Monday, November 23, 2009

Psychology's Role In Economic Recovery

Robert Shiller proposed an interesting argument in the NY Times in which he suggests that economic recovery can be attributed to the collective psychology of the crowd who expect the recession to end. However this goes against traditional economic thinking that puts little weight into consumer sentiment as a primary mover of the economy. See the following post from Economist's View.

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..:


To read the rest of Barry's response, click here.

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.

This post has been republished from Mark Thoma's blog, Economist's View.

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