Let Me Tell You a Story about the Stock Market…
Good news: Economists have finally admitted how clueless they really are. One wrote a book about it called Narrative Economics. I haven’t read it yet, but I’m going to give Robert J Schiller a hard time anyway. Largely because the very successful economist, who I admire greatly, won’t give two hoots.
The premise of the book is that narratives have power. The stories people believe and how they perceive events can explain what happens next because narratives affect their actual behaviour.
For example, economic law dictates that people should save less and borrow more when the interest rate is cut. That’s the whole point of cutting the interest rate, after all.
But what if people believe a narrative that they must build a certain sized nest egg for retirement?
Then they might save more, not less, when you cut interest rates. Because the lower rates lower their returns on savings, they have to save more to make up for the shortfall in income.
In other words, economists are not responsible for constantly being wrong about the economy and the results of economic policy. Because irrational people prefer a story over the laws of economics.
At least, that’s my interpretation…
Ironically, Schiller has a habit of being right about things while the rest of his profession get stuck in groupthink…which you could call a narrative too.
Schiller warned about the US housing bubble bursting, for example, while economists refused to consider such a possibility because it had never happened before.
So perhaps I’m being entirely unfair to the book and the author — a very impressive fellow. But I just can’t help it. It’s like a physicist claiming that nuclear power is or isn’t green based on the EU’s definition of ‘green energy’ rather than the facts.
Explaining away economics’ shortfalls by saying ‘well, if people don’t believe in economics, then it won’t predict how they’ll behave’, or ‘it didn’t happen because people expected something else to happen’ is a bit shifty. Even if it’s true, it only exposes an underlying flaw in economics.
The economists’ creation of ‘homo economicus’ — a human who follows the laws of economics (as economists define them) and is, therefore, ‘rational’ — is just as arbitrary as the legal system’s ‘reasonable man’.
They only exist in so far as the economics and legal profession define them and use them. And, if you and I don’t conform to the economists’ definition of rational or the legal profession’s definition of reasonable, we must be dumb and unreasonable.
Unless, of course, you and I know how to run our affairs better than academics…
Perhaps we know things about our own lives that they fail to take into account. Or perhaps doing the opposite to what economists recommend has proven to be a good idea over time.
One of the key tenets of narrative economics, as I understand it, is that a false narrative can still have power and should therefore be heeded. At least, investors cannot afford to ignore it.
But that seems an odd way to think about economics. False narratives can only diverge from reality for so long, as the Green Machine and the coal price are discovering right now. Believing in the narrative of climate change doesn’t pay energy bills.
Surely economics should be about sticking to the actual, not the delusional.
That won’t stop the government from using this idea of narrative economics. If narratives born in the media and on social media have such power to actually shape reality, then they must be regulated!
It’s the totalitarian’s dream. The ultimate excuse to control the narrative — it affects the outcome, after all. Therefore, unapproved narratives mustn’t be permitted.
We’ve seen that play out during the pandemic too. And the consequences.
So, as far as I’m concerned, this book provides a dangerous narrative. And so, it should be banned…
But narratives that actually stick come from somewhere — people buy into them for a reason. The White House’s attempts to deny a recession that people are experiencing every day show how hollow narratives can be. The pull of many conspiracy theories shows that people have a sense of what’s really going on.
But Shiller’s point is very useful to investors. Geopolitical guru Jim Rickards explained how a year ago in Strategic Intelligence Australia:
‘At the outbreak of the First World War, stock markets crashed, and most major markets were actually closed for months. The narrative was that European nations were dumping assets to buy gold to provide financial support for the war. In contrast, at the outbreak of the Second World War, stock markets rallied (and markets were not shut down) because investors perceived that industrial output for war fighting would lead to huge profits at companies like Ford and Boeing.
‘In both cases, war was a catalyst and narratives determined investor behaviour, but the narrative itself and investor reaction moved in opposite directions in 1914 and 1939. This shows the importance of remaining nimble and open-minded as new narratives emerge.’
In a similar vein, we’ve got the ‘good news is bad news’ phenomenon, which is occasionally rearing its ugly head in markets today. That narrative claims that bad news for the economy is good news for the stock market because it’ll force central banks to save us again.
That narrative has the ability to turn bad news into good news — remarkable stuff when you think about it.
But is it just a narrative? Or is there something to it?
That’s what economists should be focusing on. Economics should be busy pointing out where a belief in omnipotent, omnipresent, and omniscient central bankers leads…
Into too much mortgage debt.
What’s really going on here is simple.
First of all, economics is a game of counterfactuals, and it is therefore extremely difficult to analyse in the way we analyse other sciences.
If you cut interest rates and savings go up instead of down, you might conclude that cutting interest rates actually reduces the incentive to save and hundreds of years of economic law has been upended.
But you don’t actually know what would’ve happened had you not cut interest rates. Perhaps savings would’ve gone up even more and cutting them did actually have the effect that economic law suggests. Or maybe the factors that forced a cut to interest rates are what drove savings up.
You never know the counterfactual in economics. So you never know what effect policies have. Unless you believe dogmatically in some sort of economic rules, such as the law of supply and demand.
In other sciences, if economics is a science, you can do multiple experiments under the same controlled conditions, and you’ll get the same outcome. But economics simply doesn’t work like that. People are not inanimate objects, as difficult as it might seem to believe, sometimes.
If you apply the same force to a lump of metal, you’ll get the same result each time. Do it to a human’s face multiple times and you’ll get very different results each time.
Similarly, the same people who responded to interest rate cuts by borrowing more and saving less when they were young can respond in the opposite way later in life, when they are saving for retirement.
It’s incredibly difficult to take into account all the changing variables. Indeed, time plays a crucial role in economics. It can completely change relationships but doesn’t in physics.
This doesn’t upend or change economic law. It just exposes how hard it is to observe or apply that economic law. This is why governments shouldn’t meddle in an economy — it’s something they don’t understand.
Economists as being beginners in a science that is very difficult. Claiming narratives are a driving force for what seems like irrational behaviour is a cop out. Even if investors need to keep it in mind.
Until next time,
Editor, The Daily Reckoning Australia Weekend