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Does consumer confidence raise economic activity?
Dr Frank Shostak
To gain an insight into the future state of an economy, many economists refer to a variety of consumer and business surveys. Randomly selected consumers and businessmen are asked to provide their views about where the economy is heading. Thus if a survey shows that the majority of the surveyed express optimism it is regarded as good news for the economy. Conversely if the majority of the surveyed are pessimistic it is taken as a bad omen for future economic activity.
It is quite possible that a group of people will have in their possession a greater amount of information than any given individual. However, more information does not necessarily mean a more accurate knowledge of the future. In order to ascertain the facts of reality i.e. to separate the wheat from the chaff, the information must be processed by means of a theoretical framework.
Whether a forecast “makes sense” is determined not only by the amount of information available but also whether a theory, or thinking process, is in tune with the facts of reality. As long as the individuals surveyed haven't disclosed the theories behind their views, there is no compelling reason to regard various confidence or sentiment surveys as the basis for an accurate assessment of the future state of an economy.
Facts of reality that are employed in forecasting the future are ascertained from historical data. The past knowledge of individuals which was instrumental in determining their past actions shapes and constrains individual future values and know-how, thereby influencing future actions. If it were otherwise and the past didn’t have any effect on the future a world of chaos would exist, where the accumulation of knowledge would not be undertaken and economic advancement couldn’t take place. For if the future is not related to the past then knowledge today will be regarded as useless tomorrow.
According to Ludwig von Mises the knowledge of the future can only be qualitative, never quantitive. Given the view that expectations are the key driving force of the economy many economists hold that "positive" thinking and large dosages of "good" news can prevent bad expectations developing and hence a fall in economic activity. Individuals are seen as driven by a mysterious psychology susceptible to wild swings.
It is then crucial not to upset this psychology in order to keep the economy prosperous. Whenever economists discuss the state of the economy, they try to portray the bright aspect of it. Even when the economy falls into a recession, various influential economists are very guarded in their speech. On this Rothbard wrote:
After the disaster of 1929, economists and politicians resolved that this must never happen again. The easiest way of succeeding at this resolve was, simply to define “depression” out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937-38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: “recession”. From that point on, we have been through quite a few recessions, but not a single depression . . .
Again, the main reason for this gentle talk is a view that soft language will not upset an individual's confidence. In short, if people’s confidence is kept stable then stable economic activity will follow. However, what matters is not the stability of expectations, but whether these expectations correspond to the facts of reality. What is to be gained if every individual has been brainwashed to believe that things are fine while in reality the economy is falling apart?
Since it is held that stable expectations imply economic stability, economists strongly recommend that government and central bank policies must be transparent. If policies are made known in advance surprises will be avoided and volatility will be reduced. Let us assume the government presents a plan to raise personal taxes. How can the mere fact that this plan is made known to everybody prevent an erosion of individual's living standards?
Even if politicians could succeed in convincing people that the tax increase is good for them, they cannot alter the fact that individuals' after tax incomes will be reduced. Or if the central bank makes it public knowledge that it will raise money supply, how can the simple publication of this information prevent capital consumption and the development of a boom-bust economic cycle?
Stable expectations cannot undo the damage caused by loose monetary policies or by higher taxes. Moreover, irrespective of whether individuals are successful in identifying the facts of reality or not, these facts will assert themselves. Thus, if we have identified that people’s real incomes are declining, then this is a fact of reality.
Regardless of people's views and their confidence it is this fact that will force the decline in consumer outlays. The fall in consumer outlays is not caused by the fall in consumer confidence, as the popular thinking appears to have it, but by the fact that consumers can no longer afford the previous level of outlays.
Consumer expectations do not emerge in a vacuum but are part and parcel of every individual’s evaluation process, which is based on his views regarding the facts of reality. In a free unhampered market economy whenever individuals form expectations that run contrary to the facts of reality this sets in place incentives for a renewed evaluation and different actions. Reality will not permit prolonged mistaken evaluations in a free unhampered market.
We can conclude that in a free, unhampered market economy, individuals’ expectations will have tendencies to be in tandem with the facts of reality. What matters is not whether government and central bank policies are transparent, but whether these policies hurt individuals well-being. The popular view, that by means of opinion surveys one can ascertain the future direction of an economy, is somewhat questionable.
The fact that a large group of people has expressed an opinion regarding future economic conditions does not make it more accurate than the view expressed by any particular individual. What matters here is not how many people have participated in an opinion survey but the framework of thinking they have employed in backing up their views. As long as their framework of thinking is not disclosed we should ensure that we are not too swayed by various opinion surveys.
Notwithstanding their shortcomings surveys are quite useful as far as detailing the present state of consumers’ and businesses’ financial conditions. Businesses reporting about their own activities can shed light on what is going on in the economy. This data, together with information regarding government and central bank policies, can be of assistance in generating intelligent guesses of future economic conditions.
Dr Frank Shostak is a former professor of economics who now works in the private sector.
BrookesNews.Com
Monday 17 October 2005