Mood and Macro

Shiller mentions the epidemic disease models that math-bio people have developed. They look like this (in a population of constant size over the time-scale of the epidemic):

S' = a*R - b*S*I
I' = b*S*I - c*I
R' = c*I - a*R

S are Susceptibles, I are Infecteds, and R are Recovereds. Here "fear" is what people can become infected with and recover from.

S's are turned into I's when an S and an I smack into each other (motion assumed to be unbiased, not where I's are tracking down S's to infect). With probability "b" an infection occurs.

I's independently recover at rate "c". R's independently lose their immunity and become susceptible again at rate "a".

I've got a more realistic models, but that's the starting point for how anything spreads like an epidemic.

The housing bubble burst affected everyone's home value. We expect stocks to fluctuate, but people aren't prepared to have their house worth $100,000 less in a year. Besides, the burst dried up the potential for home equity loans that were a big boost to spending.

And there was a major real shock to housing construction, which was a not insubstantial part of economic growth recently. In 1987, maybe a few stock traders were let go, but with the housing bubble burst, a whole industry was nearly shut down.

Then there was the novelty of liquidity loss in CDOs. We've had stock downturns before, but the sticking up in the market due to an informational problem with many types of complex derivatives had not seem before.

Sumner's (and my)view is that fear only has an impact on nominal expenditure to the degree it impacts velocity (which is better described in terms of the demand to hold money.) Any number of things can impact velocity (the demand for money.) Only if the Fed fails to offset the change in velocity (accommodate the change in the demand for money) by changes in the quantity of money, will nominal expenditure be effected.

Whether or not the panic (sales of a variety of assets and purchases of T-bills, and a variety of FDIC insured deposit accounts, including checkable deposits, as well as a shift by banks from earning assets to deposits at the Federal Reserve) was a rational response to the growing realization that the Fed would not expand the quantity of money enough to maintain nominal expenditure, but would stick to its long time policy of smoothing short term interest rates with changes based upon estimates of the output gap and inflation, aimed most fundamentally at making sure that the core CPI would be expected to grow 2 percent from wherever it starts, and that this policy was not robust to a a large decrease in velocity, or else this gives the public too much credit, and they felt that worries about failures of famous Wall Street firms meant really bad things and when the Fed is just pushing on a string, it is hard to say.

Bryan wrote:

But I saw the 2008 crash and subsequent downturn with my own eyes, and I'm convinced that mood played a key role. The world freaked out, big time. It was the economic analog of a riot.

You may be confusing correlation with causation. During the 2008 crash, the stock market behaved rationally - investors were reacting to a sudden worsening of the expected prospects for profits, initially in the banking and financial sector, then in the manufacturing sector of the economy, specifically in direct proportion to, and following, changes in the expected growth rate of the market's dividends per share.

This change in outlook and the need to react quickly prompted the emotional response you observed among market participants.

Bryan wrote:

"But I saw the 2008 crash and subsequent downturn with my own eyes, and I'm convinced that mood played a key role. The world freaked out, big time. It was the economic analog of a riot."

And as a result of this panic people began holding a higher percentage of their income as money. This drives down the velocity of money. There is a simple solution to this -- simply increase the money supply to offset a decline in the velocity of money in such a way as to maintain a smooth growing GDPn. There are a subset of economists who think this way. These are the economists that I would like to see take over the Fed.

Don't forget oil prices. The shocking rise of oil prices from January to July caused more than hearburn--businesses and people had to change behavior quickly, as the economy was stalling and disposable income after fuel and energy was dropping fast.

The bubble in oil burst too late. By September, the markets had moved into crisis mode, further eroding confidence.

In my opinion, the banks and GSEs were bust back in March when Bear fell. We papered it over for a few months hoping that the market and economy would come out of its gradual descent. However, the rise in oil prices just clobbered consumers and producers--it was much too fast for an orderly adjustment. This caused a drop in demand in 3Q which was the last straw. No amount of denial could hide the how bad our banking system was.

In the space of five months the rolling CPI went from 5.4% (July 2008) to 0.0% (Dec 2008) and fell to -2.6% in July 2009. These are rough numbers off the top of my head.

You posit a *panic*, Sumner a *sudden widespread increase in the desire for safety/liquidity*. The big difference seems to be that he believes in EMH and you do not.

When you have developed your mood theory, we should put you into the government, as Financial Regulation Czar. You will be able to distinguish between a *panic* and a *rational bout of pessimism*, and take appropriate measures in either case. (But maybe you would prefer to remain a private investor and use your theory to make tons of money.)

I think a "mood theory" must be accompanied by an "EMH failure" theory.

If a panic incites a sell-off, there should be profit in buying low and (later) selling high. I don't think you have to be an efficient markets purist to really buy into this argument. If you're selling based on mood (and not on long-run fundamental value), then, shouldn't I be buying?

Couldn't mood simply be a symptom of or reaction to deeper problems, like a busted bubble, recalculation (Kling), and government mismanagement of NGDP (Sumner)?

Elvin has it mostly right. Take a look at the change in refiner's price of oil from the fall of 2007 until
early 2009. Multiply the monthly changes by monthly oil consumption. You'll see that just the change in price moved approximately 240 billion out of consumers hands into producers (both domestic and foreign) Those producers didn't increase their spending by anywhere near that amount. Think about a 12 to 14 month tax hike of $240 billion. Do you think that might move the economy?

No doubt the price hike caused a mood swing, but the mood swing wasn't the cause of the recession.

In talking about american spirits and moodiness: does the “Lift American Spirits” of Sarah Palin on the palm of her hand create a negative mood among Libertarians as much as the prospect of President Palin creates fear among Liberals?

I'm not sure hedonic adjustment is the correct measure, it isn't like people lose their jobs and the economy is better when they are okay with it. The path dependent response to confidence shocks might be a better model, where at some level of bad news pessimism wins and people stop trying. (See the post in my url for a graphical explanation)