Thursday, October 30, 2014

The Narrative Structure of Global Weakening

NEW HAVEN – Recent indications of a weakening global economy have led many people to wonder how pervasive poor economic performance will be in the coming years. Are we facing a long global slump, or possibly even a depression?

A fundamental problem in forecasting nowadays is that the ultimate causes of the slowdown are really psychological and sociological, and relate to fluctuating confidence and changing “animal spirits,” about which George Akerlof and I have written. We argue that such shifts reflect changing stories, epidemics of new narratives, and associated views of the world, which are difficult to quantify.

In fact, most professional economists do not seem overly glum about the global economy’s prospects. For example, on September 6, the OECD issued an interim assessment on the near-term global outlook, written by Pier Carlo Padoan, that blandly reports “significant risks” on the horizon – the language of uncertainty itself.

The problem is that the statistical models that comprise economists’ toolkit are best applied in normal times, so economists naturally like to describe the situation as normal. If the current slowdown is typical of other slowdowns in recent decades, then we can predict the same kind of recovery.

For example, in a paper presented last spring at the Brookings Institution in Washington, DC, James Stock of Harvard University and Mark Watson of Princeton University unveiled a new “dynamic factor model,” estimated using data from 1959 to 2011. Having thus excluded the Great Depression, they claimed that the recent slowdown in the United States is basically no different from other recent slowdowns, except larger.

Their model reduces the sources of all recessions to just six shocks – “oil, monetary policy, productivity, uncertainty, liquidity/financial risk, and fiscal policy” – and explains most of the post-2007 downturn in terms of just two of these factors: “uncertainty” and “liquidity/financial risk.” But, even if we accept that conclusion, we are left to wonder what caused large shocks to “uncertainty” and to “liquidity/financial risk” in recent years, and how reliably such shocks can be predicted.

When one considers the evidence about external economic shocks over the past year or two, what emerges are stories whose precise significance is unknowable. We only know that most of us have heard them many times.

Foremost among those stories is the European financial crisis, which is talked about everywhere around the globe. The OECD’s interim assessment called it “the most important risk for the global economy.” That may seem unlikely: Why should the European crisis be so important elsewhere?

Part of the reason, of course, is the rise of global trade and financial markets. But connections between countries do not occur solely through the direct impact of market prices. Interacting public psychology is likely to play a role as well.

This brings us to the importance of stories – and very far from the kind of statistical analysis exemplified by Stock and Watson. Psychologists have stressed that there is a narrative basis to human thinking: people remember – and are motivated by – stories, particularly human-interest stories about real people. Popular stories tend to take on moral dimensions, leading people to imagine that bad outcomes reflect some kind of loss of moral resolve.

The European crisis began with a Greek meltdown story, and it appears that the entire global economy is threatened by events in a country of only 11 million people. But the economic importance of stories bears no close relation to their monetary value (which can be measured only after the fact, if at all). It depends, instead, on their story value.

The Greek crisis story began in 2008 with reports of widespread protests and strikes when the government proposed raising the retirement age to address a pension funding shortfall. Reports began to appear in global news media portraying an excessive sense of entitlement, with Greeks taking to the streets in protest, even though the increase was modest (for example, women with children or in hazardous jobs would be able to retire with full benefits at just 55, up from 50).

That story might have invited some gossip outside of Greece, but it gained little purchase on international attention until the end of 2009, when the market for Greek debt started to become increasingly unsettled, with rising interest rates causing further problems for the government. This augmented news reports about Greek profligacy, and thus closed a negative feedback loop by attracting intensifying public interest, which eventually fueled crises in other European countries. Like a YouTube video, the Greek story went viral.

One might object that most people outside of Europe surely were not following the European crisis closely, and the least informed have not even heard of it. But opinion leaders, and friends and relatives of the least informed in each country, were following it, and their influence can create an atmosphere that makes everyone less willing to spend.

The Greek story seems connected in many people’s minds with the stories of the real-estate and stock-market bubbles that preceded the current crisis in 2007. These asset bubbles were inflated by lax lending standards and an excessive willingness to borrow, which seemed similar to the Greek government’s willingness to take on debt to pay lavish pensions. Thus, people saw the Greek crisis not just as a metaphor, but also as a morality tale. The natural consequence was to support government austerity programs, which can only make the situation worse.

The European story is with us now, all over the world, so vivid that, even if the euro crisis appears to be resolved satisfactorily, it will not be forgotten until some new story diverts public attention. Then as now, we will not be able to understand the world economic outlook fully without considering the story on people’s minds.

Read more from our "Dismal Soothsaying" Focal Point.

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  1. CommentedRobert O'Regan

    The implication seem to be that the story is in the neighborhood of a fable - say, 'the IMF is here to help you.'

  2. CommentedGabriel Atega

    I have always wondered why a pipeline problem in Nigeria or a storm in the GOM impact upon the prices of oil worldwide when evidently a pipeline problem can be fixed and a storm will certainly pass away. It may cause damage to communications and infrastructure but these are local and fixable in the very short term.

    How about problem hype spinned by those who want oil prices to go up, or certain economies to have troubles as one of the causes of global economic problems?

  3. Commentedjim bridgeman

    This connects with Richard Roll's explanation for the financial crisis: No house price collapse=No crisis. So why the house price collapse? Answer: people lost confidence in their ability to pay such prices. Why was that? Answer: people lost confidence that their future personal incomes would rise enough to sustain the debt required to pay the house prices. (Technical aside: the formula for the value of a growing perpetuity shows that a small change in the story people tell themselves about the future rise of their personal income leads to a huge change in the current value of that future income.) Why did people lose confidence in the story that their future personal incomes would keep rising? (remember, this is all occurring BEFORE the collapse) Answer: You tell me, but Roll suggests that house prices started to top at about the time (late 2006/early 2007) that it became apparent that Dems would sweep the 2008 U.S. elections. A coming Dem sweep makes the story one that government share of economy will grow. In most of history (at least, so people's intuitive story goes, increasing government share of economy will slow or reverse growth of personal incomes (you could look it up.) So the people's personal story became "maybe not so much growth coming in my personal income", so they got more careful on house price bidding, so prices collapse, so banks teeter and collapse and here we are.

  4. CommentedMarica Frangakis

    The Greek case certainly needs a narrative. Only the one it has been associated with serves more purposes than one. The 'fiscal profligacy' (variants: lazy Greeks, etc) narrative is far too simple to describe the complex specificities of a country, while it leaves out other factors, which were central in the Greek public debt crisis, such as the architecture of the eurozone. Not surprisingly, 5 years on, the crisis remains intractable!

  5. CommentedTimothy Williamson

    Let's see if it's possible to DTREG non-linear analysis to bring together all these elements in a quantifiable manner. Interested?

  6. CommentedTim Colgan

    Robert Shiller - I always enjoy reading your articles and listening to you speak. But as a controls engineer, it always irks me when someone uses the term from my domain - “negative feedback” - inappropriately. The “negative” here refers to the subtraction of feedback from the input reference signal. It is not “negative” as in “bad”, rather “negative” as in “minus” and generally is used to provide stability in the loop. See:

    This is a common error made by those who have adopted the term for use in other fields (similar to inappropriate use of the term “relativity” from physics). Ask an engineer if you doubt my viewpoint. And please use the term correctly in the future (actually, if you had said “positive feedback loop” it would have made sense).

  7. Portrait of Hosein Maleki

    CommentedHosein Maleki

    That's true, I guess the narrative structure may exist in other types of crises as well, like- is there going to be a war or not. Or who is going to be elected. Or alike. I really
    like this idea.

  8. CommentedJonathan Lam

    Gamesmith94134: the Instability of Inequality

    “Any economic model that does not properly address inequality will eventually face a crisis of legitimacy.” Each economic model failed respectively on the macro economical system since the scale of supply and demand has been altered by the regulations or manipulation after the globalization. Macroeconomic and microeconomic had took a cakewalk whenever the competition appears, because each applications have a contradiction as shifts in the scale from the market and state; as just as you descript in, “The increase in private- and public-sector leverage and the related asset and credit bubbles are partly the result of inequality.

    Perhaps, you may have mixed with the atmospherically force on an explosion and implosion of a balloon that micro economical strategies became irrelevance that supply and demand is not react to each other like America. When it met its macroeconomics in the price structures, the emerging market nations created another price structure that made the balloon collapsed under the pressure of competition and its market shrinks by its aggregated demand even after the quantities easing I & II. First, Mediocre income growth for everyone but the rich in the last few decades opened a gap between incomes and spending aspirations. It concurs with a lack of economic dynamism that led to sclerotic growth then and the euro zone’s sovereign-debt crisis now. Secondly, price structure collapsed, and deflationary to adjust became the catalyst to its implosion since America or the Anglo-Saxon countries, the response was to democratize credit that were not fully financed by taxes, fueling public deficits and debt. In both cases, debt levels eventually became unsustainable.

    In the part of China or India, low currency exchange rate and low labor cost may not made the best of the product available in its contest of quality; but the aggregated demand from China, India and US combined make the combustion on price that inflation is changing the status of the currency exchange rate and labor cost to rise. In addition, the high rise of price create hardship for those are below the rising living standard since they live on salary; and which polarized the rich and the poor more. With the pressure of the macroeconomic on surplus and workforce, it must face the inequality of the middle class is driving the inflation to eyelevel of its governments that price control and more regulation is put in the situation to halt its price system to synchronize with the developed nations. Its price structure exploded of its price limits after the democratized credits is put into contest with its economical developments. Besides, the aggregated demand rose significantly above the level of supply that is living standard elevates that created the short fall for the poor.

    In turn of atmospheric pressures in the free market system, we complete with state and private development. When the sovereignty confronts each other, it is how the O2 turn O3 and became the sunscreen even the sun ray is not coming through----it is just a mere reflection and it is how stable we are now that rule and regulations are kites floating in the sky and it became instability even for economists who cannot take their breath in O3. Or, how much rubber is in the balloon is required to the skin of the balloon when it blast or collapse? As the power of the middle class if you attempt to restore, you must know which side of the rubber you are taking; ”Burger-nomics” is the closest crisis I know of its legitimacy. More O3?

    May the Buddha bless you?

  9. CommentedJephtah Lorch

    If narrowing economy to data extrapolation would have been realistic, the world would be rich (or bankrupt). The current crisis is a result not only of over spending and unwarranted reliance on stock markets, it is a result of under-production and inability to recreate jobs due to mass "job export" to China, India and south-east Asia.

    In addition, non producing populations are growing much faster than producing economies. This is especially true in terms of food and water. Yes, 'growth' is in terms of electronics, weapons, oil consumption and other non food products. Foodstuff is becoming scarce, raising food prices and distanceing them from poor countries.

  10. CommentedMarc Sargen

    Great model based on garbage in. They base a model on data from 1959 to 2011 and then say they model properly addresses a statical outlier.
    When else in this time period were there any point when the a substantial portion of home owners who were under water? Even anywhere in the world?
    What were their fundamental assumptions on how these people would affect the economy & how may Super 8-balls did they use to verify its accuracy.

  11. CommentedJorge Simao

    People's mind reflect there perception of current situation -- which presents an very objective reality with factors such as unemployment, low salaries, unpredictable outcomes, high "end-user/consumer" interest rates, high prices in basic commodities, etc. To claim that it is people mind that is creating the crisis, is basically to say that economy theory was limited ability to explain (less yet predict) what happens in the real world. The argument coming from a prof. in Economics is particularly alarming, and just shows how clue-less the field/discipline is about the 21cent. modern world. And yes, even after discounting the economical, political, technological and historical variable, people mind matter. But even there just saying "animal spirits" is to blame, is to throw to the trash bin 300+ years of scientific thinking in the western world. Having failed on the economics dimension, at least bother to study the modern psychology literature.

      CommentedZsolt Hermann

      I fully agree with your opinion.
      Prof. Schiller's article coincides with the present official opinion which basically tries to ignore what is happening on the streets in the real reality, and try to hold on to a dream humanity has been chasing for centuries.
      People are afraid to look into the mirror and confront the real situation because that would force them to change and we hate changing.
      Humans are capable of getting used to the most severe austerity and pressure until it becomes intolerable and we have no choice but to move on.
      This is the pattern of our whole evolution, history through revolutions, wars, great painful "jumps".
      Unfortunately this is the real "animal spirit" that we only move, change when the blows, or pinches from behind became so painful that we have to move as other animals, without examining the situation, understanding it and making the necessary adjustments willingly, in full awareness. Instead we want to dream on, and pretend we are in a Hollywood movie with a happy ending.
      There is no need to contemplate whether we are going to be in a crisis or depression, we are already in a system failure.
      The "romantic story" of Greece has spread to the whole of Europe, to the US and China, to South America and Australia, there is nobody who would not be involved and not only in their "stories" but in their real life. Greece was just a symptom, like a pimple on the skin before the whole disease breaks out.
      The dynamic factor model's 6 shocks missed out on the 2 most important ones:
      We cannot maintain a constant quantitative growth economic model based on excessive, unnecessary and harmful overproduction in a naturally and humanely closed and finite system. We have started to exhaust both the natural and the human resources, we are beyond peak points on both fronts.
      We also evolved into a totally interconnected, global, interdependent human network not only in economics and finances but on all levels.
      In such an intermingled, closed and finite system the present polarized, fragmented, self calculating attitude and policy making leads to self destruction, like a cancer in the body.
      Only a completely new mutually responsible and considerate approach can raise humanity above this system failure.
      The true story is about how much we understand this, and how much we manage to motivate people in a positive way to change, this time wisely, pro-actively instead of by suffering and destruction.

  12. CommentedPatrick Lietz

    While the influence of the narrative is clearly underestimated in many economic models, I feel that one of the most important variables determining future economic growth has not received the attention it might deserve in your paper:

    Discretionary surplus of accessible energy.

    I argue that the plateauing of crude oil production in 2005, and the ensuing rises in price, should be seen as the bottleneck based on which longer-term economic forecasts should established.

    The emerging narrative might then cast blame on the culprit of choice (derivatives, banking system, deregulation, climate change, EU, China,...) or help us to address this by suggesting adaptive behaviors, but it would be most helpful if it helps governments and organizations to recognize the energetic constraints that we are facing now and for some time to come.

  13. CommentedProcyon Mukherjee

    The real challenge with the narrative is uncertainty.

    The interim assessment by the OECD which gives a rather appalling picture of Q2 and Q3 growth for G7 (0.9% and 0.3%), makes the narrative steeped in uncertainty about leading indicators after so much has been done on monetary loosening and employment of a policy framework that allowed adjustments to happen over time and through a transmission mechanism that dealt with inflation expectations and unemployment rate for broader macro-factors to be seeded with sustainability. But the preponderance of an uncertain narrative is not waning but growing as so much monetary stimulus (and some fiscal), although predicated as a normal follow-through action like in any other recession; it is not very normal though that higher debt to GDP ratio and higher debt to revenue ratios of governments was already sitting on a stock of global debt that was nowhere close to the earlier recessions.

    Coupled to that are extraneous factors and interaction of factors as highlighted in the treatise, Disentangling the Channels of the 2007-2009 Recession by Stock and Watson, that has rightly pointed out that “Sorting out credible instrumental variables methods for separately identifying liquidity shocks, market risk shocks, exogenous wealth shocks, and uncertainty shocks constitutes a large research agenda.”

    Procyon Mukherjee

  14. CommentedPaul A. Myers

    I think changing perceptions of "the narrative" are quite important because it tells us how people are organizing highly discordant and far-flung facts, the ultimate drivers of the narrative.

    In a shifting, globalizing economy, "facts" and "phenomena" are highly interconnected and interrelated. But there are also marked degrees of statistical "independence" between a lot of these narrative drivers. The independence tends to dampen out and localize the impacts of many events. One of my complaints about Professor Roubini's analyses is that he seems to overemphasize the interconnectedness and its cause-and-effect consequences. Yes, if there is a lot of serial correlation between bad events, then big bad things can happen. But the chain is not always a "done deal." However, Roubini is always laying down a view that should be considered seriously. If you think some chain of events might be starting, read Roubini while you're heading for the cellar.

    Another commentator said somewhere that the half-life of a "big idea" summarized into three words in today's world is about six months. So shifting narratives may not tell us much about the probably trajectory of the world economy. What then?

    I think well-thought economic models are the best view forward while each of us should try to maintain a sense of the many things that can go wrong while carefully listening to the Cassandras on world events.

  15. CommentedMarcel K

    Isn't even "normal" economic activity affected by narratives? In the 1990s, everyone was talking about the limitless potential of the internet the Nasdaq. People told each other that housing prices could never fall and we got the subprime mortgage boom. I wonder whether stories shouldn't have a larger role in economic analysis than just explaining why macroeconomic fluctuations happen?

    A related, self-interested question is whether sociologists aren't the "experts" on this topic. After all, sociologists have been looking at narratives and discourses far longer than economists and have a much better tool set for examining them.

  16. CommentedLuke Ho-Hyung Lee

    Prof. Shiller,

    I think you have missed something very important in your forecasting.

    Without being aware of it, we have made a serious mistake in developing numerous real (or physical) transaction systems through the use of information technology and developed too many job-killing machines (mostly by big companies) in real markets over the last 30 years of the Modern Information Age. I believe this is the root cause of the current economic crisis, more specifically, the current job crisis. Strangely, it seems nobody has recognized this yet, and no expert has considered this at all in his or her public ruminations about the economy.

    Could I suggest you see the following two articles I recently wrote?

    (1) “Job-Killing Machines in the Modern Information Age...”
    (2) “The Real Cause of the Current Economic Crisis and a Suggested Solution”

    If we do not replace the existing job-killing machines, that is, the existing private information-based supply chain networks, with a new job-creating machine, that is, a public information-based supply chain infrastructure, I believe it will be almost impossible to stop the further collapse of American middle-class families or to avoid the upcoming economic catastrophe.

    If you wish to know more details, please feel free to contact me.



      CommentedLuke Ho-Hyung Lee

      @lt lee,

      I would suggest you also see: “Job Creation in the Modern Information Age”

      Commentedlt lee

      I scanned your first article in which you used Zara as an example as your job killing machine. It seems to me that you are talking about the"Winner-takes-all" phenomenon enabled by modern communication and transportation technologies. If so, I cannot see how it could be reverted since a winner could only take all to the extent that it is offering better service and/or merchandise.