In the day job, I point out that the ratio of consumer spending to house prices has done a reasonable job of forecasting medium-term GDP growth, and that right now it is pointing to weakish growth.
Granted, this might in part be because of the denominator. When house prices are high – a low ratio in my chart - they subsequently fall and this depresses GDP via collateral effects (pdf) if nothing else.
But there might be something else going on. Consumer spending should be forward-looking. If so, low spending will be a sign that consumers expect bad times. And it’s possible that, across millions of consumers, errors in expectations will roughly cancel out: unless there are strong peer effects, the individuals who are wrongly optimistic will be balanced out by those who are wrongly pessimistic. To the extent that this is the case, aggregate spending will predict economic growth.
This shouldn’t strike you as outlandish. In the same spirit, Sydney Ludvigson and Martin Lettau have shown that consumer spending can predict (pdf) equity returns in the US, and Bank of England economists have corroborated this in the UK (pdf).
In fact – given economists’ inability to foresee recessions – it’s possible that consumers, in aggregate, are better economic forecasters than the professionals. Perhaps aggregate spending does what Friedrich Hayek claimed the price system does: it collects the dispersed, fragmentary and partial knowledge of millions of people into meaningful signals. Just as the decentralized price system embodies more knowledge than any central planner, so aggregate spending knows more than any centralized forecaster.
I don’t say this to make an economic forecast – though it’s worth noting that the consumption-house price ratio is sending a similar message to our record current account deficit. Instead, I do so to question the “nudge” agenda. This presumes (pdf) that wise and rational policy-makers can correct the follies of irrational lay-people. What we have here, though, is evidence that lay-people might (on average and in aggregate) know more than experts.
This is not the only evidence. The field of behavioural political economy – and, I guess, world history – reminds us that elites are as prone to cognitive biases as everyone else. As William Easterly has said:
Experts are as prone to cognitive biases as the rest of us. Those at the top will be overly confident in their ability to predict the system-wide effects of paternalistic policy-making – and the combination of democratic politics and market economics is precisely the kind of complex and spontaneous order that does not lend itself to expert intuition.
This is not to defend the simple-minded assumption that market agents are always rational. Instead, I suspect that irrationality, like intelligence, is context-specific: rational consumers (in my very limited sense of the phrase) might be irrational voters. The trick – in our personal lives as well as in economic research and policy-making – is to know when and how particular environments generate cognitive biases and when they don’t.