Smart consumers. stupid voters

What do ordinary folk know about economics? This question has been revived by Simon, who argues that support for a no-deal Brexit is based upon “information failure” caused by our biased and inadequate media. This is in a similar spirit to Jason Brennan and Bryan Caplan, who argue in different ways that voters are irrational and/or misinformed.

My chart offers a corrective to this view. It shows that the ratio of retail sales to share prices has been a fantastic predictor of equity returns since the current vintage of retail sales data began in 1996. The correlation between the ratio of retail sales to the All-share index and subsequent three-year changes in that index has been a whopping 0.76 since 1996.

Ordinary people, then, know something very important. In aggregate, they know where the stock market is going.

I’m not saying anything new or original here. My chart is merely a simplification of work by the Bank of England and by Martin Lettau and Sydney Ludvigson (pdf) which shows that consumer spending predicts equity returns.

There’s a simple reason for this. Consumer spending is forward-looking: if we expect good times, we’ll spend more than if we fear the sack or a pay cut. When spending is high, therefore, it predicts good times and when it’s low it predicts bad. For this reason, there’s also a strong correlation (0.48) between the retail sales-All-share ratio and subsequent three-yearly changes in manufacturing output, an indicator of cyclical conditions.

Of course, if you take any individual consumer, s/he might well be ill-informed or irrational. But across millions of them such errors will cancel out. There’s sometimes wisdom in crowds.

Now, you might object that my chart overstates this wisdom. Share prices tend to over-react, rising and falling too much. This means that their ratio to any stable indicator – even a time-trend – will also predict subsequent returns.

True. But irrelevant. The fact that shares over-react and can be predicted by consumer spending tells us that ordinary folk know more than the so-called expert fund managers who move share prices.

The people, then, can be smarter than elites.

How can we reconcile this with Simon’s depiction of many of them as know-nothings? Simple. There are, in my context, at least three big differences between consumers and voters.

First, consumers don’t need to know why things are happening. They only need a feel – often inarticulable – of what might happen. If we ask them in aggregate “where’s the economy going?” they can tell us. If we ask why, we might well get nonsense. David Leiser has shown one reason for this. People, he says, are terrible at making connections between economic events. For example, they fail to blame austerity for low returns on their savings. Instead, they often believe that good begets good. So, if you think Brexit is a good thing, perhaps for reasons independent of economics, you’ll be tempted to think it’ll have good economic effects: wishful thinking is powerful and ubiquitous.

Secondly, consumers have skin in the game whereas voters (as individuals) do not. If you spend too much or too little, you suffer. If you have a stupid opinion about politics, however, you don’t because your opinion doesn’t alter the outcome. In this way, consumers are incentivized to think whereas voters are not.

Thirdly, consumers’ errors are largely uncorrelated – except to the extent that there are peer effects or information cascades. Voters’ errors, however, can be correlated thanks to the influence of the mass media. One of the key conditions for there to be wisdom in crowds is therefore more likely to hold for consumers (at least in the circumstance I’ve described) than for voters.

All this poses a big and under-appreciated question: how might we change our political institutions so that we’ve more chance of mobilizing the disaggregated wisdom of people whilst filtering out the madness of crowds.

Representative democracy, with MPs acting as Burkean filters against poor judgment used to be one, albeit very imperfect mechanism. It’s now clear, though, that we need others which might well include some form of deliberative democracy (pdf). With a few honourable exceptions - such as Paul Evans - nobody seems much interested in this issue, however. As long as our side wins, we don't care about the rules of the game or its health. 

Comments

[Raphael Shirley]

What do you think about Idea Futures?

http://mason.gmu.edu/~rhanson/ideafutures.html

Could you do a post on it or perhaps some other means to put voters' skin in the game?

[Marble Bar]

Here's an even simpler reason than yours: people start spending less, share prices go down a bit later because companies aren't selling as much. What's that got to do with voter intelligence?

[rogerh]

How to run democracy - a tricky problem. I don't suppose most normal people care much who runs the country, so long as they don't make a mess of it.

A bit suspicious of spreading government around too much, localisation looks a dangerous road to go, too easy for the enthusiastic and those with axes to grind to capture power. After all, normal people don't want to turn out to a dank smelly town hall on a wet Wednesday night. There are enough nutters in politics without encouraging more.

Make elections every two years seems a cheap and simple way to keep their noses to the grindstone. The long term is merely a concatenation of short terms.

[Scurra]

@rogerh: Why not have elections every twenty minutes then? Where is a good place to draw the line? Elections every two years would certainly serve to keep MPs noses to the grindstone, but only to the effect of them having to be continually running re-election campaigns and not actually doing any governing. Of course one might argue that this would be a positive advance on the current situation.

[Brutto]

Seems to me that the logical conclusion would be that only taxpayers, who finance the system and have a stake in the outcome, should have a right to vote. Of course we are then on the slippery slope of whether voting should be weighted in proportion to taxes paid..still: looks better to me than the current system of influence based on party political contributions....

[Almar]

@Brutto: Once you allow for VAT and other indirect taxes, almost every adult is a taxpayer.

Almar

[John Davies]

Can we apply this logic to Brexit? That result tells us that, on balance, millions of people feel leaving the EU is going to be “better” for them. It’s a binary question that each individual adds their own mix of reasons to. I take the point that equity returns are not the same as economic growth, but we should also consider the fact/possibility that “better” includes non-economic considerations.

[FFB]

To me, there is also one huge point you forget : every person has 1 vote, but some people are richer than others and therefore have a larger influence on retail sales.

If 60% of the population is dumb but spends only 40% of the total money, you can have stupid votes but wise spendings...

[The Freeconomist]

The proposals for "Deliberative Democracy" you link to would merely be a plaster but not change the fundamental problem.

The fundamental problem is this: in a democracy you buy nothing but promises. You may know how one party ran the country for the past four years, but not how the opposition party might have run it. And nobody has an incentive to put any effort in making a good choice because whoever he/she votes for, his/her government will get determined by the other members of society.

Given that people are smart consumers and stupid voters, why not turn law - to a large extent - over to the private market, making a choice between different legal rules much like making a choice between different cars or different Internet providers.

In such a Polycentric Legal System, where people in the same country could subscribe to different legal codes, law would be a private good produced on a private market. - And market forces can be expected to lead to rapid improvement in the quality of law in general.

People could compare alternative brands – much like in the case of “normal” products. Information would be imperfect, as it is in making most decisions; people may make mistakes. But at least alternatives exist; they are there to be looked at. You could talk with neighbours who subscribe to a different legal code and compare costs and benefits.

[Lindsay Berge]

Off topic but the link for Why S&M? My Inspiration (http://www.darwilliams.net/music/tabs/WDYHITHS.html) seems to be broken.
This site can’t be reached www.darwilliams.net’s server IP address could not be found.
DNS_PROBE_FINISHED_NXDOMAIN

[rogerh]

Re more frequent elections. The snag with a five year cycle is that it allows a long period of doing nothing followed by promises for the next period followed by more doing nothing. Theoretically a decent opposition would offer an effective counter but in practice we have an opposition that plays exactly the same game or as now is totally unelectable. Meanwhile a five year period is long enough that voters forget what was promised last time and focus on the shiny new promises.

So shorten the cycle, not that difficult, Boris looks like running a quicky fairly soon (or not) because it suits him.