Economics is a tough science. People are complicated — they have different (and unstable) desires, react differently to events, and view the world in different ways. Markets are complex interactions between millions of these different people.
In this respect, understanding the economy requires an understanding of people's motivations. They invest and spend money (or withhold from investing and spending money) to fulfill certain desires and objectives, such as making a profit, building a nest egg, or simply acquiring useful goods and services. Sometimes these economic decisions are rational. Other times, instincts like greed (during an economic boom) and fear (during and after a bust) can cloud our rationality.
Markets go through phases of mass optimism and mass pessimism — booms and busts. John Maynard Keynes called the forces underlying these phases animal spirits, the emotional and intuitive factors that drive economic decisions. They are an unavoidable part of economics, since there are questions that can't be answered in an easily quantifiable way. For example, am I investing in a company selling goods and services that people want? Is the market getting stronger or weaker? Are people feeling more confident about the future or less confident? Will interest rates — which set both borrowing costs and the return on your savings — rise or fall in the future? How about inflation?
Economists have gotten vastly better at addressing these questions than when Keynes was writing in the 1930s; for example, there are now business confidence and consumer confidence indices. But many of the actions we take still depend on gut decisions, for consumers and businesspeople alike.
The power of our animal instincts and the weight of our experience can override rational argument. For example, individuals who lived through the 1970s (when price inflation was much higher) tend to expect much higher inflation than those who didn’t. Then there's Germany, a country that remains hawkish because it still hasn't gotten over the hyperinflation that led to the fall of the Weimar Republic.
In an essay at Project Syndicate, 2013 Nobel economics laureate Robert Shiller describes animal spirits as being at the heart of the most recent boom and bust. Shiller sees the power of narrative and storytelling as a significant force:
We seem to be at the mercy of our narratives. Ever since 2009, most of us have just been waiting for some story to turn our hearts aglow with hope and confidence — and to reinvigorate our economies.
Think of the story of the real-estate boom in the United States and other countries in the first half of the 2000s. This was a story not of a "bubble"; rather, the boom was a triumph of capitalist enterprise in a new millennium. [Project Syndicate]
Yet as the bubble burst, and boom turned to bust, a new set of distortionary narratives set in:
With the abrupt end of the boom in 2006, that ego-boosting story also ended. We were not all investing geniuses after all. It was just a bubble, we learned. Our confidence in ourselves, and hence in our futures, took a hit, discouraging economic risk-taking.
Then the financial crisis erupted, scaring the entire world. A story of opportunity and riches turned into one of corrupt mortgage lenders, overleveraged financial institutions, dimwitted experts, and captured regulators. The economy was careening like a rudderless ship, and the sharp operators who had duped us into getting on board — call them the 1 percent — were slipping away in the only lifeboats.
By early 2009, the plunge in stock markets around the world reached its nadir, and fear of a deep depression, according to the University of Michigan Consumer Sentiment Survey, was at its highest level since the second oil crisis in the early 1980s. Stories of the Great Depression of the 1930s were recalled from our dimmest memories — or from our parents’ and grandparents’ memories — and retold. [Project Syndicate]
Often, the narrative of fear is broken by events. If a large number of people believe that the world is going to end on a certain date and it doesn’t, then people’s faith in the narrative will be shaken. Similarly, if consumers and businesses believe that we are doomed to a long, deflationary depression, then an economic recovery will overturn that narrative.
But if enough people believe we are doomed, they can set us on that course through their economic decisions. All they have to do is cease investing and spending, and start sitting on cash and safe assets to ride out the storm. In that scenario, a narrative can become a self-fulfilling prophesy, while strengthening the underlying emotion of fear because the depression came true!
Japan is one country that appears to be caught in this trap. Japanese businesses and consumers have lived through 20 years of economic stagnation and price deflation. If people expect deflation — which causes the value of currency to rise — they tend to sit on cash and wait for its value to grow. By doing this, they reduce the level of demand in the economy, which can launch a self-defeating cycle in which businesses cut prices, resulting in more deflation.
Conversely, if people stop believing that deflation will occur, their perceived incentives to sit on cash are reduced. They may start to spend and invest at higher rates, resulting in a different, more positive kind of self-fulfilling prophesy.
Robert Shiller sees Prime Minister Shinzo Abe's bold recovery program — known as Abenomics — as an intervention to change the fearful narrative of deflation:
Visiting Japan on a speaking tour, I am struck by the positive impact of the economy-related stories on people’s thinking and behavior, and also by how fragile that change is. Since Prime Minister Shinzo Abe assumed office in December 2012 and launched his program of monetary and fiscal stimulus and structural reform, the impact on Japanese confidence has been profound. According to the International Monetary Fund, the output gap — the difference between actual and potential GDP — narrowed from -3.6 percent in 2011 to -0.9 percent in 2013.
Most of the rest of the world lacks a comprehensive, easily understood narrative of positive change similar to Japan’s "Abenomics." The output gap for the world’s major advanced economies, as calculated by the IMF, remains disappointing, at -3.2 percent in 2013, which is less than halfway back to normal from 2009, the worst year of the global financial crisis, when the gap was -5.3 percent. [Project Syndicate]
Will Abenomics succeed at breaking the cycle? The early signs are promising, although clearly Japan has other economic issues that go beyond mere narrative — not least a declining population, and a rigid, inflexible labor market.
Ideally, markets would recover quickly of their own accord. Sometimes that might happen thanks to a technology shock, or other positive shock. But if it doesn’t, then there is little alternative but to try to break the economy out of a negative feedback loop. If Abenomics succeeds in changing the narrative — and shocking Japan's economy into life — then it will serve as a template for the future.