EDITOR NOTE: There are a couple of economic conditions and indicators that base their data on a survey of business and household sentiment. These surveys ask similar questions: how are you feeling about the economy; how are you feeling about your current financial prospects; do you plan on making purchases or investments, etc.? The reports they generate might give you a good representation of market psychology, but chances are that they won’t give you an accurate picture of the economy at large. Observing a herd heading toward better pastures might not be all that different from observing the same herd heading off a cliff. Seeing investors rallying into a crash or panic selling into a new bull market isn’t all that different from watching businesses malinvest optimistically into oblivion or to stay frozen with unduly prudence in the face of its greatest (and missed) opportunity. Transparency in market sentiment is not as important as transparency in the effects of government and central banks policies that shape the markets and the sentiment surrounding them.
In order to gain insight into the current and future state of an economy, many economists hold that it is helpful to get the view on this from consumers and businesspersons. Randomly selected consumers and businesspersons are asked to provide their views about the current and the future state of the economy.
Thus if the majority of those surveyed express optimism it is regarded as good news for the economy ahead. Conversely, if the majority of surveyed are pessimistic it is taken as a bad omen for future economic activity.
Is it valid to hold that surveys can tell us where the economy is heading? Moreover, why should we regard an opinion supported by a large percentage of people as any more credible than the view of a particular individual?
The prevailing view is that the knowledge regarding possible future economic conditions is dispersed. It is held that a large group of people is likely to have more information than any one individual.
Therefore, the chances of any individual obtaining an accurate picture of the economy are thus very low.
Consequently, it is logical to conclude that a large group of people selected randomly has a high likelihood of securing an accurate picture of future economic conditions.
It is quite possible that a group of people is going to be better informed than any particular individual. However, greater information does not necessarily mean better knowledge of the future.
Whether a forecast seems to be reasonable is determined not only by the amount of information available but also whether a theory employed to make the forecast makes sense. In order to ascertain the facts of reality the information must be processed by a theoretical framework.
As long as the individuals surveyed have not disclosed the theories behind their views, there is no compelling reason to regard various surveys as the basis for an accurate assessment of the future state of an economy.
Can Positive Thinking Prevent Decline in Economic Activity?
Given the view that individuals’ expectations are important drivers of economic activity many commentators hold that "positive" thinking and a large dose of "good" news can prevent the emergence of “bad” expectations and thus a decline in economic activity.
Individuals are seen as driven by a mysterious psychology that is susceptible to wild swings. It is then crucial not to upset this psychology in order to keep the economy prosperous.
These days whenever various experts discuss the state of the economy, they try to portray the positive aspect of it. Even when the economy falls into a recession, various influential commentators are very guarded in their speech.
On this Rothbard wrote,
After the disaster of 1929, economists and politicians resolved that this must never happen again. The easiest way of succeeding at this resolve was, simply to define "depression" out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937–38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: "recession". From that point on, we have been through quite a few recessions, but not a single depression. But pretty soon the word "recession" also became too harsh for the delicate sensibilities of the American public. It now seems that we had our last recession in 1957–58. For since then, we have only "downturns", or, even better, "slowdowns", or "sideways movements". So be of good cheer, from now on, depressions and even recessions have been outlawed by the semantic fiat of economists; from now on, the worst that can possibly happen to us are "slowdowns". Such are the wonders of the "New Economics".1
Again, the main reason for this gentle talk is a view that soft language is not going to upset an individual's confidence. If people’s confidence is kept stable, then stable economic activity is likely to follow suit or so it is held.
Can Transparent Government Policies Support Economic Growth?
Since it is held that stable individuals’ expectations imply economic stability, economists recommend that government and central bank policies should be transparent. If policies are made known in advance, surprises will be avoided and volatility will be reduced.
Some economists, such as Milton Friedman, maintain that if inflation is expected by producers and consumers, then it will cause very little damage.2
The problem, according to Friedman, is with unexpected inflation, which causes a misallocation of resources and weakens the economy. According to Friedman, if a general rise in prices can be stabilized by means of a fixed rate of monetary injections, people will adjust their conduct accordingly. Consequently, Friedman says, expected general price increases, which he calls expected inflation, are going to be harmless, with no real effect.
Observe that, for Friedman, bad side effects are not caused by increases in the money supply but by the outcome of that—increases in prices. Friedman regards money supply as a tool that can stabilize general rises in prices thereby promoting economic growth. According to this way of thinking, all that is required is to fix the growth rate of money supply, and the rest will follow suit.
It is overlooked that “fixing the money supply's growth rate” does not alter the fact that the money supply continues to expand. This means that it will continue the diversion of resources from wealth producers to non–wealth producers even if prices of goods remain stable. This policy of attempting to stabilize prices is, instead, likely to generate more instability.
Alternatively, let us assume that the government presents a plan to raise personal taxes. How is the mere fact that this plan is communicated to everybody going to prevent an erosion of individual's living standards?
Even if politicians could succeed in convincing people that the tax increase is going to benefit them, this cannot alter the fact that individuals’ after-tax income is likely to be reduced.
Alternatively, if the central bank makes it public knowledge that it will raise the money supply growth rate, how can the simple publication of this information prevent capital consumption and the development of a boom-bust economic cycle?
Stable expectations cannot undo the damage caused by loose monetary policies or by higher taxes. Irrespective of whether individuals are successful in identifying the facts of reality or not, these facts are going to assert themselves and will exert their impact on individuals conduct.
Thus, if we have established that people’s real incomes are going to decline, then this is a fact of reality. Regardless of people's psychological disposition, this fact is going to undermine people’s outlays.
The decline in outlays is not going to occur because of the decline in confidence but because consumers can no longer afford the previous level of outlays.
Consumer Expectations in Free versus Hampered Market
Consumer expectations do not emerge in a vacuum but are part of every individual’s evaluation process, which is based on his views regarding the facts of reality.
In a free unhampered market economy, whenever individuals form expectations that run contrary to the facts of reality this sets in place incentives for a renewed evaluation and different actions. Reality is not going to permit prolonged mistaken evaluations in a free unhampered market.
Let us assume that as a result of incorrect evaluation too much capital was invested in the production of product A and too little invested in the production of product B.
The effect of the overinvestment in the production of A is to depress profits, because the excessive quantity of A can only be sold at prices that are low in relation to costs.
The effect of underinvestment in the production of B will lift its price in relation to cost, and thus will raise its profit. We suggest that this will lead to a withdrawal of capital from A and channeled towards B, implying that if investment goes too far in one direction, and not far enough in another the counteracting forces of correction are likely to be set in motion.3
In a free market, the facts of reality are going to assert their dominance through individuals’ evaluation and therefore their actions.
In contrast, in a distorted market economy by enforcing their policies, governments and central banks can set a platform for a prolonged deviation of expectations from the facts of reality. As a result, it could take a long time for the facts of reality to assert their dominance.
Notwithstanding, neither the government nor the central bank can indefinitely defy these facts. A classic case is the artificial lowering of interest rates by the central bank that results in boom-bust cycles.
We can conclude that in a free, unhampered market economy, individuals’ expectations are likely to correspond to the facts of reality. This is in contrast to a hampered economy where government and central bank policies give rise to expectations that are detached from the facts of reality.
We are also of the view that it is questionable that by means of opinion surveys it is possible to ascertain the future direction of an economy. That a large group of people has expressed a view regarding future economic conditions does not make it more accurate than the view expressed by any particular individual.
What matters is not how many people have participated in an opinion survey but the framework of thinking they have employed in backing up their views.
As a rule, at the peak of the business cycle, most individuals express great optimism regarding the likely economic conditions in the months ahead. Bad business conditions emerge when least expected—just when all businesses are holding the view that a new age of steady and rapid progress has emerged.
Furthermore, what matters is not whether government and central bank policies are transparent, but the effect these policies have on individual’s life and well-being.
Original post from Mises Institute