Irrational impulses

Nobel laureates George Akerlof and Robert Shiller on the non-economic motives that feature insidiously in our financial decisions  

Published 3 years ago on Jun 03, 2017 Read

The newspapers and the pundits tell us when the economy goes into recession that it is necessary to “restore confidence.” This was J. P. Morgan’s intention after the stock market crash of 1902 when he put together a bankers’ pool to invest in the stock market. He employed the strategy in 1907. Franklin Roosevelt analysed the Great Depression in similar terms. “The only thing we have to fear,” he declared in his first inaugural address in 1933, “ is fear itself.” Later in the same speech he added: “We are stricken by no plague of locusts.” Ever since the founding of the US republic, business downturns have been proclaimed as the result of a loss of confidence. 

Economists have a particular interpretation of the meaning of the term confidence. Many phenomena are characterised by two (or possibly more) equilibria. For example, if no one rebuilds his house in New Orleans after Hurricane Katrina, no one else will want to rebuild. Who would want to live in desolation, with no neighbours and no stores? But if many people rebuild in New Orleans, others will also want to. Thus there may be a good – rebuilding – equilibrium, in which case we say that there is confidence. And there may also be a bad – non-rebuilding – equilibrium, with no confidence. In this view there is nothing more to confidence than a prediction, in this case regarding whether or not others build. A confident prediction is one that projects the future to be rosy; an unconfident prediction is one that projects the future as bleak. 

But if we look up confidence in the dictionary, we see that it is more than a prediction. The dictionary says that it means “trust” or “full belief.” The word comes from the Latin fido, meaning “I trust.” The confidence crisis that we are in at the time of this writing is also called a credit crisis. The word credit derives from the Latin credo, meaning “I believe.”

Given these additional shades of meaning, economists; point of view, based on dual equilibria or rosy versus bleak predictions, seems to miss something. Economists have only partly captured what is meant by trust or belief. Their view suggest that confidence is rational: people use the information at hand to make rational predictions; they then make a rational decision based on those rational predictions. Certainly people often do make decisions, confidently, in this way. But there is more to the notion of confidence. The very meaning of trust is that we go beyond the rational. Indeed the truly trusting person often discards or discounts certain information. She may not even process the information that is available to her rationally; even if she has processed it rationally, she still may not act rationally. She acts according to what she trusts to be true.

If this is what we mean by confidence, then we see immediately why, if it varies over time, it should paly a major role in the business cycle. Why? In good times, people trust. They make decisions spontaneously. They know instinctively that they will be successful. They suspend their suspicions. Asset values will be high and perhaps also increasing. As long as people remain trusting, their impulsiveness will not be evident. But then, when the confidence disappears, the tide goes out. The nakedness of their decisions stands revealed.

The very term confidence – implying behaviour that goes beyond a rational approach to decision making – indicates why it plays a major role in macroeconomics. When people are confident they go out and buy; when they are unconfident they withdraw, and they sell. Economic history is full of such cycles of confidence followed by withdrawal…

When people make significant investment decisions, they must depend on confidence. Standard economic theory suggests otherwise. It describes a formal process for making rational decisions: People consider all the options and how advantageous each outcome would be. They consider the probabilities of each of these options. And then they make a decision.

But can we really do that? Do we really have a way to define what those probabilities and outcomes are? Or, on the contrary, are not business decisions – and even many of our own personal decisions about which assets to buy and hold – made much more on the basis of whether or not we have confidence? Do they not involve decision-making processes that are closer to what we do when we flip a pancake or hit a golf ball? Many of the decisions we make – including some of the most important ones in out lives – are made because they “feel right.” John F. “Jack” Welch, the long-time CEO of General Electric and one of the world’s most successful executives, claims that such decisions are made “straight from the gut.”

But at the level of the macroeconomy, in the aggregate, confidence comes and goes. Sometimes it is justified. Sometimes it is not. It is not just a rational prediction. It is the first and most crucial of our animal spirits.