish animal spirits from fundamental shocks: positive animal spirits shocks are followed by transitory movements in real activity and increases in inflation, while favorable fundamental shocks may result in permanent movements in activity and may be either inflationary or deflationary.

In Section IV, we estimate an expanded VAR with the variables implied by the model augmented with a measure of confidence. As in the three variable systems of Section II, the results show that confidence innovations are associated with little immediate response of real activity but prolonged growth in consumption, income, and measured productivity. There is no evidence of reversion in these variables – in particular, the point estimates suggest that income and consumption are higher by more than two-thirds of a percent in the long future in response to a confidence innovation, with the confidence bands associated with these impulse responses lying above zero at horizons in excess of ten years. Confidence innovations are associated with transitory increases in real interest rates and hours of work, and also lead to a large and persistent reduction in inflation. These empirical responses are not at all similar to the implications of animal spirits shocks in our model, nor are they particularly consistent with the theoretical responses to level shocks.

We next postulate a structural equation in which surprise movements in confidence are attributable to the signal agents receive about the growth rate and to the innovation in the current state of productivity. We estimate a subset of the structural parameters of the model via a modified version of simulated method of moments. We are able to resoundingly reject the hypothesis that animal spirits shocks (as specified in this paper) are an important source of the observed relationships between confidence innovations and macroeconomic variables. On the other hand, we do find convincing evidence in favor of the information interpretation of consumer confidence. The implications of confidence innovations for output and spending at short horizons are far too small for confidence to be primarily a reflection of changes in current fundamentals, yet the longer horizon implications are far too large and significant for confidence innovations to not be conveying information about fundamentals. Our results suggest that there are information shocks about future productivity not wholly reflected in current productivity, and that these shocks account for a significant fraction of the innovation in measured confidence. …


1 In an interesting but almost forgotten early contribution, Hall (1986) – partially repudiating Hall (1978) – argues that an important fraction of the random walk in consumption comes not from the expectational surprise in the Euler equation but from a second disturbance that he has more recently referred to as “spontaneous consumption”. In Hall (1993), this is interpreted as a shock to the taste for consumption relative to leisure.

2 In some ways, a limiting case of animal spirits appears in the “sunspot” literature. Though pinned down only by extrinsic coordinating variables, expectations in the equilibria of these models are self-fulfilling, and thus not irrational (see Farmer (1999)). The existence of sunspot equilibria depend on strong increasing returns, supply externalities, or other mechanisms that are typically not accepted as empirically plausible. The notion of animal spirits in this paper does not encompass sunspots.

3 We employ the term “information” in the same way Cochrane (1994b) and Beaudry and Portier (2006) use the word “news”. Lorenzoni (2008), somewhat confusingly, uses the term “news” to refer to noise in a public signal, which functions much like our animal spirits shock.

Originally published at the Economist’s View and reproduced here with the author’s permission.