Business confidence is empirically proven to increase growth productivity and tech development.

The idea that changes in consumer and business confidence can be important business cycle drivers is an old but controversial idea in macroeconomics. It assumes that confidence reacts not only to movements in economic fundamentals but is itself an independent cause of economic fluctuations distinct from those fundamentals. In recent decades, cycles of boom and bust in Japan, East Asia, and the United States have focused renewed attention on the question of confidence. These experiences suggest that optimism about the future helped fuel economic booms and that subsequent buildups of pessimism contributed to the busts. Moreover, these episodes fostered intense debate about the role of monetary policy in boom-and-bust cycles. Central banks have been sharply criticized for stoking the booms and inflating confidence by setting excessively accommodative monetary policy.

This Economic Letter considers the role of confidence in macroeconomic models. Specifically, the Letter examines professional economic forecasts to investigate whether relative optimism and pessimism—that is, expectations that good or bad times are ahead—may be important business cycle drivers. It also analyzes how monetary policy responds to buildups of confidence.

Confidence as a source of business cycle fluctuations

Psychological factors such as optimism and confidence played an important role in business cycle theories formulated in the 1920s and 1930s. For example, the British economist Arthur Pigou stressed the importance of changes in expectations as a determinant of business cycles: “The varying expectations of business men…constitute the immediate cause and direct causes or antecedents of industrial fluctuations.” In other words, when people are confident about the future, they may consume, invest, and work more today. John Maynard Keynes also argued that confidence played a large role in driving economic activity: “Our decisions to do something positive, the full consequence of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

Economic booms are often characterized by waves of optimism and the view that the economy is entering a new era in which the business cycle has been tamed. The idea that “this time, things are different” became pervasive during the expansion of the mid-2000s, just before the worst financial crisis since the Great Depression. New financial products were thought to have protected market participants by spreading risk widely, thereby justifying the surge in mortgage lending and the phenomenal run-up in house prices. Similarly, the emergence of new information technologies fueled a wave of euphoria that drove the stock market boom of the late 1990s and the longest economic expansion in U.S. history. A similar sense of confidence developed during the Roaring Twenties, spurred by new technologies such as autos and radio, financial innovations, and improved business practices. The Japanese boom of the 1980s with its ballooning property prices also shared some of these characteristics. Each of these episodes ended with a stock market crash when overly optimistic expectations were dashed.

The proposition that confidence can influence the business cycle raises the question of how expectations are translated into actions that affect economic activity. One way that confidence can cause business cycle fluctuations is when people’s actions are influenced by what they think other people might do. For example, if customers start to fear that a bank may not be able to honor deposits, they may rush to withdraw their money before other customers do, triggering a run. The bank may fail and some people may lose their deposits. If this is repeated widely, a general loss of confidence in the financial sector can occur. Since fear is not always a rational process, even a solvent bank could suffer a run that mushrooms into a broad financial panic. Such a crisis of confidence could squeeze liquidity throughout the banking system, causing a contraction in credit that harms broad economic activity.

If such a banking panic occurs, the economy settles in a bad equilibrium. But if there is no broad crisis of confidence in the financial system, the economy may settle in a good equilibrium. Clearly, confidence can ultimately dictate the outcome. Economists use what are called models of multiple equilibriums to describe this process. In these models, the economy can settle in different resting points. The level of confidence becomes one variable that can determine which one of these points the economy settles in. Banking crises often triggered sharp and deep downturns in the 19th and early 20th centuries. The creation of the Federal Reserve in 1913 as a lender of last resort and the introduction of deposit insurance in 1933 greatly reduced runs in the banking sector. However, confidence continues to play an important role. It was crucial during the 2007–2008 financial crisis when investors worried about which financial institutions were solvent. Investment banks and other nonbanks were particularly vulnerable because they did not have the option of emergency borrowing from the Federal Reserve through the discount window. Confidence is also a vital factor in the current European debt crisis as investors consider the possibilities of sovereign defaults.

Over the past 10 years, macroeconomists have noted that confidence can also affect the economy if it is related to developments that might influence future economic performance. For instance, confidence could increase because of the emergence of innovative technologies that potentially boost future productivity and economic growth, as in the late 1990s or the 1920s. However, because such information is often very noisy, people may end up overreacting to it by being either too optimistic or pessimistic (see Jaimovich and Rebelo 2007). In macroeconomic models, this information changes people’s expectations about the future and thus their current economic decisions. Since it often takes time to deploy workers and build capital stock, businesses will add jobs and boost investment today in anticipation of future economic growth (see Den Haan and Kaltenbrunner 2009). In this way, optimism about the future can lead to an economic boom today, along the lines suggested by Pigou. But the boom may ultimately lead to a bust if new developments fail to fulfill the original expectations and sentiment sours.