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Pessimism as a threat to the economy

Pessimism as a threat to the economy

Citizens and companies fear a darker horizon. When that happens, they spend and invest less and save more. All this ends up weighing down the economy ‘s growth. 

Seven decades after his death we remember John Maynard Keynes – one of the fathers of modern economics-.  In the words of his colleague, Arthur Pigou: 

“the most influential economist of his time”

When things go well, his figure goes to the back room. His name disappears from the stage. But when we fear curves ahead, his surname returns to the stands. When the economy bottoms out, his legacy is used. He is the last resort to get out of the black hole. 

Right now, we are in the second scenario. The snowball of bad economic news threatens to turn into an avalanche. Keynes had a theory on animal spirits. It studied for the first time on how emotions are as important as reason to understand decision making. That psychology makes the economy not behave as what ultra-rational economic models predict.

  • Stagnation
  • Left and right trade conflicts
  • Slowdown in the labor market 
  • Job insecurity
  • Brexit
  • Retreat of globalization. 

Bad news is the new normal in the pages of the newspapers. Nowadays, a regular press reader has breakfast along with a bad unemployment figure. Then he goes to bed after reading disturbing bad news about the German industrial sector. Might the great European giant be immersed in a technical recession… This raises doubts throughout the euro area. To what extent are we really exposed to this cascade of pessimism? Is there a real risk of contagion? What remains of the dreaded theory of self-fulfilling prophecy?

In economics, the bandage always goes before the wound. “We still don’t have it.” Shoots Raymundo Campos, an economist at the Bank of Mexico and author of Economics and Psychology. (Fondo de Cultura Económica, 2019). 

“we don’t possess enough evidence to understand the relationship between bad news and growth. We don’t even know the possible transmission channels ”

But history is there. Philippe Bacchetta (University of Lausanne) and Eric van Wincoop (University of Virginia) worked together. They demonstrated the rapid spread of the brutal 2008 crisis had many dimensions. It was not only related to the globalization of international finance or with the credit restriction. 

“Credit did not decrease, at least not in a perceptible way, beyond the United States. Various members of the global economic ecosystem revised their expectations downward. And their fears met with self-fulfillment. Demand dried up and the anticipated slump became reality,” they wrote. 

Today, the avalanche of bad news darkens the horizon. 

“Of course, the spiral of self-fulfilling prophecy could happen again. Only widespread pessimism has to break out. Luckily, I don’t think it’s happening now: I just see a slowdown. “

A recession arrival depends “on popular narratives.” The Nobel laureate Robert Shiller, elaborated last month in The New York Times:

 “Virtually none of us have a formula for deciding on our plans. Therefore, we are influenced by the emotions and theories suggested. The stories we hear from others.” 

There is a key distinction between bad business news and bad macro news. The first can affect, at most, a specific sector. It does not have a general effect on the future of the economy. The second, (GDP or unemployment) stresses Alex Imas. Professor of behavioral economics at Carnegie Mellon University, 

“if they make people nervous, they have the potential to depress investment. This, consumer confidence.”

There, a problem can come. If citizens fear a darker horizon, they restrict their consumption. Also, they withdraw their investments and increase savings, weighing down growth. The beginning of every good economic flu.

“Negative news does not have much impact. It tends to be seen as a mere exception. When there are more and they come from different independent sources, the problem comes. It creates a feeling of uncertainty and low credibility. That’s when consumers put off purchases and focus on cheaper versions of essential goods.” slides Fred Van Raaij, professor in the Department of Social Psychology at the University of Tilburg (Netherlands). 

Penelope Hernández. Director of the Laboratory for Research in Experimental and Behavioral Economics (Lineex, attached to the University of Valencia) says:

 “We believe that the economy is going to get worse. Then we stop drinking coffee and we put less money in the pension plan. These are small things. But be careful: When we add all the citizens, there is less consumption, savings, and investment. The economy slows down even more.” 

If we give a speeding car a little push, – says the Nobel laureate – then changing course is more difficult.

“For this vicious cycle to start, the economic fundamentals have to be very weak. Much more so than now.”

Most analysts point to a deepening of the slowdown. – Not to the apocalypse. – In the most likely scenario, the global economy will unfold. And it will do it in the short and medium term. The CEO of Bankia, José Sevilla, expressed it. He did the last presentation of the entity’s results: 

“Due to the influence of the media and the situation in general, it seems that the economy has stopped. But the demand for credits continues. There is a disconnect between the prevailing message and reality. We should not have the idea everything is going wrong. Bad information can help to slow down the cycle”. 

Despite the reduction in forecasts, Spanish growth will fall to around 2%. This, according to the latest macro table from Brussels. A figure that many advanced economies would sign. Even some emerging economies, such as Mexico or Brazil would. Data for reflection, but not for alarm. You can see the glass half full or half empty. But not completely empty.

Pessimism as a threat to the economy

The trauma of the Great Recession

We humans have an almost natural tendency to think the worst. We make wounds of a recession remain open. José Luis Ferreira is a professor. He works in the department of Economics at the Carlos III University. 

“There is a curious duality. The general economic sentiment and the individual financial health of those consulted. This is a pattern that repeats itself. The tendency is to always exaggerate negatively. But when the individual situation is measured, it turns out that they are better than they are.”

Part of this overreaction stems from a trauma. The severe blow of the Great Crisis was incredibly hard in the United States. In Europe, it will take time to disappear from the collective subconscious. A decade later, we are still anchored in that same fear. Very few saw the bump coming. Now, no one wants to stumble twice on the same stone. Everyone is waiting for a change in trends. Just give a glance at the bookstore windows: hundreds of books on how to survive the next recession. 

“But a recession cannot be predicted”, completes Ferreira. “If the cycle has been in a boom phase for some time, it doesn’t mean it will end. There is no theory that says they have a certain duration.”

We only have one certainty. In the next crash of the economy, emotions, and not just reasons, will have a lot to say. As Franklin D. Roosevelt (1933-1945), author of the New Deal that lifted America out of the Great Depression, said: 

“The only thing we have to be afraid of is fear itself.”

Seven long decades later, in October 2008, George W. Bush Jr. paraphrased it in his own way: “Anxiety feeds more anxiety.”

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