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

September 4th, 2008

Share |

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.?

Tags: , , , , ,