How Much Do Mood Swings Drive Business Cycles?

Every month, the Conference Board releases its consumer confidence index. Last month, confidence was up. The index is supposed to be a reading of how we feel about the current economic climate, a measurement of what Keynes referred to as our animal spirits. But while these surveys indicate how we’re reacting to the economy, they also influence it, creating a sort of self-reinforcing feedback loop. So, is the economy dictating our mood? Or is our mood dictating the economy?

A new working paper (pdf here) by Paul Beaudry, Deokwoo Nam and Jian Wang attempts to untangle the two by asking whether (and if so, how much?) mood swings drive business cycles:

This paper provides new evidence in support of the idea that bouts of optimism and pessimism drive much of U.S. business cycles. In particular, we begin by using sign-restriction based identification schemes to isolate innovations in optimism or pessimism and we document the extent to which such episodes explain macroeconomic fluctuations. We then examine the link between these identified mood shocks and subsequent developments in fundamentals using alternative identification schemes (i.e., variants of the maximum forecast error variance approach). We find that there is a very close link between the two, suggesting that agents’ feelings of optimism and pessimism are at least partially rational as total factor productivity (TFP) is observed to rise 8-10 quarters after an initial bout of optimism. While this later finding is consistent with some previous findings in the news shock literature, we cannot rule out that such episodes reflect self-fulfilling beliefs. Overall, we argue that mood swings account for over 50% of business cycle fluctuations in hours and output.

By examining changes in stock prices, consumer expenditures and measures of consumer confidence, the authors conclude that fluctuations in the public mood (“Optimism and pessimism shocks”) are the “main driving force of business cycles.” As to the ultimate question of which is driving which, the authors are more equivocal:

These results do not tell us if the mood swings are a reaction of the future growth (as suggested by the news shock literature) or cause the future growth (as suggested by the self-ful lling equilibrium literature), as the methods used in this paper cannot separate these two.

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  1. Quite simply, we at Shirlaws have always recognised that business decisions are not solely based on the facts & figures but on how the business owner is “feeling”. Our Stages model recognises the rollercoaster of emotions that a business owner goes through throughout their business journey and can predict what feelings will inevitably be prevalent in the business as it moves along its path.
    Businesses invest in opportunities when they feel confident – investment drives the economy – confidence drives the economy.

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  2. dave gershner says:

    Hidden due to low comment rating. Click here to see.

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  3. Tim says:

    “The reason, of course, [that the Congressional Budget Office expects revenue to be just 14.8 percent of G.D.P. this year] is that taxes were cut in 2001, 2002, 2003, 2004 and 2006″-

    Well, no, actually, the PRIMARY reason is not the tax rate itself, but that people and companies are making much less and incurring losses on gains which they carry forward.

    As this research confirms, the fact is that mood DOES matter, a LOT, to the investment decisions of those with the capital to spend or invest. If those people aren’t optimistic, for whatever reason (like for instance they think their President harbors confiscatory socialist motives, or just feel he’s an incompetent, feckless leader), you have a huge problem. That is where we find ourselves today. Blaming those with the capital to invest for not investing is like getting mad at somebody for not going on a date with you; it’s your job to sell THEM on why its a good idea, not their obligation to go on the date! Until the Obama gets the fundamental fact that PRIVATE INVESTMENT, not Government, is the primary driver of economic health (and thus really all else) we are going nowhere.

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    • dave gershner says:

      Again I notice you make no sense, you say companies are making less, etc….

      since gw bush left the WH the DJIA is up about 50%, pretty good return, unprecedented in first 3 years of any prez in history

      So are you better off with Obama? at least 50% better if you’re an investor or have 401k

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  4. Fred says:

    How can they claim to have identified moods as the “main driving force of business cycles” when they admittedly can’t even discern cause from effect?

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  5. James says:

    I’ve always been skeptical of those news reports linking market swings to some event or other, and doubly so when the link is to some mass emotion. After all, aren’t there a good many contrarian types like me, who guard our money in times of “irrational exuberance”, but see downbeat periods as good times to buy?

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  6. `moody' says:

    Certainly, this seems to be somewhat the case with the stock market. In my case, it is not a matter of mood, but of the reality of situation. Real work requires extreme c0ncentration and time. Taking a break helps. Blogging (right now) does not. Hence, putting on the breaks is unavoidable. Having a child home from school means, less time and hence more disciplined effort.

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