Confidence spills over internationally.

Cyclical economic fluctuations can originate in (possibly nonfundamental) shifts in expectations about economic activity. This idea goes back at least to Pigou (1927) and Keynes (1936), who postulated that waves of optimism or pessimism might influence current economic conditions. For many years mainstream macroeconomic models have largely ignored the role of such factors as drivers of business cycles. More recent literature, both empirical and theoretical, attempts to formalize and quantify the impact of fluctuations in moods. As will be shown below, most studies document a highly significant role of such factors.

An important, related and highly relevant question is, whether confidence also spills over borders and affects cyclical fluctuations abroad. The importance and relevance of this question stems from three observations. First, that economic fluctuations between countries are highly correlated, so that obviously business cycles spill over borders (e.g., Gong and Kim 2018). Second, that confidence indicators are highly correlated across countries as well (Ha et al. 2020). Third, that the literature (with special emphasis on structural macroeconomic models) has a clear problem with explaining where such high correlation comes from. Neither the international real business cycle model (Backus et al. 1992) nor new Keynesian models (Justiniano and Preston 2010) can explain the high correlation of business cycles, unless productivity shocks are assumed to be correlated. Trade seems by far not sufficient to explain comovement, adding financial factors helps somewhat (Olivero 2010; Brzoza-Brzezina et al. 2018), but international correlations still remain a puzzle.Footnote1 This paper investigates the role of confidence in driving the international comovement of economies.

The literature on the role of confidence in driving cyclical fluctuations in a closed economy context is abundant. We use it to define the main concepts. Contemporaneous papers (at least a substantial share) distinguish two types of confidence shocks (see e.g., Barsky and Sims 2012).