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Volatile emotions are driving the world economy

Financial markets and economic growth are supported mainly by animal spirits, not rational calculation

August 29, 2014 6:00AM ET

Economic predictions depend on figuring out what generates economic activity. Since the turn of the 20th century, economists have struggled to grasp what drives various parts of the economy, from consumer goods to commodities to housing. Yet the underlying causes of financial events remain elusive.

Scientists at University College London, however, appear to be finally making some headway. A team of researchers at the Centre for the Study of Decision-Making Uncertainty led by professor David Tuckett, one of London’s leading psychoanalysts, is studying the psychological moods of market participants to decipher what drives economic activities.

The team is using a large database of financial news stories from the mid-1990s until today, scanning articles for various words and phrases. The selected terms are then divided into fear or anxiety words and optimistic or happiness words. The balance between these two divisions generates what the team is calling the animal spirits measure — a Keynesian term used to describe the psychological state of investors that drives economic activity in spite of market uncertainties.

When the system finds a lot of anxiety words in the financial press, the researchers say it is an indication that the market under study is about to sink. When the software returns a lot of optimistic keywords, the market might be on an upward swing. During a recent discussion, Tuckett refused to provide details on the specific words and phrases the researchers are targeting, but he noted that the terms were carefully selected on the basis of interviews and extensive psychological investigation.

The results that the team has come up with for Britain are very robust, suggesting volatility in the stock market is caused by animal spirits. The researchers tested causality by running a prediction-based statistical hypothesis known as Granger causality. The test works by lagging one variable and using it to predict past values of the next variable. If this first variable predicts the second variable better than the alternative case, in which the first variable is not used, then it is assumed to cause the second variable. The results also strongly indicate that the volatility index (VIX) — which is known as the fear index among financial experts — is driven by the sentiments that Tuckett and his team are finding in the financial press. The results for the U.S. markets are not as impressive, but they give some reason for hope. For example, the relationship between Tuckett’s animal spirits measure and the U.S. VIX index shows strong correlation. The following graph illustrates one of the team’s animal spirits measures (inverted) mapped against the VIX index.

Animal Spirits (inverted) vs. VIX 'Fear' index

Source: Centre for study of Decision-Making Uncertainty, UCL.

I suspect that the reason the British measure is currently more powerful than the U.S. measure is that the researchers did their fieldwork in Britain. It is likely that the U.S. press uses different keywords for anxiety and optimism, since there are marked cultural and idiomatic differences between the two countries.

The animal spirits measure also seems to predict movements within a given economy. For example, GDP growth increases when the animal spirits measure indicates optimism and falls when it shows pessimism. One likely reason for this is that business investment, which typically drives economic growth, is subject to the psychological whims of the business community. This is in line with John Maynard Keynes’ writings about the economy in the 1930s. The following graph maps animal spirits measure against U.S. GDP.

US GDP vs. animal spirits measure

Source: Centre for study of Decision-Making Uncertainty, UCL.

Tuckett and his team’s research suggest that we need to look at the financial markets and the economy in a completely new way. Rather than see them as the inevitable outcome of decisions based on the rational self-interest of consumers and investors, we should see those decision-makers as people who are subject to psychological mood swings. Seen in this light, financial markets and the economy look a lot less like a roomful of businessmen calculating potential profits and losses in line with some perfect knowledge about what is going on in the economy and a lot more like moviegoers being swayed emotionally by what they see onscreen.

Some notable economists have begun to recognize this. In their book “Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism,” Nobel Prize–winning economists Robert Shiller and George Akerlof insist that financial markets and economies are driven mainly by psychology and that this psychological drive should not be assumed to be in any way rational, at least not in the narrow sense economists use the word. Tuckett and his team’s findings are in line with Shiller and Akerlof’s arguments and have caught the interest of economists at the Bank of England, who want to prevent economic catastrophes like the one that accompanied the financial crisis of 2008, which led to a government bailout of many British banks and a massive recession.

Beyond this, however, the researchers' findings raise enormous ideological questions about how our economies and societies should be structured. Since the late 1970s, politicians have argued that markets are best left unregulated and governments should take a more hands-off approach to economic policymaking. The justification given for this is that markets are inherently stable and produce efficient outcomes and thus we get the best possible financial results when we allow markets to self-regulate. But these assertions are based on the assumption that all participants in the market — especially those in the financial and investment markets — behave in a perfectly rational, nonemotional way. Tuckett’s findings shatter this particular myth. 

Officials should rein in speculative greed in the financial markets and focus on economic outcomes that promote a sense of security and encourage everyone to partake in growing the economy.

If market participants are driven primarily by their emotions, then we have to ask which emotions we want to see prosper among citizens. While policymakers are now embracing this trend, as evidenced by Fed Chairwoman Janet Yellen’s recent intervention in the market for junk bonds, Tuckett’s team is putting together a coherent framework for determining the extent to which emotional valuations should be allowed influence prices in financial markets. Officials should rein in speculative greed based on self-serving, unrealistic and overoptimistic evaluations in the financial markets and focus on economic outcomes that promote a sense of security and encourage everyone to partake in growing the economy. This is also in line with theories advanced by behavioral researchers such as Cass Sunstein, who advocate that regulatory institutions should nudge economic actors into taking more economically efficient actions.

When we understand greed is not necessarily good — especially when financial speculation may cause redistributions of wealth that have little to do with efficient capital allocation — it becomes clear that governments have a role to play in the allocation of resources. If investments are driven by emotion rather than rational calculation, it is no longer clear that they would result in optimum economic outcomes, as standard economic theory suggests. For instance, in economies where wealth distribution is polarized and markets do not provide for citizens, governments might be justified in not only redistributing income but also in allocating investment.

The U.S. government should, for example, directly invest in health care and infrastructure as well as media and the arts. It is clear that health care coverage is cheaper in countries where it is funded by the government. Similarly, large corporations’ monopoly on U.S. media and the arts not only is undesirable but also stifles creativity and critical reasoning. The extent to which we allow governments to regulate markets, redistribute wealth and allocate investment is a debate that we as a society must have. But Tuckett and his team’s findings show that we no longer need to listen to the chorus that tells us markets always and everywhere know best.

Philip Pilkington is a London-based economist and member of the Political Economy Research Group at Kingston University. He runs the blog Fixing the Economists.

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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