Mood and Macro
By Bryan Caplan
I’m not convinced mood swings are as obvious as they might seem. I’ve
argued that the stock market crash of 1929 was a rational response to
the sudden awareness that we were rushing headlong into Depression. I
wonder if that stock market crash was one of those examples where Bryan
thinks it’s “obvious” there was a mood swing. Even if Bryan doesn’t
believe that, I’d estimate about 99.9% of historians do look at the
crash that way.
I’m not going to argue the Depression with an expert like Scott. But I saw the 2008 crash and subsequent downturn with my own eyes, and I’m convinced that mood played a key role. The world freaked out, big time. It was the economic analog of a riot.
But hasn’t Sumner shown that the fundamental problem was falling nominal GDP? I’m sympathetic, but he never really explains why money velocity suddenly plunged. (Yes, the Fed started paying interest on reserves, but that’s far from the whole story). After the 2008 crash, people clearly became much more reluctant to spend, holding their income constant. Why? Partly because their net worth had fallen, but as people often point out, that didn’t seem to matter after the 1987 crash. What was difference? In 2008, far more people were scared out of their minds, which scared people who hadn’t been scared by the original shock, which scared additional people…
What would a full-blown mood theory of macro fluctuations look like? Ideally it would begin at the micro level – with the individual psychology of traumatic events. What exactly scares people, and how long do they stay scared? Then we’d move to the social psychology of fear – how do we respond to other people’s fear, and how does “social proof” affect individuals’ emotional recovery? Once we’ve got these psychological patterns nailed down, it would be easy to insert them into a standard New Keynesian nominal rigidities model and see what happens.
Empirically grounded mood theories will probably imply that fluctuations are (slowly) self-correcting even in the presence of total nominal rigidity. The large literature on hedonic adaptation finds that even after blood-curdling experiences, normal people don’t remain miserable/ fearful/ angry forever. After six months or a year, people come to terms with what happened. It’s almost like they get bored of feeling afraid.
Of course, this doesn’t mean that a year after the 2008 crash, our average mood will revert to normal. The effects of the initial panic ripple out gradually. People who lost their shirts in 2008 probably feel mostly better by now. People who lost their jobs last month still feel like the world is ending.
None of this means that mood is the whole story. Mood, market conditions, and policy all interact. For example, if nominal wages were perfectly flexible, the anxiety ripple effects of consumer panic would be far more muted. After a fear-driven demand shock, prices and wages would fall, output and employment would stay the same, and life would get back to normal. To take another example: If Sumner ran the Fed, he would have maintained nominal GDP, and fear would have been localized to the construction and mortgage industries.
Is mood just Keynesian “animal spirits” in new clothes? For that, I’ll defer to historians of thought. But the difference between a mood story and textbook Keynesianism is that the mood story would explicitly build on empirical psychology. In textbook Keynesianism, the “animal spirits” can do almost anything. A serious mood theory, in contrast, would be constrained by evidence on e.g. the timing of hedonic adaptation.
One last question: What are the policy implications of macro mood theories? Many economists hastily assume psychological stories boost the case for government intervention, but that’s far from clear. (See e.g. my lecture on “Behavioral Political Economy”). Mood theories amplify the case for preventative flexibility; if wage rigidity fans the flames of panic, that’s yet another reason against labor market regulation. Mood theories allow for the possibility that decisive government action (or mere rhetoric!) could save the day; but they also suggest that decisive government action could start the very stampede it’s supposed to stop. Furthermore, the empirics of hedonic adaptation highlight a self-correcting psychological mechanism that supplements the self-correcting market mechanism.
In any case, we should figure out whether mood theories are true before we start worrying about their policy implications. If I chose macro theories purely for their policy implications, I’d be an Austrian. But I’m not.