174. "One 'Crash' Won't Scare Away Investors" The New York Times, (January 3, 1988). Also published as "Negative Wealth Effect: Pop Goes the Psychology" International Herald Tribune, (January 4, 1988).
Recent forecasts by economists about near-term levels of economic activity draw heavily on psychological and sociological presuppositions. Pushed aside are economic theories of business cycles, or the stimulative effects of the declining exchange rate. Instead economists advance two propositions: first, an economic slowdown - possibly a recession - will be caused by a “negative wealth effect.” The second: though there may be a recession, it will be mitigated by a “confidence-building” reduction in the deficit.
Neither thesis is well anchored on theory or fact.
There are reasons to forecast an economic showdown. The recovery is already one of the longest on record, and while economists are never able to explain business cycles, even to their own satisfaction, their regular occurrences are well established. Yet before Oct. 19 most economists were not predicting a near-term slowdown, let alone a recession. What changed?
At issue is not the $1 trillion or so that investors lost on Oct. 19. Nobody dares to suggest that people made detailed purchase plans on the basis of recent run-ups in their paper profits. What is said to have changed is the psychology of investors. Indeed there is evidence that as people grow wealthier they also feel richer and are more willing to spend, take on more debt and dip more deeply into their savings. But since Oct. 19, economists argue, people feel poorer and hence will do the opposite.
But there is no solid evidence to support the economists’ presupposition about the wealth effect. Indeed, data from a number of experiments point in a different direction, suggesting that people are not so much influenced by a single event like the Oct. 19 collapse, but by sequences of events. These events drive feelings more than feelings drive events, the data indicate.
In one experiment, Prof. Vernon L. Smith of the University of Arizona gave economics students a simulated portfolio of stocks as well as money to invest in a computerized exercise. All of the student investors were given the same information and were free to take home their profits after 15 or more sessions of simulated trading. In binges of speculation, Prof. Smith’s investors drove up stock prices far above their fundamental value. When the computerized markets eventually crashed, the investors learned little. It took two, three or more of these simulated crashes to lower bidding close to the stock’s fundamental value.
These and other research findings suggest that if the Dow Jones industrial average remains around 2,000 or gradually creeps up in the coming months, then Oct. 19 is likely to be treated by investors as an aberration rather than as a part of a larger trend or pattern. Although it will not be forgotten by investors, it will also not have any lasting effect on investments or purchasing habits. Under this scenario, the negative wealth effect is likely to be small.
If, however, during the next few months, the stock market drops several hundred points in a day or drops severely over several days before creeping back up, investors will leave the market in droves, institutional investors will cut back on their investments in stocks and individuals will curtail their purchases. Whether or not Oct. 19 is treated as a major negative wealth effect cannot be determined by what happened on that day, but by what happens next.
A recent study at Harvard also shows that the media tend to interpret stock market run-ups by focusing on positive news, and crashes by focusing on negative news, out of a total pool of news that contains both positive and negative items. In simulated trading, this news bias led investors to splurge or tighten their belts more than market trends alone would warrant.
Practically all of the post-crash economic forecasts assume that Congress will trim the deficit and implement the agreement reached late in November. This is judged to be a positive factor, but not for the obvious reason. Many economists are far from sure that the present deficit levels are indeed harmful, and many question whether a major reduction of the deficit now, when the economy is believed tp be slowing down is the proper policy. Moreover, it is easy to see that trimming the deficit by $30 billion, which amounts to a fraction of 1 percent of the gross national product, is unlikely to have major economic consequences. And many other changes in the economy could quickly increase the deficit by $30 billion or more.
So what is the fuss all about? In answering, economists sound ever more like pop sociologists: it is a matter of confidence. If Congress and the President had not reached an agreement in November to cut the deficit, or if Congress will not implement the agreement, then they say the public will lose confidence.
Trimming the deficit is thus viewed as sending a signal - working on people’s psyches, not on their pocketbooks. Some of the confidence building is aimed at Americans who must continue to buy a lot, or to invest, if the economy is not to fall out of bed. Some of it is directed at foreigners who must finance a good part of our remaining deficit if interest rates are to be held down.
The trouble with this line of analysis is that it is very narrow. If the lever of deficit reduction is pulled, confidence will be high; if not, it will collapse. The fact is, public confidence is a complex phenomenon.
Imagine two scenarios: In one, the deficit is cut at once, but other problems arise - say, the arms reduction agreement fails or the President grows morose over the First Lady’s health. Under these conditions, public confidence in the Government will hardly improve.
In the second scenario, assume that the deficit is cut, but by no more than $33 billion, without any further agreement between the Congress and the President, but the next summit talks exceed all expectations the President finds new vigor and actively campaigns for his legacy and successor, and the stock market in Japan soars because of rising confidence in the Tokyo Government. Under these conditions, public confidence may swell.
If predict one must, it now appears that even if the deficit is trimmed as promised, public confidence is not going to rise significantly, because it is affected by many other factors. The fact that we now have a lame duck Administration and that the summit talks have been largely discounted complicates the picture.
In short, if psychology is to be factored in, one must recall that people’s psyches are simultaneously affected by many factors. We should look at trends or patterns and not isolated events. But even these findings should be treated with sizeable grains of salt. Psychology and sociology are still young disciplines. Economists would do well sticking to their own knitting rather than practicing psychology without a license.