Saturday, 13 December 2008

Tim Harford on perceptions and economic behaviour

Interesting article this weekend from Tim Harford in the FT. He says that economic behaviour is not mainly determined by media-influenced perceptions. These perceptions - which contrary to popular belief, are not only controlled by Robert Peston, but occasionally other journalists too - may impact consumer confidence but this doesn't drag the real economy down.

He quotes Neal Gandhi (who I met yesterday at Entrepreneur's World) as saying of Peston “because of his influential position, his predictions come true almost exclusively because he has predicted them”. While I agree with Tim that this is going too far, there is still a big question about what influences economic behaviour.

The economist's contention (and this is at the heart of Tim's book The Logic of Life) is that rational incentives control behaviour more than intangible psychological factors. But Tim does not mention one major factor. Incentives depend on how we believe the world will behave in the future, not the present. And this is not completely predictable without perfect information.

In a fast-changing economic environment the problem is exacerbated. Our information is incomplete and we have to go on assumptions about how we think other people will behave, in turn based on what we think they will think about how others will behave, and...so on*.

This calculation is impossible to carry out accurately and most people, in most situations, do not bother trying. Instead, they use heuristics to substitute for analysis (see this paper by Colin Camerer of Caltech for an interesting review of relevant neuroeconomic research). These heuristics originate partly from a person's character and personality, built over the long term and changing slowly if at all. And they also come from the short-term conversations we are involved in. That includes the influence of the media, as well as the chats we have in the pub and what we hear when talking to customers or colleagues.

So would you buy a house today? If not, why not? Would you be influenced by a media report saying that house prices are falling?

Would you invest in the stockmarket today? Would you be influenced by a media report saying that the stockmarket is going to decline?

And would you spend £300,000 on opening a new retail outlet? Would you be influenced by what an article in the FT says about future consumer consumption? Even if you think the article's predictions are wrong, would you be concerned about what your potential customers, investors or lenders might think when they read it?

So if this is true, why didn't the economy go into a permanent spiral of decline when we last entered a recession? I believe there are basic pro-growth biases which in the long run will counter short-term confidence issues. These include technological progress, the continuing growth of knowledge and the basic desires of humans to make our lives better.

Ultimately, as Tim says, economic decisions do run into hard limits - people will end up having to make certain decisions because the money in their pocket runs out, or because their car breaks down and must be replaced eventually. But these limits are not universal constants. They are influenced by prior economic performance, which has been affected by the very perception issues we are talking about.

The simplest economic impact of negative media coverage is on investment; investment is a function of expected returns, and expected returns are by definition a function of expectations. Perhaps more research is needed on this, but it can't be right to dismiss the impact of the media completely. If nothing else, Tim Harford's media report provoked me to spend a productive economic resource (a chunk of time) writing this article. I hope the positive utility of reading it made a difference to your day.

* Yes, game theory gives us a way to deal with this but please don't tell me that anyone in real life is using that to make their decisions.

3 comments:

Tony Mason said...

But is'nt this the same argument as regards the use of Technical Analysis to make investment decisions - if a significant number of investors decide that the chart shows an increasing price - then they invest - and surprisingly the share goes up! (and vice-versa).

My perception is that commentators are seeing the result and working backwards to a conclusion - I seem to remember (possibly 18 months ago) there were a number of economic commentators who had been predicting a UK house price crash since 2004/5 - who were mocked in the press for getting it wrong for so many years.

The explanation being that we had reached a "new paradigm" the markets had "de-coupled" - we now find the markets were more coupled than before - and the new paradigm was a huge global ponzi scheme.

The economist magazine estimated back in 2006 that the UK house price was 30%+ out of line with historic fundamentals - we now today have a Barclays senior economic advisor stating a drop of this magnitude.

Leigh Caldwell said...

Hi Tony

Thanks for the comment. Good point.

I suppose my argument is this: undoubtedly prices do overshoot the fundamentals - the "bubble" effect. However, the fundamentals themselves are affected by perceptions. If people believe in continuing growth in demand, they will invest more. This in turn will increase the long-run potential of the economy, and therefore the growth prediction becomes in part self-fulfilling.

But you are right to say that the perception doesn't entirely create the growth. Undoubtedly house prices have been higher than they "should" be, share prices in 2000 were higher than they "should" have been and so on.

But in 2002, share prices were much lower than they should have been and this genuinely damaged some types of investment (e.g. in information technology) for a couple of years, with a permanent effect on economic growth.

Sameer Agarwal said...

This whole idea of what prices should have been is so lame. Prices are always what they should be.