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.