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?