Join our community of smart investors

Talking ourselves poorer

Let's start from the fact that stock market fluctuations are correlated with changes in productivity growth. The bull markets of the 1920s, 1980s and 1990s were accompanied by rising productivity growth. And the bear markets of the 1970s and late 00s were associated with falling productivity growth. What's the causality here?

The conventional view is that a pick-up in the rate of technical progress leads both to firms adopting new technology and thus becoming more productive and to greater optimism about the future and hence to rising share prices.

However, Christopher Gunn at Carleton University shows that the causality might run the other way. A pick-up in optimism, or animal spirits, causes share prices to rise and also encourages firms to adopt new technologies. In this way, animal spirits don’t just cause fluctuations in demand, but can cause changes in productivity growth too.

One thing lends credence to this view - that cutting-edge technologies often exist for years before firms adopt them. For example, the internet and good methods of supply chain management were around in the 1980s, but most firms only started to use them in the 90s. One reason for this lag isn't just that firms waited for the technology to improve. It's that they had to become optimistic about future demand (and their ability to use the technology) before investing in the new equipment.

This raises a worrying possibility, that talk of an "end to growth" or of the "great stagnation" might be self-fulfilling. One reason why we're seeing little productivity growth and investment is simply that animal spirits are so depressed that firms aren't adopting new technologies.

But where do changes in animal spirits come from? Kristoffer Nimark has an answer, in what he calls "man bites dog" business cycles. The idea here is that some kinds of news are unusual and add to uncertainty. Such news has a double effect: it causes folk to reduce their spending because of the uncertainty, and it increases economic volatility because after people have become uncertain, they are more sensitive to subsequent developments which either increase their worse fears or diminish them.

To see the point, take company borrowing. Although surveys tell us that banks have recently become more able to lend, firms are still not borrowing. Why not? One reason is that the news in 2007-08 that banks were in trouble was a "man bites dog" story which increased firms' uncertainty about the future availability of credit. Subsequent news has diminished this uncertainty, but not sufficiently to reduce firms' fears that credit lines might be withdrawn in future. We've gone from a belief that credit will be available to one where it might not be. And this is sufficient to reduce borrowing and investment.

Dr Nimark shows how the sensitivity of the economy to productivity shocks (and the changing ability of banks to supply credit can be seen as such a productivity shock) varies a lot, depending upon whether they are accompanied by "man bites dog"-type stories or not.

His theory fits two big facts. One is that economic uncertainty clusters over time. It was low in the 60s and in the "Great Moderation" of the 90s and early 00s, but was high in the 70s and now. Such clustering requires a propagation mechanism whereby uncertainty feeds on itself. Dr Nimark provides one.

Secondly, economic volatility can change without obvious changes in the "fundamentals"; it is hard, for example, to find a full explanation for the "Great Moderation." This missing link might be the absence then of "man bites dog" stories about the economy.

Now, none of this means that talk is the only problem. It's just that it might be exacerbating the real ones we have. And this in turn raises a deeper point about the nature of the economy. Insofar as sentiment does play a role, it means the economy is not simply a piece of machinery in which tweaks to dials have predictable effects. It's much more complex than that - and thus less controllable.