Giddy with expectations

Are you an econ geek if you’re anticipating a GDP statistics release more than you did a history making presidential inauguration? Well, guilty as charged.

This Friday’s release has me giddy because we’ll have fourth quarter’s consumption expenditures numbers. If consumption is down big again its an indication that psychology matters and it would be evidence in favor of doing something to improve expectations (and the fiscal stimulus if you think it would reduce pessimism).

Bayesian update declaration: the early 90’s recession had two quarters of greater than 1.7% (annualized) consumption declines. If this quarter’s consumption decline is greater than 1.7%, then I will take it as evidence that psychology is playing a part. However, the other thing to take into account is that wealth has declined (via home prices). If people take this into account when making their consumption decisions, then the issue isn’t really “animal spirits” but rational changes in behavior due to new information. About 27% of wealth in 2007 was in housing ((See here, chart B100)). Assuming other assets remain constant in value, the 15-25% decline in housing prices since 2007 ((The Case-Shiller index shows 15% decline through October 2008. 25% is my high estimate of declines.)) corresponds to a 4-7% decline in wealth for 2008. Its not surprising, then, that consumption would fall by about those magnitudes. For updating then, an annualized decline between 1.7% and 5% will be moderate evidence that psychology matters. We’re deep in animal spirits territory if the decline is greater than 5%. BTW, the largest annual decline during the depression was nearly 9%.

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