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News : International Last Updated: Jul 29, 2009 - 7:34:50 AM


The influence of "Animal Spirits" on Business Climate Surveys; Economists provide Queen with belated answer on credit crunch
By Finfacts Team
Jul 28, 2009 - 4:33:20 AM

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The Blue Drawing Room, Buckingham Palace, London.

In recent years, surveys of the business climate or sentiments are conducted frequently and especially in the current economic situation they are regularly cited in order to forecast the economic development. These surveys often capture great attention of the public but rarely attract the attention of researchers. Therefore little work has been done so far to model and explain resulting data. As one of the first, Thomas Lux of the German Kiel Institute for the World Economy and Professor at Kiel University, hypothesises that trends in survey outcomes might be influenced by social interaction, often called "animal spirits," rather than rational forecasting behaviour. He is able to illustrate strong support for his hypotheses and the influence of social interaction on respondents’ forecasts. In related news, economists have provided a belated answer to Queen Elizabeth why no one saw the credit crunch coming.

The British economist John Maynard Keynes used the term "animal spirits" in his seminal 1936 book, The General Theory of Employment, Interest and Money, as a description of emotion or affect which influences human behavior and can be measured in terms of consumer confidence - - "Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."

Aiming to explain data of surveys such as the Michigan Consumer Sentiment Index or the Business Climate Index published by the Centre for European Research (ZEW), Prof. Lux developed a model on the evolution of business survey data in his paper Rational Forecasts or Social Opinion Dynamics? which will be published in what Kiel terms "the prestigious Journal of Economic Behavior and Organization." He takes into account studies on social interdependences between individuals’ decisions and social spillover effects, and explains the disparities between empirical data revealed by the ZEW and actual economic movements by means of a collective process of opinion formation.

Lux focuses on a comparison between ZEW survey data and the index of industrial production as a measure of real economic activities. He stresses that the survey data reveal more drastic and abrupt swings in opinion, whereas the production index is noisier in its evolution. This implies that respondents seem to have a much clearer picture concerning business cycle dynamics. One might explain the large and pronounced swings through the release of information on macroeconomic data. However, Lux takes another approach and hypothesises that these swings are imprints of a process of social interaction among respondents. Accordingly, an individual’s opinion is influenced by the development of opinions of peer respondents - - due to private exchange or as a response to a changing average mood. In the course of the paper Lux additionally examines external factors influencing opinion dynamics.

As a starting point Lux constructs a model in which survey respondents face a choice between a positive or negative attitude similar to the method of existing surveys in which respondents are asked about their opinion concerning the future state of the economy. The decision to switch from a negative attitude to a positive attitude (or vice versa) is influenced by both, objective macroeconomic data and the social dynamics of group pressure inherent to the peer group. As it turns out, inclusion of macroeconomic variables does not significantly effect the fit of the model, whereas the introduction of the “momentum” effect as a refinement of the collective opinion formation process does. Lux also shows that the empirical business climate survey is hard to distinguish from simulations of the opinion formation model with artificial agents. These results indicate that social interaction plays an important role in explaining the ups and downs of survey data - - as would be expected!

The Queen and Economists

Last November, Queen Elizabeth was given an academic briefing on the origins of the credit crunch and wound up the "lesson" by asking why nobody had seen the crisis coming.

The monarch had the main aspects of the current global financial crisis explained to her during the inauguration of a new building at the London School of Economics (LSE).

The origins and effects of the crisis were explained to her by Professor Luis Garicano, director of research at the LSE's management department, the Press Association reported.

Prof Garicano said afterwards: "The Queen asked me: 'If these things were so large, how come everyone missed them? Why did nobody notice it'?"

When Garicano explained that at "every stage, someone was relying on somebody else and everyone thought they were doing the right thing", she commented: "Awful."

SEE: Finfacts article - - Global Financial Crisis: Warnings of danger from 2001 and a Fed all bark but no bite - with monumental consequences

 

The Observer newspaper reported on Sunday that a group of eminent (what's the criteria for that?) economists has written to the Queen explaining why no one foresaw the timing, extent and severity of the recession.

The three-page missive, which blames "a failure of the collective imagination of many bright people," took many months to finalise.

Signed by LSE professor Tim Besley, a member of the Bank of England monetary policy committee, and "the eminent historian" of government Peter Hennessy, the letter, a copy of which was obtained by the Observer, tells of the "psychology of denial" that gripped the financial and political world in the run-up to the crisis.

The letter explained that as low interest rates made borrowing cheap, the "feelgood factor" masked how out-of-kilter the world economy had become beneath the surface, with some countries, such as the United States, running up enormous debts by borrowing from others, including China and the oil-rich Middle Eastern states, that were sitting on vast piles of cash.

Despite these yawning imbalances, they say, "financial wizards" managed to convince themselves and the world's politicians that they had found clever ways to spread risk throughout financial markets - whereas "it is difficult to recall a greater example of wishful thinking combined with hubris".

"Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well,"they say. "The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction."

That meant when the reckoning came it was extreme, starting in summer 2007 and culminating in the near-collapse of the entire world financial system after the bankruptcy of Lehman Brothers last autumn.

"In summary, Your Majesty," they conclude, "the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole."

The Financial Times in an editorial today comments that"there is nothing like a monarch’s pointed question to make the great and good squirm. Queen Elizabeth stumped her hosts at the London School of Economics by asking why no one had seen the financial crisis coming. Scholars at that and other universities should feel the sting: if they cannot be counted on to spot dangers to the economy, why have economists at all?"

The FT says: "A prime suspect is a theory too optimistic about the rationality of people’s choices and the possibility of capturing them in mathematics.

The truth may be simpler and more depressing: that no economic theory can perform the feats its users have come to expect of it. Economics is unlikely ever to be very good at predicting the future. Too much of what happens in an economy depends on what people expect to happen. Even state-of-the-art forecasts are therefore better guides to the present mood than the future. though they may also be self-fulfilling prophecies."

The FT concludes: "So we do need economists in public debate, but ones not blinded by mathematical sophistication or paradoxes beyond the lay public’s grasp. The public intellectual’s virtues – curiosity about other fields, aversion to dogma – could do the discipline much good. Unfortunately these are no longer much valued in the academic hierarchy. University presidents should perhaps take up Her Majesty’s query."

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