Confidence Is Never An Economy Problem

The press likes to talk a lot about consumer confidence as one of the important factors in the current financial crisis. Commentators are often saying if only we could restore consumer confidence then the economy would be better. They will often also say that once consumer confidence is restored people will start spending money again. Both statements are false.

Numerous economic, consumer and corporate measurements become available at various times and fall into one of three categories. Either, they are lagging, concurrent [aka coincident], or leading measurements of behavior and the economy. Most economic, consumer and corporate statistics are concurrent or lagging measurements. Very few are leading indicators of the economy or consumer behavior. There are three economic leading indicators. The percent change in the price of the overall stock market, the slope in the US Treasury interest rate yield curve, and the premium for corporate debt over matched maturity treasury bonds.

When consumers are spending because they and their neighbors have jobs, consumer confidence is high. When consumers stop buying or saving because of job layoffs, health issues, shortages, etc. their confidence is low. Confidence does not create spending. It is just the opposite. Spending creates consumer confidence. Psychologists know that doing happy things makes people happy and not the reverse.

Therefore, consumer confidence is a concurrent indicator. It is low because people are not doing things such as spending and working. If more people were working and spending, confidence would be higher.

Granger Causality and the Financial Crisis

When the media, the public and politicians look for a cause of an economic event such as the recent severe stock market decline, the current economic slowdown, and the spate of financial institution failures, there is a strong tendency to look for some related event that happened before, such as the decline in home prices. The consensus becomes that since it happened prior, it must be the cause of the economic problems. These days there is a lot of talk about the nationwide decline of home values and about seeking solutions to stabilize home prices. The thinking is that stable home prices will restore economic growth and that the decline in home values precipitated many if not all of the economic problems.

Unfortunately, in economics, finding causes is not that easy. Economic agents and economic values respond to expectations about future events, such as the future value of assets and cash flows. Two economic events, A and B, can both respond to some future expected event, C, but A can reveal itself before B happens and both can happen before the expected C occurs. This is called Granger Causality. It looks like A caused B but both were simultaneously affected by the expectation of C. It is just that A is noticed before B happens. In the current economic environment, it is the change in some economic expectation that caused the decline in home values that is also causing the economic slowdown and many if not all of the other current economic problems, such as the credit tightening and freeze. It could be a host of factors. Some possibilities are the election of a Democratic Congress or President, an expected increase in taxes, a new war, a terrorist attack, or a change significantly affecting corporate profits to name a few but not all possibilities.

A simple, common example of Granger Causality is as follows. People wake up in the suburbs and commute to the city to work. When they wake, they listen to weather forecasts and if the weather person forecast rain later in the day, many of the commuters will take an umbrella with them to work. A person living in the city, who wakes up after the commuters start arriving in the city can look out the window and see if the commuters are carrying umbrellas. The city person will observe that when many commuters carry umbrellas, there is a good chance of rain later in the day. Statistically and through observation, the city person can conclude that commuters carrying umbrellas cause rain. This observation is known as Granger Causality since the commuters carrying umbrellas are caused by an expectation of rain later that day from the weather forecast and the umbrellas do not cause the later rain. Commuters carrying umbrellas happens before rain but does not cause the rain. Umbrellas are linked to rain because they are used for rain but they are not the cause.

Likewise, in the current economic environment, there was a change in an economic expectation that caused house prices to decline. (See my previous piece on Home Values Were Not In A Bubble.) This change in economic expectation also caused the increase in credit spreads, an increase in the risk of debt default by institutions, corporations and individuals. All are responding to the expected future economic event that will cause a decline in all asset values, including commodities, equity values and corporate cash flows and not just home values. It is just that the decline in home prices happened before or simultaneous with many of the other events. It does not show that house prices caused these other events. In fact, since houses are assets like many other assets, such as commodities and stocks, houses needed some expectation change for house values to decline.

Recessions Reallocate Resources

All the time, people put money into the economy to sell services and products with the hopes of making a future profit. These hopeful people lease and build commercial space, hire staff, order supplies, research and innovate, and make or order products for resale. These business people allocated time, money, capital and people to these operations to make money. Some of these ventures will be highly profitable and others will fail to achieve profitability. Those that fail to make money will close.

The closing of unprofitable business ventures occurs in good and bad economic times, but business closings accelerate in recessions. In a robust economy, in addition to the many profitable businesses, some businesses eke out just enough profitability to meet expenses but not make an adequate profit for the investment deployed. In good economic times, many economically unprofitable businesses that are just meeting their expenses will continue operations and will increase in number. These economically marginal businesses continue because their owners hope that their businesses will become profitable. These continued unprofitable operations divert capital and talent from more profitable business opportunities.

In a slowing, recessionary economy, there is an overall decline in the sale of services and products of most businesses, but the economic decline will more adversely affect marginal business operations. These marginal ventures will suffer economic losses and need additional capital investment. Many of these business owners will not want to continue to have business losses or put new funds into what appears to be a failing business venture and these unprofitable operations will not survive a recession. The closing of these marginal operations will free up resources including capital and human talent for use in other business enterprises that face greater prospects of profitability.