Mood swings and business cycles

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Across Europe, the confidence of the public and investors has bounced up and down as leaders grapple with the debt crisis of weakened economies. But do consumers have reason to worry, or does worrying make it worse?

Perhaps they really should go with their gut.

The booms and busts of business cycles are strongly influenced by the mood swings of the public, according to a new statistical analysis published by the National Bureau of Economic Research.

"You have these periods of optimism that seem to forecast a boom part of the cycle," said Paul Beaudry, an economist at the University of British Columbia and a Canada Research Chair in macroeconomics.

The research finds new evidence to support the famous Keynesian idea, and was conducted by Mr. Beaudry, Jian Wang of the Federal Reserve Bank of Dallas and Deokwoo Nam of the City University of Hong Kong.

Different indicators that can measure mood -- including surveys of consumer confidence, amount of spending and stock indexes -- tend to accurately predict periods of economic growth and contraction, according to the study.

"All these indicators move very similarly just before an upturn or downturn," Mr. Beaudry said in an interview.

In fact, the research says, they tend to move in that order -- consumer confidence leads the way, the public spends more, and investment follows. Once these measures are moving together, effects to the general economy can be felt within a quarter, and a burst of optimism can still be felt two years down the line.

"Over all, we argue that mood swings account for over 50 per cent of business cycle fluctuations in hours and output," the paper says.

The good times see measurable increases in real wages, hours worked and a mild bump in interest rates, but the study notes that optimism does not seem to influence inflation.

Consumers are particularly good at predicting strong fundamentals because they aggregate many different pieces of information. "It's a lot of little people together doing this...each one might have a story about why they think things are getting better," Mr. Beaudry said.

For example, he said, consumers accurately predicted in the early 1990s that the Internet and improved computing would boost the economy, even before true gains were felt. Though speculation eventually emerged and the bubble popped, Mr. Beaudry said, there was a period of real gains -- when the total pie of the economy got bigger.

More recently, dour confidence in 2008 predicted a recession months before the full force of the slowdown hit.

Legendary economist John Maynard Keynes famously espoused the idea of "animal spirits" driving the economy, but this paper uses new statistical tools to back it up.

The research finds novel ways of controlling for the plethora of possible influences on a nation's economy, such as Bank of Canada announcements, while trying to find a signal in the noise.

"It's as if nothing else seemed to be happening in the economy at that point," Mr. Beaudry said of the tools' effects.

However, the analysis is limited in separating whether optimism is a well-founded reflection of future growth or the cause of it. In the latter theory of a self-fulfilling prophecy, good feelings in the public directly cause a burst of economic activity, regardless of fundamentals.

Mr. Beaudry is confident that the results show that the public's optimism and pessimism accurately reflect the fundamentals of the economy.

If so, for the weary investors of Europe, you might be right to worry.