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Sunday, November 22, 2009

"What if a Recovery Is All in Your Head?"

Robert Shiller wonders if the recovery is based upon a self-fulfilling prophecy:

What if a Recovery Is All in Your Head?, by Robert J. Shiller, Commentary, NY Times: 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... 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 ... 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.
Certainly, people did not always believe that there is a regular “business cycle” that starts and stops in a definite pattern. The idea began to spread in the popular consciousness in the 1920s and reached full bloom in the ’30s — with one major complication, the Great Depression... “Recession,” a kinder, gentler term, began to be used around the time of the 1937-38 contraction to refer to a normal downturn in the business cycle. ...
Recessions, as the term came to be used, implied timetables that mark their expected end. Uttering the word does not risk damaging confidence, at least not fundamentally. A diagnosis of a recession can be shrugged off as something from which you will recover... A depression came to be another matter entirely.

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article ... titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase...
In important ways, we are still using that 1930s pattern of thinking. We are instinctively fearful of reckless talk about depressions, and we try to support one another’s confidence. We like the idea that modern scientific economics seems to show that all recessions end in due course.
For now, our common efforts at building confidence appear to be working somewhat. But the economy has still not recovered, by any means. ...
The problem might be put this way: There is still a nagging doubt afloat that the current event is really just another example in that long sequence of recessions. In which mental category does the current contraction belong: recession or depression? We may still be at a tipping point. To the extent that the theory of the self-fulfilling prophecy is correct, there is a case for continued vigilance, to ensure that adverse events don’t encourage widespread talk of the second category.

Barry Ritholtz responds [Note: Updated version posted at Barry's request]:

How Overrated is Sentiment in Economics?, by Barry Ritholtz: There is a small cadre of Economists — original thinkers, contrarians, out of the box theorists — whom  I respect a great deal. It is a modest list ranging from Richard Thaler to David Rosenberg to Robert Shiller, with lots of smart econ wonks in between.

This morning, however, I find myself somewhat disagreeing with one of the smarter of the economists, Professor Bob Shiller... Hence, it is with trepidation that I point out the flaws in Shiller’s discussion about the recovery, (titled “What if a Recovery Is All in Your Head?“). It is a thought provoking but unpersuasive argument... To be fair, he uses the column to incite a debate, rather than defend the position that the recovery is “mostly mental.”

I find numerous things worth challenging in the column... Let me offer 10 items..:

1. Time: The typical post-war Recession lasts 8 months, not “a couple of years”; We are now in month 23. If people started to spend because they sensed it was “late in the recession” or somehow intuited that it was time for the contraction to end, well then, based upon history, 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.

Home Economicus does not really exist — but then again, neither does Homo Idiotus.

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. Is this a Sentiment factor — or a rational response to changing conditions?

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, or bad sentiment?

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. 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 (Witch burning, bloodletting, organized religion, etc.).

Note however that this does not reflect collective negative sentiment, but is actually the result of what happens when a faulty belief system dominates a society.

6. Doom Warnings Began Making Sense: Many of the doomsayers have been warning of the coming apocalypse for years. ... Why did this group suddenly gain traction in 2008? Maybe it was because  the population is not nearly so stupid as the politicians believe. The masses saw with their own two 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, consumers froze, dramatically reduced spending. But the freefall is now over, and while its arguable whether the recession is over (by some measures it is, others not) most of us will agree that the Great Recession ended sometime in Spring of ‘09.

The US consumer is no longer frozen like deer in headlights. Is that sentiment, of just the reality of the situation — what happens when the ice melted?

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.  Perhaps the public has learned (a teeny bit) who to listen to and who to ignore.

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 . . .

I appreciate that Professor Shiller was not arguing in favor of “its all mental.” He sought to spark a debate; I hope this response rose to the challenge . . .

I find that I have a knee-jerk, negative reaction to explanations based upon mass psychology, sentiment, story-telling, and the like. I have to consciously force myself not to dismiss them. I'm not sure why that is, though it probably has something to do with a feeling that such explanations aren't scientific, and hence have no place in serious academic investigations. That is, prior to the crisis I thought that the real economy drove sentiment, and not the other way around. Sentiment could definitely provide a feedback loop that strengthens negative or positive economic shocks, but psychology was not the prime mover. Thus, sentiment changes that did not have evidence to support them would quickly die out before having much, if any effect.

But this crisis has caused me to reevaluate. I still find the Shiller-type animal spirits, psychology based explanations hard to swallow, but when the foundation supporting your beliefs is called into question (in this case modern macroeconomic models), it's important to open your mind and at least give alternative explanations a chance. That's particularly true when the person pushing the stories has a pretty darn good record of using them to warn of bubbles, as Shiller does. So I'm trying.

    Posted by on Sunday, November 22, 2009 at 10:35 AM in Economics, Macroeconomics, Methodology | Permalink  TrackBack (0)  Comments (57)


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