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 in his NYT column. For those of you who may be unaware, the Sunday Times Business section (now that Ben Stein is gone) is a veritable Murderers’ Row, a 1927 Yankees of economic thought and insight. It is one high percentage power hitter after another, with very little weakness in the line up. And Shiller is one of the star batters in that powerhouse line up.
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, as we shall soon see. 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’s start with the basic premise:
“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 as an explanation for mass behavior late in a recession, 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 began in December 2007, according to the National Bureau of Economic Research, so it 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.”
Not exactly. Let me offer 10 items that challenge that basic premise:
1. Time: The typical post-war Recession lasts 8 months, not “a couple of years”; We are now in month 23. If people started to spend because they sensed it was “late in the recession” or somehow intuited that it was time for the contraction to end, well then, based upon history, that would have been somewhere around August 2008.
2. Not Totally Irrational: One of my complaints about economics is it over-emphasizes people as rational, unemotional actors. However, when it comes to sentiment, economics seems to make the same mistake in the opposite direction — it assumes that people are foolish, unthinking creatures unable to engage in ANY rational thought whatsoever. All sentiment, no rationality at all.
The reality is quite different: Sometimes, people behave the way they do because they have figured out a problem and are responding to it intelligently.
Home Economicus does not really exist — but then again, neither does Homo Idiotus.
3. Healthy Fear of Job Loss: Employed people began to spend their money more carefully when they saw coworkers getting laid off in increasing numbers. That is a rational act in the face of an increasing possibility of a loss of income. This is unlikely to change in the near future, so long as large public layoffs remain a news item. Is this a Sentiment factor — or a rational response to changing conditions?
4. Asset Deflation: Consumers cut back their spending when they saw their biggest assets (Homes, Stocks) lose a significant value. Again, a rational response to a change in personal financial conditions, or bad sentiment?
5. False Belief System: Earlier this year, the Dow had dropped over 5,000 points in 6 months. One of the collective fallacies our culture operates under is the delusion that the market is some kind of astute forecasting machine. It is not — it represents the collective wisdom of 10 million panicked monkeys. That millions of slightly clever, pants wearing primates can combine their collective ignorance, their intellectual foibles, biases and false beliefs somehow into something resembling intelligence was one of the false beliefs of the era. Unfortunately, this is a condition the monkeys are prone towards (Witch burning, bloodletting, organized religion, etc.).
Note however that this does not reflect collective negative sentiment, but is actually the result of what happens when a faulty belief system dominates a society.
6. Doom Warnings Began Making Sense: Many of the doomsayers have been warning of the coming apocalypse for years. Pick a Cassandra: Jeremy Grantham, James Grant, Steve Roach, Nouriel Roubini, Robert Prechter, David Rosenberg, Mark Faber (as well as your own humble blogger).
Why did this group suddenly gain traction in 2008? Maybe it was because the population is not nearly so stupid as the politicians believe. The masses saw with their own two eyes the decay in the economy. Suddenly, the warnings were not as far fetched as they previously seemed.
7. Reacting to Flat Income: Families have recognized their incomes have remained flat to negative over the past decade, while their expenses have increased. What should be the rational reaction to this realization? (Hint: a new car, a bigger house, a new vacation are not on the list of options).
8. Time to Exit the Bunkers: Ten months ago, people were betting the economic world was coming to an end. The economy was in freefall, consumers froze, dramatically reduced spending. But the freefall is now over, and while its arguable whether the recession is over (by some measures it is, others not) most of us will agree that the Great Recession ended sometime in Spring of ’09.
The US consumer is no longer frozen like deer in headlights. Is that sentiment, of just the reality of the situation — what happens when the ice melted?
9. The Cheerleaders Now Look Like Fools: At the onset of a recession, we often see cheerleaders, OpEd writers, and money losing fund managers make the argument that there is no economic slowdown — that the weakness is only in people’s minds. I call these people the Pervasive Pollyannas of Prosperity. (Think Phil Gramm, Amity Shlaes, Don Luskin). Some are partisans, others are dumb, others still merely incompetent — a few are all three. Yet despite their best efforts of the cheerleaders, the economy still went into freefall. Perhaps the public has learned (a teeny bit) who to listen to and who to ignore.
10. Deleveraging: We know why this recession was so deep and long — the wanton use of leverage by people and financial institutions. The deleveraging that is taking place is a long slow process. It is rational, it is intelligent, and it will be how families will restore their balance sheets — the paradox of thrift be damned . . .
I appreciate that Professor Shiller was not arguing in favor of “its all mental.” He sought to spark a debate; I hope this response rose to the challenge . . .
Pervasive Pollyannas of Prosperity (July 2, 2008)
What if a Recovery Is All in Your Head?
ROBERT J. SHILLER
NYT, November 21, 2009