Emotions and feelings play a crucial role in economics. Estimates of consumer and business confidence are crucial inputs into any forecasting exercise. The role of expectations has held centre stage in macroeconomics since at least the 1930s. In academic economics, the revolt against Keynes was born out of something called rational expectations, a way of thinking about human behaviour that tore the macroeconomics profession apart. What we do know is that how we feel about the future often defines it.
Economists are often criticised for the way they model behaviour: their assumptions are ridiculed for their lack of realism. Some of these barbs are well deserved.
Robert Shiller, the Yale professor who coined the term "irrational exuberance", forecast the dotcom crash in the early years of the last decade and also called the sub-prime US housing market slump. A small band of like-minded economists has built a new field of study called behavioural finance. Shiller has complained that when he gives seminars on all of this, no other macroeconomists bother to turn up.
We should not underestimate the scale of the challenge involved in trying to incorporate into our models the complexities of how we form beliefs and why we behave as we do. But some progress has been made. Game theory, which has been around for decades, is all about behaviour and has been successfully applied in a wide range of policy-oriented areas. The insights of behavioural finance are seeping into mainstream thinking. Nobel prizes have been awarded to scholars in the field.
Beliefs and their associated behaviours affect the economy and help determine the growth outlook. Think about the situation regarding the Irish consumer. Given high unemployment, ever higher taxes, negative equity and all of the other headwinds that are so familiar, it is easy to explain why consumers have been so cautious – the retail sector has been weak simply because the money isn’t there. Attention is focused on the inability of so many people to service their mortgages; surveys show that many people have very little discretionary income.
All of this is true, but is it the whole truth? The Central Statistics Office has just published data on how much we save. The proportion of our disposable income that we save was 10.2 per cent in 2012. In 2002, it was a shade under 6 per cent. As soon as the financial crisis hit in 2007, our savings rate shot up to just over 16 per cent. Out of total disposable income of €87.1 billion, we save a fair chunk. Why?
Clearly, a lot of this "saving" is just debt being paid off. But have we slipped into irrational pessimism? Fear of the future – or maybe just a reaction to the unrelenting gloom of the daily news flow – may have led some of us to save more than we would normally do. This is where the debate over austerity hits hard: if the Government could somehow credibly convince us that this is the "last bite", I suspect that consumer behaviour would change. We would save just a bit less, spend a little more. "Credibly commit" are not easy words for politicians. Tim Harford has just published a book, The Undercover Economist Strikes Back, How to Run – or Ruin – an Economy, which covers all of this superbly. Interest rate policy is one area where credibility has been firmly established. We have handed over the levers of monetary power to technocrats in Frankfurt.
Once we understood – believed – that inflation would never be allowed to take off again, our behaviour changed in quite dramatic ways. But the design of those credible commitments needs to be done with care: Harford likens the design flaws of the euro zone to the ones contained in the Doomsday Machine in the movie Dr Strangelove: ". . . that is the problem with commitment devices: if something goes wrong and a crisis happens anyway, the commitment device guarantees that it will escalate into Armageddon. Unfortunately we have an important parallel in economics: it's called the euro zone".
Consumers and businesses need a sense of stability, a credible reason to believe that the worst is over, at least domestically. Obsessing over largely irrelevant budget minutiae is damaging.
The bigger picture, which is improving, is all important. Anything that Michael Noonan can do to encourage us to
believe in ourselves would be extremely powerful – and probably do more for
the economy than any trivial budget measure. Confidence, right now,
is all important.