Mood and Macro
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.
Feb 8 2010 at 1:15am
Shiller mentions the epidemic disease models that math-bio people have developed. They look like this (in a population of constant size over the time-scale of the epidemic):
S’ = a*R – b*S*I
I’ = b*S*I – c*I
R’ = c*I – a*R
S are Susceptibles, I are Infecteds, and R are Recovereds. Here “fear” is what people can become infected with and recover from.
S’s are turned into I’s when an S and an I smack into each other (motion assumed to be unbiased, not where I’s are tracking down S’s to infect). With probability “b” an infection occurs.
I’s independently recover at rate “c”. R’s independently lose their immunity and become susceptible again at rate “a”.
I’ve got a more realistic models, but that’s the starting point for how anything spreads like an epidemic.
Feb 8 2010 at 2:06am
The housing bubble burst affected everyone’s home value. We expect stocks to fluctuate, but people aren’t prepared to have their house worth $100,000 less in a year. Besides, the burst dried up the potential for home equity loans that were a big boost to spending.
And there was a major real shock to housing construction, which was a not insubstantial part of economic growth recently. In 1987, maybe a few stock traders were let go, but with the housing bubble burst, a whole industry was nearly shut down.
Then there was the novelty of liquidity loss in CDOs. We’ve had stock downturns before, but the sticking up in the market due to an informational problem with many types of complex derivatives had not seem before.
Feb 8 2010 at 7:08am
Sumner’s (and my)view is that fear only has an impact on nominal expenditure to the degree it impacts velocity (which is better described in terms of the demand to hold money.) Any number of things can impact velocity (the demand for money.) Only if the Fed fails to offset the change in velocity (accommodate the change in the demand for money) by changes in the quantity of money, will nominal expenditure be effected.
Whether or not the panic (sales of a variety of assets and purchases of T-bills, and a variety of FDIC insured deposit accounts, including checkable deposits, as well as a shift by banks from earning assets to deposits at the Federal Reserve) was a rational response to the growing realization that the Fed would not expand the quantity of money enough to maintain nominal expenditure, but would stick to its long time policy of smoothing short term interest rates with changes based upon estimates of the output gap and inflation, aimed most fundamentally at making sure that the core CPI would be expected to grow 2 percent from wherever it starts, and that this policy was not robust to a a large decrease in velocity, or else this gives the public too much credit, and they felt that worries about failures of famous Wall Street firms meant really bad things and when the Fed is just pushing on a string, it is hard to say.
Feb 8 2010 at 8:13am
You may be confusing correlation with causation. During the 2008 crash, the stock market behaved rationally – investors were reacting to a sudden worsening of the expected prospects for profits, initially in the banking and financial sector, then in the manufacturing sector of the economy, specifically in direct proportion to, and following, changes in the expected growth rate of the market’s dividends per share.
This change in outlook and the need to react quickly prompted the emotional response you observed among market participants.
Feb 8 2010 at 10:51am
“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.”
And as a result of this panic people began holding a higher percentage of their income as money. This drives down the velocity of money. There is a simple solution to this — simply increase the money supply to offset a decline in the velocity of money in such a way as to maintain a smooth growing GDPn. There are a subset of economists who think this way. These are the economists that I would like to see take over the Fed.
Feb 8 2010 at 10:52am
Don’t forget oil prices. The shocking rise of oil prices from January to July caused more than hearburn–businesses and people had to change behavior quickly, as the economy was stalling and disposable income after fuel and energy was dropping fast.
The bubble in oil burst too late. By September, the markets had moved into crisis mode, further eroding confidence.
In my opinion, the banks and GSEs were bust back in March when Bear fell. We papered it over for a few months hoping that the market and economy would come out of its gradual descent. However, the rise in oil prices just clobbered consumers and producers–it was much too fast for an orderly adjustment. This caused a drop in demand in 3Q which was the last straw. No amount of denial could hide the how bad our banking system was.
In the space of five months the rolling CPI went from 5.4% (July 2008) to 0.0% (Dec 2008) and fell to -2.6% in July 2009. These are rough numbers off the top of my head.
Feb 8 2010 at 12:42pm
You posit a *panic*, Sumner a *sudden widespread increase in the desire for safety/liquidity*. The big difference seems to be that he believes in EMH and you do not.
When you have developed your mood theory, we should put you into the government, as Financial Regulation Czar. You will be able to distinguish between a *panic* and a *rational bout of pessimism*, and take appropriate measures in either case. (But maybe you would prefer to remain a private investor and use your theory to make tons of money.)
Feb 8 2010 at 1:31pm
I think a “mood theory” must be accompanied by an “EMH failure” theory.
If a panic incites a sell-off, there should be profit in buying low and (later) selling high. I don’t think you have to be an efficient markets purist to really buy into this argument. If you’re selling based on mood (and not on long-run fundamental value), then, shouldn’t I be buying?
Couldn’t mood simply be a symptom of or reaction to deeper problems, like a busted bubble, recalculation (Kling), and government mismanagement of NGDP (Sumner)?
Feb 8 2010 at 4:22pm
Elvin has it mostly right. Take a look at the change in refiner’s price of oil from the fall of 2007 until
early 2009. Multiply the monthly changes by monthly oil consumption. You’ll see that just the change in price moved approximately 240 billion out of consumers hands into producers (both domestic and foreign) Those producers didn’t increase their spending by anywhere near that amount. Think about a 12 to 14 month tax hike of $240 billion. Do you think that might move the economy?
No doubt the price hike caused a mood swing, but the mood swing wasn’t the cause of the recession.
Feb 8 2010 at 10:56pm
In talking about american spirits and moodiness: does the “Lift American Spirits” of Sarah Palin on the palm of her hand create a negative mood among Libertarians as much as the prospect of President Palin creates fear among Liberals?
Feb 10 2010 at 9:43pm
I’m not sure hedonic adjustment is the correct measure, it isn’t like people lose their jobs and the economy is better when they are okay with it. The path dependent response to confidence shocks might be a better model, where at some level of bad news pessimism wins and people stop trying. (See the post in my url for a graphical explanation)
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