Models Miss Risk of Falling Confidence: David G. Blanchflower
Consumer confidence is low and dropping around the world. And I am worried.
In a “60 Minutes” interview on June 7, 2009, U.S. Federal Reserve Chairman Ben S. Bernanke said: “Well, I absolutely agree that confidence is key. People don’t know what’s happening. And they’re afraid. And they’re not sure what, you know, whether or not the system is going to recover. So, how do you get confidence, that’s the question. And I think the way to get confidence is to show progress.”
Improvements in what John Maynard Keynes called these animal spirits -- which he defined as “a spontaneous urge to action rather than inaction” -- are vital if we are to see a recovery emerge from what is, hopefully, a once-in-a-lifetime, financial cataclysm.
When the U.S. housing market began to collapse in 2006, animal spirits among businesses and consumers started falling precipitously from July of that year. A broadly similar story happened about six months later in the U.K.
The Monetary Policy Committee at the Bank of England holds its monthly meetings on the first Wednesday and Thursday of each month. On the Friday before, at what is called Pre-MPC, the staff economists brief the committee on the data developments during the previous month. After that meeting, the MPC enters a purdah period, the next of which starts this Friday.
I recall sitting through countless presentations through the early part of 2008 and being told not to draw any inferences from the decline of the various pieces of qualitative data from both consumers and businesses.
The young staff economists, who were mostly freshly minted doctorate holders, were more interested in estimating open- economy dynamic stochastic general equilibrium models (DSGE) than thinking about what was going on in the real world. In any case, we were told these survey responses didn’t correlate well with observed outcomes, so they should be ignored. It turns out they were wrong; they were lead indicators.
The bank’s agents would report monthly to this meeting that their business contacts were telling them things were pretty bad. The scores they produced for sales, output, investment and employment intentions all started falling rapidly from mid-2007. Nobody showed much interest in what I called the economics of walking about. But they had it right.
At the same time, the Baltic Dry Index of shipping costs collapsed to a low of 663 on Dec. 5, 2008, from its peak of 11,793 on May 20, 2008. It rose through 2009, but has dropped more than 50 percent since the middle of May. This mostly reflects declining world steel production and car manufacturing.
Animal spirits followed much the same path as the Baltic Dry, picking up strongly through 2009. Now they have stalled, even going into reverse in the past few months. It turns out this isn’t unique to the U.S., but has also occurred in the U.K. The worry is that they are heading down once again.
The Thomson Reuters/University of Michigan preliminary index of consumer sentiment fell to 66.5 in July from 76 a month earlier, below forecasts. Readings on consumer expectations and current conditions also fell in early July from June. The expectations reading fell to 60.6, the lowest level since March 2009, from 69.8. Meanwhile, the current-conditions reading declined to 75.5, the lowest since November, from 85.6.
This week, the Conference Board’s consumer-confidence index, which had declined in June, retreated even further in July. The index now stands at 50.4, down from 54.3 in June. It is made up of the present situation index, which decreased to 26.1 from 26.8, and the expectations index, which, relating to conditions six months ahead, fell to 66.6 from 72.7 last month.
The three series are plotted in Chart 1 since 2004. Interestingly, from 2004 to 2008 the present situation index was well above the expectations, but with the onset of recession, they switched. Consumers have been expecting the future to be better than the present and hence there have been a series of negative surprises.
A similar situation now exists in the U.K. The Nationwide consumer confidence index, which is plotted in Chart 2, fell in June for the second month running. Of particular note, the expectations index fell from 94 to 88 compared with an increase from 23 to 24 in the present situations index.
It is clear from the chart that the same broad pattern holds in the U.K. as in the U.S. -- the expectations index is well above the current measure since the end of 2008. The gap between expectations and outcomes is even more marked in the U.K. than in the U.S. Expectations appear to have been especially optimistic for the last couple of years in the U.K.
The question is whether this falling consumer confidence, along with a declining Baltic Dry, tells us anything about consumer spending or investment. I suspect it does. At the least it suggests to me that there are marked risks to the recovery.
Consumers in both the U.K. and the U.S. are fearful of high and rising unemployment and falling incomes. Fiscal retrenchment is likely to hurt confidence even more.
The danger is that this will generate a further downward spiral. And watch out for those economists with their worthless Markov-switching DSGE economic models who will probably tell you this decline in expectations doesn’t mean much.
What do they know? In such circumstances, common sense prevails. Confidence is the key. The worry is we aren’t making enough progress.
(David G. Blanchflower, a former member of the Bank of England’s Monetary Policy Committee, is professor of economics at Dartmouth College and the University of Stirling. The opinions expressed are his own.)
To contact the writer of this column: David Blanchflower at email@example.com