How Overrated is Sentiment in Economics?

There is a small cadre of Economists — original thinkers, contrarians, out of the box theorists — I respect a great deal. It is a modest list ranging from Richard Thaler to David Rosenberg to Robert Shiller, with lots of econ wonks in between. 

This morning, however, I find myself somewhat disagreeing with the main premise of Professor Shiller’s NYT column. For those of you who are unaware, the Sunday Times Business section (now that Ben Stein is gone) is a veritable Murderers’ Row, the 1927 Yankees of economic thought and insight. Its one high percentage power hitter after another, with very little weakness in the line up. Shiller is one of the star batters.

It is with some trepidation that I point out what I find to be flaws in Shiller’s discussion about the recovery, titled “What if a Recovery Is All in Your Head?.” Its a thought provoking but unpersuasive argument, as we shall soon see. To be fair, he uses the column to provoke a debate, rather than defend the position that the recovery is “all mental.”

I found numerous things worth challenging in the column. Let’s start with the basic premise:

“Beyond fiscal stimulus and government bailouts, the economic recovery that appears under way may be based on little more than self-fulfilling prophecy.

Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession began in December 2007, according to the National Bureau of Economic Research, so it is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.”

Here are 10 items that challenge the column’s main premise:

1. Time: The typical Recession lasts 8 months; We are now in month 23. If people started to spend because they sensed it was “Late in the recession” or that it was time for the contraction to end, well then, that would have been somewhere around August 2008.

2. Not Totally Irrational: One of my complaints about economics is it over-emphasizes people as rational, unemotional actors. However, when it comes to sentiment, economics seems to make the same mistake in the opposite direction — it assumes that people are foolish, unthinking creatures unable to engage in ANY rational thought whatsoever. All sentiment, no rationality at all.

The reality is quite different: Sometimes, people behave the way they do because they have figured out a problem and are responding to it intelligently.

3. Healthy Fear of Job Loss:Employed people began to spend their money more carefully when they saw coworkers getting laid off in increasing numbers. That is a rational act in the face of an increasing possibility of a loss of income. This is unlikely to change in the near future, so long as large public layoffs remain a news item.

4. Asset Deflation: Consumers cut back their spending when they saw their biggest assets (Homes, Stocks) lose a significant value. Again, a rational response to a change in personal financial conditions.

5. False Belief System: Earlier this year, the Dow had dropped over 5,000 points in 6 months. One of the collective fallacies our culture operates under is the delusion that the market is some kind of astute forecasting machine. It is not — it represents the collective wisdom of 10 million panicked monkeys. This is not a sentiment error, but is actually a faulty belief system. That millions of slightly clever, pants wearing primates can combine their collective ignorance, their intellectual foibles, biases and false beliefs somehow into something resembling intelligence was one of the false beliefs of the era. Unfortunately, this is a condition the monkeys are prone towards.

6. Doom Warnings Began Making Sense: Many of the doomsayers have been warning of the coming apocalypse for years. Jeremy Grantham, James Grant, Steve Roach, Nouriel Roubini, Robert Prechter, David Rosenberg, Mark Faber (and your own humble blogger). Why did this group suddenly gain traction in 2008? Maybe it was because  the population is not as stupid as the politicians believe, and saw with their own eyes the decay in the economy. Suddenly, the warnings were not as far fetched as they previously seemed.

7. Reacting to Flat Income: Families have recognized their incomes have remained flat to negative over the past decade, while their expenses have increased. What should be the rational reaction to this realization? (Hint: a new car, a bigger house, a new vacation are not on the list of options).

8. Time to Exit the Bunkers: Ten months ago, people were betting the economic world was coming to an end. The economy was in freefall, and people had dramatically reduced spending. The freefall is now over, and while its arguable whether the recession is over (by some measures it is, others not) we can all agree the Great Recession ended in the Spring og ‘09. The US consumer is no longer frozen like deer in headlights.

9. The Cheerleaders Now Look Like Fools: At the onset of a recession, we often see cheerleaders, OpEd writers, and money losing fund managers make the argument that there is no economic slowdown — that the weakness is only in people’s minds. I call these people the Pervasive Pollyannas of Prosperity. (Think Phil Gramm, Amity Shlaes, Don Luskin). Some are partisans, others are dumb, others still merely incompetent — a few are all three. yet despite their best efforts of the cheerleaders, the economy still went into freefall.

10. Deleveraging: We know why this recession was so deep and long — the wanton use of leverage by people and financial institutions. The deleveraging that is taking place is a long slow process. It is rational, it is intelligent, and it will be how families will restore their balance sheets — the paradox of thrift be damned . . .

Source: What if a Recovery Is All in Your Head? ROBERT J. SHILLER NYT, November 21, 2009

Originally published at The Big Picture and reproduced here with the author’s permission.
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