Friday, April 10, 2009

What affects consumer confidence - animal spirits or market information?

One of the most important lessons learnt from the ongoing financial and economic crisis is that the standard macroeconomic models are inadequate in explaining changes in the business cycle. In the aftermath of the bursting of the sub-prime mortgage bubble, the global financial markets and the economy have been gripped by a psychological gridlock that has resulted in credit getting squeezed out, investors and businesses deferring investment decisions, and consumers postponing their purchases. Traditional approaches to reflate or stimulate the financial markets through conventional and unconventional monetary policies and the economy through fiscal policy alternatives like government spending and tax cuts have had limited traction.

In this context, the studies by behavioural economists focussing on variations in market confidence in determining policy outcomes, assumes significance. However, there has been an intense debate about what determines market confidence - animal spirits (which posits that surprise movements in measured confidence proxy for exogenous changes in sentiment can have causal effects on aggregate demand) or market information (measured confidence reflects aggregated information individuals possess regarding present and future economic fundamentals). In other words, the animal spirits view claims that causality runs from changes in confidence to changes in economic activity, and the information view argues that changes in confidence are due to the arrival of new information about future productivity.

Mark Thoma points to an article by Robert Barsky and Eric Sims that seeks to explore the relationship between consumer confidence on side and animal spirits and information on the other side. They find little evidence that the animal spirits sentiments can account for the bulk of the relationships between consumer confidence and macroeconomic variables, but find enough to support the information view - that the surprise movements in confidence reflect information about future economic prospects.

Apart from the animal spirits driven shocks affecting consumer confidence, the information related fundamentals driven shocks are a current level shock and an anticipated growth rate shock to productivity. They write in favor of the evidence supporting the information interpretation of consumer confidence and that too on expectations over a long time horizon, "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. Putting the two together, it would appear as though confidence innovations are likely conveying information about future fundamentals, and in particular long run productivity."

Mark Thoma though feels that the evidence is not as conclusive, "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."

No comments: