You Won’t Believe What's Driving the Economy
Do humans act largely rationally, or can stories and rumors throw an entire economy off course? Lately, economists are increasingly recognizing that narratives matter.
In the early 1920s, the U.S. suffered a brutally sharp economic contraction, in which inflation turned rapidly to deflation and stock price-to-earnings ratios dropped to 50-year lows. The economists Milton Friedman and Anna Schwartz, in their book "Monetary History of the United States," blamed an inexperienced Federal Reserve, which had abruptly increased its discount rate by 1 percentage point.
In a recent speech, Yale University economist Robert Shiller offered a different explanation. Rumors were circulating that the Communist revolution in Russia would soon spread to America, and newspapers were warning that the profiteering associated with World War I would soon give way to a decline in prices. It's thus plausible, Shiller argues, that these and other narratives spread economic uncertainty, discouraging consumer spending and business investment.
Shiller makes similar arguments about the Great Depression and the 2008 financial crisis. In the 2000s, stories about people getting rich by flipping houses contributed to a belief that house prices would always go up. The financial industry played a huge role by catalyzing the epidemic of opinion and exploiting it for its own ends. But bankers couldn't have created the bubble without the help of mortgage borrowers who bought into the narrative.
Shiller has long been one of the few economists to take the role of the “animal spirits” that drive mass opinion seriously. What's different in his new work -- on what he calls “narrative economics” -- is the idea that stories move more or less like infectious agents, with some being much more contagious than others, and that an epidemiological approach might help us better understand their movements. The data needed to do so are starting to become available -- for example, from textual analyses of news feeds and social media.
Shiller's work illustrates a more abstract argument recently made by sociologist Jens Beckert of the Max Planck Institute for the Study of Societies. If economists typically assume that rational expectations drive human behavior, Beckert argues that people operate on “fictitious expectations" -- informed guesses about the future founded in part on prevailing narratives and the beliefs of others. People are neither rational nor irrational, but somewhere in between. They learn what they can from the social world around them, even if they're sometimes drawn into error as a result. This idea of “social learning” is commonly studied in biology, yet has been largely neglected in economics.
These are academic takes on ideas that have long been in the ether. Former Wall Street analyst Robert Prechter, for example, has published a number of insightful books –- most recently, "The Socionomic Theory of Finance" -- arguing that moods, including unconscious ones, drive financial markets, rather than vice versa. It's a perspective that turns our common thinking about causality back to front, and takes some getting used to, but it's catching on.
It is perhaps appropriate that the power of stories is gaining greater recognition during the age of Donald Trump, who rose to the presidency thanks in large part to an utter disregard for objective reality. As Shiller acknowledges, Trump is a “master of narrative." Let's hope this one doesn’t prove to be disastrous.
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