Do sentiments make the economy or the economy makes the sentiments?

September 4th, 2008

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Not long ago, we had lunch with one of our friends. Invariable, the conversation turned into the economy. Judging from the quantity of bad news (e.g. sub-prime, credit crisis, inflation, recession threats, oil prices, falling stock prices, etc.) from the media lately, our friend remarked that “I can tell something is wrong with the economy.” Indeed, we believe large segments of the population are thinking the same too. That’s why surveys are reporting falling business and consumer confidence.

Clearly, sentiments are turning for the worse.

In the midst of economic uncertainties, it is very easy to blame the cause of worsening economic conditions on sentiments. Politicians are fond of using this myth (whether deliberately or out of ignorance). For example, Malcolm Turnbull (Australia’s shadow Treasurer) accused Wayne Swan (Australia’s Treasurer) for “talking up” inflation, as if the tongue of Wayne Swan has the power to move economic forces. But is sentiment so powerful that it can move economic mountains? On Tuesday’s ABC 7:30 Report, Malcolm Turnbull stated in an interview that had it not been Wayne Swan’s talk, consumer confidence confidence would not be so low and the RBA would not have to raise interest rates that much.

But do sentiments make the economy or the economy makes the sentiments?

We do not subscribe to the theory that sentiments alone are the root cause of the business cycle. In fact, as we explained in What causes economic booms and busts?, the business cycle has its roots on human decisions and actions. It is not swayed by the cyclical tide of sentiments. But having said that, sentiments can accentuate the effects of the underlying root causes.

This remind us of a story by Marc Faber,

It was autumn, and the Red Indians on the remote reservation asked their new chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn?t tell what the weather was going to be. Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But, being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, ?Is the coming winter going to be cold??

?It looks like this winter is going to be quite cold indeed,? the meteorologist at the weather service responded.

So the chief went back to his people and told them to collect even more wood. A week later, he called the National Weather Service again.

?Is it going to be a very cold winter??

?Yes,? the man at the National Weather Service again replied, ?It?s definitely going to be a very cold winter.?

The chief again went back to his people and ordered them to collect every scrap of wood they could find. Two weeks later, he called the National Weather Service again.

?Are you absolutely sure that the winter is going to be very cold??

?Absolutely,? the man replied.

?It?s going to be one of the coldest winters ever.?

?How can you be so sure?? the chief asked.

The weatherman replied, ?The Red Indians are collecting wood like crazy.?

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  • Dorian

    “Malcolm Turnbull stated in an interview that had it not been Wayne Swan?s talk, consumer confidence confidence would not be so low and the RBA would not have to raise interest rates that much.”

    Am I missing something here? Surely low consumer confidence equals less spending, which equals lower inflation, which is why the RBA just dropped rates, rather than raised them.

  • Dorian

    “Malcolm Turnbull stated in an interview that had it not been Wayne Swan?s talk, consumer confidence confidence would not be so low and the RBA would not have to raise interest rates that much.”

    Am I missing something here? Surely low consumer confidence equals less spending, which equals lower inflation, which is why the RBA just dropped rates, rather than raised them.

  • Hi Dorain!

    Surely low consumer confidence equals less spending, which equals lower inflation

    The root of price inflation is not ’caused’ by sentiments. In the same way, a high thermometer reading does not ’cause’ the weather to be hot. We recommend our guide, What is inflation and deflation? for a better understanding of inflation and deflation.

  • Hi Dorain!

    Surely low consumer confidence equals less spending, which equals lower inflation

    The root of price inflation is not ’caused’ by sentiments. In the same way, a high thermometer reading does not ’cause’ the weather to be hot. We recommend our guide, What is inflation and deflation? for a better understanding of inflation and deflation.

  • Pete

    I don’t think Wayne Swan had that much effect personally. First of all, a lot of people don’t even listen to politicians, and secondly, a lot of people don’t actually care what they say (me for one).

    Politicians get a bad wrap for not saying things straight – but if you were in their position you would realise that you cannot say everything straight because the opposition will rip you apart on semantics.

    Anything a politician says needs to be careful not to tread on the toes of any demographic or ethnic/cultural/religious group that may have enough power to create bad press.

    An example is (probably a bad one) the problems the coalition had on ‘sorry day’. The coalition had no choice but to say sweet nothings and pretend to be sorry, although they screwed that up too and were eaten alive for problems with semantics as they deserved to be for such a silly mistake. My point is that the politicians could not say it as they wanted to say it, or risk bad press against them, which they cannot afford.

    Whether this makes them outright liars is down to a person’s interpretation of their role in society.

    I got completely off-topic sorry. My point was that Wayne got chewed a bit for the semantics of what he said because he probably didn’t think it through well enough. As for the actual impact of what he said, given that most people wouldn’t trust a politician as far as they could throw one, I doubt it had any major impact on its own at all. People tend to judge things more by what their friends tell them, what they talk about social groups, what they can see. If people see houses for sale at 400K (when they are just overpriced) they will tend to think that the ‘value’ of houses has risen and hence they are still a good ‘investment’.
    Because economic forces are slow, i think it is unlikely that anything WS had to say would make any difference as the effects of what he said could not easily be seen in the short-term.

    And after all in Australia and most westernised countries, we are very short-termist, we live on credit and typically dont think more than 20yrs ahead at best, unlike longer term countries where they consider generations ahead.

    Still, I think Malcolm Turnbull is right in calling WS an unexperienced economist, however I also think Malcolm would make some awful decisions and doubt any of the politicians really have a clue when it comes to managing the economy. But, Malcolm, it is always easy to criticise someone for their decisions when you have the gift of hindsight.

  • Pete

    I don’t think Wayne Swan had that much effect personally. First of all, a lot of people don’t even listen to politicians, and secondly, a lot of people don’t actually care what they say (me for one).

    Politicians get a bad wrap for not saying things straight – but if you were in their position you would realise that you cannot say everything straight because the opposition will rip you apart on semantics.

    Anything a politician says needs to be careful not to tread on the toes of any demographic or ethnic/cultural/religious group that may have enough power to create bad press.

    An example is (probably a bad one) the problems the coalition had on ‘sorry day’. The coalition had no choice but to say sweet nothings and pretend to be sorry, although they screwed that up too and were eaten alive for problems with semantics as they deserved to be for such a silly mistake. My point is that the politicians could not say it as they wanted to say it, or risk bad press against them, which they cannot afford.

    Whether this makes them outright liars is down to a person’s interpretation of their role in society.

    I got completely off-topic sorry. My point was that Wayne got chewed a bit for the semantics of what he said because he probably didn’t think it through well enough. As for the actual impact of what he said, given that most people wouldn’t trust a politician as far as they could throw one, I doubt it had any major impact on its own at all. People tend to judge things more by what their friends tell them, what they talk about social groups, what they can see. If people see houses for sale at 400K (when they are just overpriced) they will tend to think that the ‘value’ of houses has risen and hence they are still a good ‘investment’.
    Because economic forces are slow, i think it is unlikely that anything WS had to say would make any difference as the effects of what he said could not easily be seen in the short-term.

    And after all in Australia and most westernised countries, we are very short-termist, we live on credit and typically dont think more than 20yrs ahead at best, unlike longer term countries where they consider generations ahead.

    Still, I think Malcolm Turnbull is right in calling WS an unexperienced economist, however I also think Malcolm would make some awful decisions and doubt any of the politicians really have a clue when it comes to managing the economy. But, Malcolm, it is always easy to criticise someone for their decisions when you have the gift of hindsight.

  • maria

    Pete the politicians only have to worry about not treading on the toes of only one “ethnic” group, and that group is Americans. One American in particular, Rupert Murdoch.

  • maria

    Pete the politicians only have to worry about not treading on the toes of only one “ethnic” group, and that group is Americans. One American in particular, Rupert Murdoch.