Monday, 8 November 2010

How are beliefs about growth formed?

Two articles this evening lead me to ask the question: how do we predict GDP growth?

Before reading on, why not ask yourself this question: what do you expect next quarter's GDP growth figures to be? How about the next 12 months? And why? I'd be interested to see some of your answers in the comments to this post - please also say which particular GDP figures you're predicting (personally I'm most familiar with the UK and US figures, but would be interested in comments from the eurozone and other regions too)*.

I'm not going to test you on the accuracy of your forecasts: I'm more interested in the prediction itself, and your reasoning, than whether it turns out to be right.

My prompts for thinking about this are:
  1. a paper Roger Farmer sent me this evening, introducing the concept of a belief function describing what people expect next year's growth and inflation figures to be
  2. David Smith's blog excerpt of his Sunday Times column today, in which he discusses this quarter's UK GDP figures, and the differing unemployment picture between the UK and the US
  3. (Honourable mention also to Scott Sumner's post on British austerity, which is more about the balance between monetary and fiscal policy but is also implicitly about the effect of growth expectations on current growth.)
So here's my question. Are your expectations of next quarter's GDP growth mainly influenced by:
  1. This quarter's GDP growth?
  2. Your personal experience of the economic environment? (Chris Olivola mentioned some research to me the other day: if you ask people whether they believe in global warming, they are more likely to say yes on a hot day than on a cold day. He said this is like asking someone how the economy is doing, and they answer based on how much change they have in their pocket).
  3. What you read in the media, or hear from your friends, about GDP growth?
If you consider that a manager deciding whether to employ more people - or sack their current staff - is going to be partly influenced by their expectations of economic growth, you can see the importance of this question.

My hypothesis: point 3 has the biggest impact. I don't think most people in business know the current GDP figures. And I think our direct experience of economic events is strongly filtered through the lens of our beliefs; which are in turn influenced by the information we receive from outside. If the media, and our friends, think there is still a recession, then we will expect growth to be slow. And this, to some extent, will mean that growth really is slow.

Of course expectations are only one factor that influences GDP - inventories, replacement cycles of durable goods, fiscal policy, wealth and incomes, exports, and exogenous events such as weather or the Olympics are all important too. The balance of these different factors is one of the main research subjects of empirical macroeconomics. But the effect of expectations, especially on investment but also on employment, is strong.

Thus, we want to understand how people form their opinions about future growth. How much of their beliefs do they gain from media messages? How much from social contact? (And how much from direct evidence gathering?) How were those media and social messages formulated? How did those journalists or friends pick up their beliefs in turn? What is the lag time? How fast do beliefs spread, and what are the conditions that influence that velocity?

These are critical research areas for cognitive economics. I don't know of any programme of research across these areas, so maybe I need to start one.

* I'll post my own predictions tomorrow

5 comments:

IT Consultant said...

Interesting article.

Luis Enrique said...

this is not my area at all, but I seem to remember that the (very old) chapter on learning dynamics (by George Evans) in the 1st Handbook of Macroeconomics had a section on experimental research on learning ... I'd be surprised if more hasn't been done in the intervening years, but I'm not in a position to supply references. Could maybe do a citation search on George Evans Learning Dynamics. hope that helps!

Roger Farmer said...

Leigh -- I think you are right that that the most important effect comes from stories, newspapers etc. But those influences are formed on the basis of current observations. The belief function I describe in my paper assumes that beliefs about the growth of nominal GDP are a random walk. In other words, if nominal GDP grew by 2% last year, you guess that it will grow by 2% next year plus or minus a shock that is accounted for by gossip, newspaper stories, etc. That assumption fits the data pretty well.

Min said...

"Are your expectations of next quarter's GDP growth mainly influenced by:

"This quarter's GDP growth?"

I do not know about "mainly", but that is certainly important.

The Golden Rule of the social sciences:

The best predictor of behavior is prior behavior.

"Your personal experience of the economic environment? (Chris Olivola mentioned some research to me the other day: if you ask people whether they believe in global warming, they are more likely to say yes on a hot day than on a cold day. He said this is like asking someone how the economy is doing, and they answer based on how much change they have in their pocket)."

Well, not consciously. ;) But my thinking, as a lay person, is definitely influenced by on the ground, anecdotal evidence.

"What you read in the media, or hear from your friends, about GDP growth?"

Are you kidding? Only to the extent that I think there may be a self-fulfilling prophecy.

----

As for my prediction for the U. S. GDP for the next quarter, beats me. For the next year, though, I think that it will be flat or negative. For one thing, the second shoe is dropping in the mortgage market, as people get thrown out of their houses and investors sue banks. The fraud is hitting the fan. For another thing, we have persistent high unemployment, over 20% by the way unemployment was measured during the Great Depression (from what I hear). Normally unemployment is a "lagging indicator" -- so lagging that you have to ask what it indicates besides itself. But I think that persistent unemployment bodes ill for the future. And, despite public opinion, neither major political party seems willing to do anything about it. (And high unemployment is consistent with the Reps' desire for low wages.) Third, the Reps won big in the elections. They are the party of pro-cyclical policy. (You would think that they never read the Bible. ;)) And both parties believe in "fiscal responsibility", which, IMO, is irresponsible under current circumstances. In addition, I think that austerity in Europe and England will have negative impact on the U. S. So I look for the U. S. economy to tank by the end of 2011.

Anonymous said...

Maybe growth should stop.
http://www.treehugger.com/files/2010/11/no-growth-economy.php