Can Positive Thinking Fuel Economic Booms?

Economists pay close attention to consumer sentiment, seeing it as an important indicator of how an economy will do in the future. Consumers feeling flush may be more inclined to make big purchases, which would have ripple effects across the economy. Those feeling tight might pinch pennies and contribute to an economic contraction.

But the effects of sentiment on long-term growth vary by the type of economy, find Chicago Booth’s George M. Constantinides, Utrecht University’s Maurizio Montone, University College Dublin’s Valerio Potì, and Athens University of Economics and Business’s Stella Spilioti.

There are three main theories on this subject, the researchers explain. One is that positive consumer sentiment anticipates future economic growth but doesn’t cause it. Another is that sentiment has only a short-term effect on economic growth because it has no relation to fundamentals. A third theory is that sentiment has an immediate and lasting effect on economic growth through a “self-fulfilling feedback loop.”

Each theory is valid in certain contexts, depending on an economy’s size and state of development, the researchers find. Less advanced economies tend to have less efficient financial markets, so consumer sentiment has a larger effect on economic growth in those countries.

Stock prices can be an indicator of future economic activity, and consumer sentiment can drive markets. The harder it is to distinguish between psychological mood swings and fundamentals, the researchers write, the more likely it is that sentiment alone fuels booms and busts.

The researchers analyzed data from 1975 to 2019 for 17 Organisation for Economic Co-operation and Development member countries. Of those, six—Canada, France, Germany, Italy, the United Kingdom, and the United States—belong to the G7, a grouping of the world’s most advanced economies, while 11 are non-G7 countries (Australia, Austria, Belgium, Denmark, Finland, Ireland, Netherlands, New Zealand, Spain, Sweden, and Switzerland).

Consumer sentiment in non-G7 countries predicts large increases in consumption, employment, and income for as far out as four years, along with an increase in overall productivity, the research suggests. In G7 countries, sentiment tends to drive only modest increases in consumption, employment, and income, and for no longer than two years. Future productivity there is determined by fundamentals, not sentiment.

For example, a positive sentiment shock of at least one standard deviation (which occurs 16 percent of the time) led to consumption gains of 0.91 percent for non-G7 countries one year later and 0.52 percent for G7 countries. However, while the consumption boost for non-G7 countries lasted for up to three years, it was statistically insignificant beyond one year in the richer economies.

The pattern was even more pronounced for employment. Among less advanced economies, a similar rise in sentiment was followed by employment growth of 0.59 percent a year later, while G7 countries experienced growth of only 0.16 percent. Two years later, employment was 0.13 percent higher for G7 countries, and effectively flat in years three and four. Non-G7 countries still had strong employment growth of 0.5 percent two years later and 0.35 percent after three years. Growth dropped to 0.13 percent in year four.

In less advanced economies, the researchers find, higher stock prices also allowed for an increase in capital investments and associated rates of return for a prolonged period of time. In G7 countries, investors correct sentiment-driven overpricing within one year—but elsewhere, it isn’t fully corrected for two to three years, indicating that people misinterpret consumer optimism as a good investment opportunity, according to the researchers.