What are people pessimestic about?

Flipping through this paper on expectational shocks, I was at first surprised at the behavior of consumption to irrational exuberance. Consumption goes down at first but as the as exuberance wears off consumption goes back to normal. This makes sense, on reflection, because if you irrationally think your investments will have high returns in the future, you’ll consume less now and invest more. When you realize that you’ve been all a fool, you reduce your investments and start consuming again.

This got me to thinking about what people are pessimistic about these days. If this fear is the opposite of irrational exuberance (i.e. we believe investments in the future aren’t going to pay off as much as they will) then we’d actually see an increase in consumption per the logic of the paper above. So it can’t be that.

But then what is driving precautionary savings? What are people afraid of? What do people mean when they say we need to bolster confidence?

Even if interest rates are zero and there’s a flight to risk (rationally or not), if people believe credit will be available tomorrow, there’s no reason for precautionary savings. Are people afraid credit won’t be available in the future? is credit unavailable to the unemployed? do people think its not?

8 thoughts on “What are people pessimestic about?”

  1. This assumes an infinitely lived agent, who can wait out any downturn. A finitely lived agent will cut back on consumption if there’s no chance of recovery. E.g. a 65 year old who was counting on his stock market holdings to pay for retirement is not going to start spending more now that it’s lost 40%.

  2. At least one reason why people save is because they know they will die one day, and before they die they must live for a time without an income, by drawing down on their savings. Friedman’s permanent income hypothesis says people consume according to their expected lifetime income: well if the investments you were counting on for the end of your life yield less, then your lifetime income has gone down.

  3. You’re describing a rational decrease in current consumption due to lowered expectation of future income, but how does this interact with a sudden increase in pessimism? By your explanation, we’re not talking about precautionary savings, we’re talking about normal savings. There’s no need to “bolster consumer confidence”; they’re doing what they need to do to smooth income.

  4. Bruce Sterling just did an interesting column on fear and panic. I think he dances a little too much around the central issue, though: certain trusted institutions have demonstrated that they are untrustworthy. It’s difficult to invest when you are convinced that your prospective investment will conceal critical information from you. Fool me once, shame on you, fool me twice, you ain’t gonna fool me again. That sort of thing.

  5. I’m personally iffy on the boosting confidence part, but there are plenty of stories you could tell. If people were irrationally exuberant on the way up, then they can irrationally overshoot on the way down, and a supposedly cooler head like the gov’t can step in until they regain rationality. Or, there could be sunspot equilibria (need more than one agent for this). Or maybe there’s a kind of hold-up game going on, with each agent not wanting to be the first to stick his neck out. “Robust” control seems to be hot now, where agents worry about the worst possible case – well maybe now the worst possible case just got worser, and only gov’t actions can credibly eliminate the possibility of GD2.

    As for credit, banks aren’t going to lend to just anyone, you need to have collateral (i.e. credit rationing).

  6. Just to repeat my interest here: I’m trying to understand this fiscal stimulus’ effect on confidence. Given its not clear how policy should deal with the rest of your possibilities, policy makers must think folks are overshooting on the down side. Take policy to be data about which of your explanations is right and let’s assume the overshooting story for now.

    How would you model such an overshooting? Its not a negative version of the shocks studied in the paper I linked to… its not irrational underexuberance. I haven’t seen how people model access to the credit markets. Maybe this was a shock to access (or to anticipated access).

    (I don’t know about optimal policy in sunspots and I know little but the gist of robust control. I’m going to start sitting in a robust control reading group (Sargent/Hansen’s book) this spring. Maybe they model shocks to the worst case outcome, but I know they address optimal policy. Hold-up is unlikely in the macroeconomy as with so many agents someone will make an epsilon mistake and get us out of the bad equilibrium. Regarding credit, calculated risk has data that suggests that situation is getting better. If that’s what policy makers are trying to fix with fiscal stimulus, it’ll be too late in my estimation.)

Comments are closed.