Both business and consumer confidence are affected by the state of the economy. A recession, or even a slowdown in the economy, will make people worried for their jobs and future incomes and hence cut back on spending and either save more or reduce their debts. Similarly firms are likely to cut back on investment if they are pessimistic about the future. But both consumer demand and investment are components of aggregate demand. A cut in aggregate demand will drive the economy further into recession and cause even greater pessimism. In other words, there is a feedback loop. Recession causes pessimism and hence a fall in aggregate demand, which, in turn, worsens the recession.
A similar process of feedback occurs in times of optimism. If the economy recovers, or is thought to be about to do so, the resulting optimism will cause people and firms to spend more. This rise in aggregate demand will help the process of recovery (see Accelerating the recession and Animal Spirits).
The following article by Robert Shiller, co-author of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, looks at the swing from pessimism to optimism over the past few months.
An Echo Chamber of Boom and Bust: Robert Schiller New York Times (29/8/09)
Efficient Market Hypothesis: True “Villain” of the Financial Crisis? The Market Oracle (26/8/09)
Monthly confidence indicators for the EU can be found at:
Business and Consumer Surveys: Time Series European Commission Directorate-General for Economic and Financial Affairs. (Each of the ‘en’ cells links to a zipped Excel file.)
Questions
- Explain why “confidence has rebounded so quickly in so many places” in recent weeks.
- Is Robert Shiller’s explanation of feedback loops consistent with the accelerator theory?
- In what circumstances do business and consumer psychology result in destabilising speculation and what causes turning points in the process? Why may such turning points be difficult to predict?
- Examine the monthly Economic Sentiment Indicator (ESI) for the UK from the ‘Business and Consumer Surveys: Time Series’ link above. You will need to refer to the final column in the Excel ESI Monthly worksheet (Column GV). Chart the movements in this indicator over the past three years. Also chart the quarterly growth in UK GDP over the same time period. You can find data from Economic and Labour Market Review (ONS), Data tables, Table 1.01, Column YBEZ. Is ESI a leading or a lagging indicator of GDP?
- What implications does Shiller’s analysis have for the management of the economy?
- Why may stock market movements not be a ‘random walk’?