Consumer Confidence Helps, Until It’s Gone

Amid the constant turmoil in domestic and global politics these days, the economy’s steady expansion has been a source of comfort. But look more closely and you will find that economic growth rests on a surprisingly amorphous base: consumer confidence.

In the United States, consumer confidence has been ascending since 2009. What’s more, the domestic data have been synchronized to a remarkable degree with similar metrics from around the world.

We know that consumer confidence is a critically important advance indicator of economic booms and busts. At the moment, it is forecasting a continuing expansion. Yet the troubling fact is that we don’t fully understand how and why consumer confidence acts as it does.

Since 2009, there have been ups and downs in consumer confidence lasting months, but those downward swings have not interrupted the long uptrend in the United States. This pattern has held for all four major U.S. indexes: the University of Michigan’s consumer sentiment survey, The Conference Board’s consumer confidence index, the Bloomberg Consumer Comfort Index, and the Organization for Economic Cooperation and Development’s consumer confidence index.

Some recent readings have been a bit weak, but we have seen such minor shifts many times since 2009 and they haven’t meant much. Even the recent shutdown of the U.S. government — and the prospect of further political conflict — may not matter for this metric. When the government shut down briefly in October 2013, there was a temporary drop in confidence, but that didn’t stop the longer-run rise.

The simplest explanation is the necessarily slow but consistent recovery from the crushing financial crisis of 2008 and 2009. After all, a financial crisis of that magnitude leads to lawsuits, bankruptcies, career disruptions and other economic events that muddy a recovery, and they take a long while to clear up.

There is some truth to that explanation, but it omits a critical yet elusive factor: animal spirits. John Maynard Keynes popularized that term in 1936, referring to a psychological state in which people get a consumerist and entrepreneurial bug that allows them to forget their worries and let their optimism guide their economic decision-making. In homage to Keynes, the economist George Akerlof and I used “Animal Spirits” as the title of a book in 2009. Flourishing animal spirits involve complacency, a playful mood, a “damn the torpedoes, full speed ahead” feeling of confidence.

That kind of exuberance now seems to be fueling the stock market, where prices have outstripped fundamental valuations. Real (inflation-corrected) corporate earnings per share for the Standard & Poor’s 500-stock index were, for the third quarter of 2017, only 6 percent higher than they were in the second quarter of 2007, just before the financial crisis. In contrast, real stock market prices were 39 percent higher. That disproportionate increase is based much more on how earnings are being valued than on how the level of earnings has increased. Such surges have happened before. The four major confidence indexes took a long ride up between 1990 and 2000, again after a recession. From the bottom of the Michigan index in October 1990 to a peak in February 2000, real S&P 500 price per share rose 256 percent while real earnings per share rose only 78 percent.

Why did share prices rise so much in that period? A traditional explanation is that investors had a “rational expectation” of future earnings increases, but it is clear that they were grossly mistaken. The S&P 500 lost just over half its real value from its peak on March 24, 2000, to its trough on Oct. 9, 2002. No concrete event caused this plunge, though we can point to the bursting of the dot-com bubble and a recession. Both were plausibly caused by a drop in overinflated confidence.

The critical question, then: What drives these decadelong swings in confidence, including the upsurge that is still underway? Take the current confidence cycle.

While Donald Trump’s presidency may have exerted some impact on animal spirits in the past year, it doesn’t explain the preceding eight years of slowly improving confidence. And I am skeptical that the upward swing can be entirely explained by factors such as government and central bank stabilization policy or technological innovation.

Scholars are working on this issue. At the American Economic Association meeting in Philadelphia this month, I led a session on “Confidence, Animal Spirits and Business Cycles.” All three researchers presented papers describing how animal spirits are helping to drive the economy in the United States and across the world.

In short, confidence indexes are indeed leading indicators in a vast array of countries, and these individual country confidence indexes are driven by a global cycle, though how this cycle is synchronized still isn’t clear. Fluctuations in animal spirits remain an essential mystery for economists, though it is encouraging to see that quantitative studies of the issue are underway. As a practical matter, consumer confidence numbers are important but still limited in their predictive power. For example, the latest consumer confidence index numbers do not strongly suggest any imminent change in the uptrend we have been seeing for so long. That bodes well for the economy over the short term.

But history indicates that a long uptrend like this one will eventually shift downward, even if we can’t say when it will happen. While the timing will be a surprise, we can expect a sharp change in direction that is likely to have serious consequences for the economy in the United States and around the world.