Yes, there is a confidence fairy

Giles Wilkes does a good job of dismissing the idea that the "confidence fairy" is responsible for our economic recovery. I half agree.

I agree that "confidence" is a non-explanation for fluctuations in consumer spending. Such fluctuations can, for the most part, be explained by observable economic variables such as incomes, unemployment and credit availability, as John Muellbauer, for example, has shown. Insofar as spending is forward-looking, it's not because of confidence, but because consumers - in aggregate - have genuine foresight; this is why consumption-wealth ratios help predict equity returns.

So far, I'm with Giles. My chart show why I part with him. It shows that there's a close correlation between investment fluctuations and business confidence, as measured by the European Commission.

Of course, correlation isn't causality. It could be that both change for the same reasons - such as changes in interest rates and profits - or it could be that falling investment causes weaker sentiment.
But this is unlikely to be the whole story. There's a decent body of research which shows that sentiment, or animal spirits, affects investment. Central bankers agree with this. Here is Frederic Mishkin (pdf):

There is strong theoretical support for the management of expectations to stimulate spending when the policy rate hits the zero lower bound.

And here are Bank of England economists (pdf) on QE:

Asset purchases may have broader confidence effects beyond any effects generated through the effect of higher asset prices.

For example, QE might have worked - insofar as it did - by signalling that central banks were willing to do everything possible to ease the crisis, thus preventing an even more catastrophic collapse in in confidence. And the point of forward guidance is to give companies confidence that policy wouldn't tighten. As Mark Carney said in February:

Forward guidance is working. Expected interest rates have remained low even as the economy has recovered strongly. Uncertainty about interest rates has fallen. Most importantly, UK businesses have understood the message. Surveys [show that] virtually all businesses understand guidance, and almost three-quarters of them say it has boosted their confidence in UK economic prospects.

My point here is that one popular idea about the economy is 100% wrong. The media sometimes give the impression that consumers are like PR girlies, swayed by sentiment and "confidence" whereas business "leaders" are hard-headed experts. In fact, the opposite is the case. It is consumers, in aggregate, who are reasonable and bosses who are skittish and sentimental.

However, what we have here is an example of irrationality paying. Business confidence acts like a vengeful and capricious god does to primitive tribespeople; it must be appeased by regular sacrifices. As Michal Kalecki wrote:

Under a laissez-faire system the level of employment depends to a great extent on the so-called state of confidence...This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis.

Comments

[Luke]

Does the skittish sentimental tendencies of mega serious capitalists explain more about lack of investable opportunities than anything else?

(Please humour someone who just doesn't understand this "lack of profitable investment opportunities" stuff.)

[luis enrique]

I believe in a consumer confidence fairy of sorts. At least when a recession hits and people become uncertain about their job security and revise downwards their expected income, I can believe they consume less (this is part of a balance sheet recession - one reason why somebody may wish to pay off debts / decline new credit). And if I believe that, don't I also have to believe consumption will increase as people start to feel more confident? I don't expect to be able to see this in the data particularly strongly, because I'm thinking of a small gradual impact and also because it's closely associated with improvements in observables like income and unemployment, which some people take as alternative explanations but really I think are part of the same story.

[rogerh]

When I start up my car I drain energy from the battery and provided the engine starts then that energy is put back into the battery ready for next time. I have confidence that next time my car will indeed start because the system is simple and I know the signs of a failing battery. A government that prints money to start up an economy relies on a similar confidence - but if the economy does not start then more money-printing is needed until it does - a 'flat battery' is not a feature of a modern Western economy. Such a counter-intuitive process takes some getting used to.

Now suppose my car took say 10 minutes to start, during that time its value is declining and at then end of 10 mins if it don't start it becomes a heap of junk. Similarly the money printing process would seem to decline the foreign exchange rate - that country's value. Except that has not happened at least wrt Western democracies. If they were non-starting cars then Western democracies would all be worthless or nearly worthless junk by now but their relative value has not changed much, so money printing can continue.

So, a consumer listening to the endless engine-cranking is not filled with confidence. Business leaders may hope that one last turn of the key, a jump-start or a dose of Eze-Start will get the engine going, for business leaders know the whole game depends on putting up an appearance of confidence - especially as this car has a magic battery that 'never' runs flat.

[Jeff]

You are not describing the confidence fairy but something more like a stability-, integrity-, and/or energy- (demand-) "fairy". Obama gets all credit for the latter.

[jbakho]

Business investment in capacity rises when there is an increase in demand. Business investment plummets when demand plummets.

Risk of investment falls as capacity utilization approaches 100 percent. Investment can skyrocket when demand is far less than capacity.

Business confidence has everything to do with demand and is only indirectly correlated with interest rates. If rates stimulate demand, investment may increase based on higher demand. If demand is not there (as has been the case for many sectors this recession) the rates can go to zero but the confidence of business to invest will still be lacking.

[Kaleberg]

This isn't surprising. Wages are generally highly constrained and most people are just barely getting by. They have no choice but to spend rationally, especially now that credit is no longer available and their savings depleted. Businesses are rolling in dough thanks to the elimination of business taxes and massive subsidies. They can afford to play stupid games and hold popularity contests. Their decision makers are generally rewarded with super-jackpot lottery winnings no matter how stupid or damaging their decisions are. Why shouldn't they play and let everyone else die in earnest?

[djb]

krugman means that people who believe in making all the wrong economic interventions citing the confidence fairy are wrong

he does not mean that people who have confidence in rational policy are wrong

[urban legend]

I'm not sure how it is possible for "confidence" -- probably in particular, confidence of people without great wealth that money spent will be easy to replace by a continuing stream of income -- to not be an essential element of consumer spending. That is a definitional thing, however; it does not follow that our existing tools to measure that kind of confidence actually capture it apart from the hard data referenced. But how could business people be affected in their investment (spending) by confidence while consumers in their business are not? It makes no sense.

[Edis Bevan]

Otherwise known as the Violet Elizabeth Bott tactic. (from the Just William books - Violet Elizabeth was the girl who got her way by threatening to 'Thcream nd Thcream and Thcream til I am thick. So there!'

...This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis.

[chris]

@ urbanlegend - it is poss for confidence to matter for aggregate business investment but not for consumer spending, for 2 reasons:
1) Across millions of different consumers, confidence can cancel out; if I feel cheerful, you might not. Across companies, this is less likely because many CEOs have similar backgrounds and training, so their sentiment might be correlated.
2. A few individuals' spending barely affects aggregate consumer spending. But investment is lumpier, and so one or two multi-million projects can affect the total, and these can be sentiment-driven.

[Pablo Mira]

"...could be that falling investment causes weaker sentiment." Can you elaborate more? Seems strange: "I did not invest, so I feel depressed"