Narrative Economics: a review

For years, thinking about economics has been heavily influenced by the idea of homo economicus – that people are rational and well-informed. Robert Shiller’s latest book, Narrative Economics, is an attempt to replace this conception with that of people as homo narrans (pdf) – story-telling animals. He writes:

Ultimately, the mass of people whose consumption and investment decisions cause economic fluctuations are not very well informed. Most of them do not view or read the news carefully, [and they’d be little better informed if they did – CD] and they rarely get the facts in any discernable order. And yet their decisions drive aggregate economic activity. It must be the case, then, that attention-getting narratives drive these decisions.

Much of the book (which is an extension of an earlier paper (pdf)) is an enjoyable and well-informed description of such narratives. I especially liked his discussion of bimetallism, wherein he shows that Brexit is not the first debate about an abstruse issue which triggered a culture war – although bimetallism has the advantage of bequeathing us the Wizard of Oz.  

There’s one Big Fact which is consistent with the idea that narratives drive economic activity. It is that asset prices are prone to momentum. This is especially the case in the housing market. Since Nationwide monthly data began in 1991, there has been a significant correlation (of 0.45) between annual inflation in one period and in the next. And Meb Faber has shown that a simple rule of buying equities when prices are above their ten-month moving average and selling when they are below it has beaten a buy-and-hold strategy – something which applies to UK and emerging market stocks as well as the S&P 500.

One reason why momentum exists could be that prices are driven by narratives and that these spread like epidemics – a point previously made  (pdf) by Christopher Carroll. A story that’s driven prices up in one period can infect other investors and so drive prices up in the following period.

Perhaps, then, homo economicus is itself an example of narrative economics, a story that has gained hold - – as Katrine Marcal has argued.

For me, this raises three issues.

One is: what causes some narratives to go viral whilst other don’t? It is not merely their truth-value: the Laffer curve and the Great Moderation were both popular stories too. Shiller says there’s a big random element to whether a story will take hold:

Just as it is difficult or impossible to predict which motion picture will be a box office hit, it is difficult to predict which narrative will eventually have economic impact.

Again, a Big Fact is consistent with this. It is that economists have consistently failed to forecast recessions – which might be because they’ve under-rated the role and spread of narratives.

A second issue is: how consistent is all this with homo economicus?

On the one hand, it might merely add substance to max U stories: it is narratives that form our tastes (not least for risk) and shape expected returns; think of the stories that drove up tech stocks in the late 90s.

On the other hand, though, stories are dangerous. They encourage us to see patterns and to overlook randomness. We thus get an illusion of knowledge and hence overconfidence. And so we take on more risk and buy more speculative stocks than a rational investor might. In this way, homo narrans is at war with homo economicus.

My third issue is: if narratives matter to people in their economic lives, when their own money is at stake, might they be even more influential in areas where individuals have less skin in the game? Perhaps narratives matter more in politics than in economics. Which, given that their popularity is not a function solely of their truthfulness, might be a problem.

Comments

[georgesdelatour]

Chris

Can I just say your recent posts - like this one - are really, really good. Great work!

I think the idea that we are first and foremost storytelling creatures is extremely plausible. Maybe we should think of the flaws in our theories as if they were plot holes.

[Frank Wilhoit]

What would be the Latin for humans with an emotional age of five seconds, trapped forever in the birth trauma and consumed, to the exclusion of any other thought, in the emotional compulsion to exact revenge for it?

[georgesdelatour]

Historical parallels with Brexit are tricky. I wonder if Joseph Chamberlain’s campaign for Imperial Preference (and, ultimately, for Imperial Federation) may be useful.

It’s amazing to realise that splits over an issue we’ve largely forgotten doomed Arthur Balfour’s government to defeat in 1906, and were a major factor in the political dance between Baldwin and MacDonald in the inter-war years. Chamberlain conjured up the same demons back in 1906 as Guy Verhofstadt just did in his recent pro-imperialism speech to the LibDem conference: that if we don’t federalise into a larger political unit, foreign powers will overwhelm us. For Chamberlain it was Germany and the USA; for Verhofstadt it’s Russia and China. There are, of course, striking similarities between Chamberlain’s federal ideas and Jean Monnet’s. I suspect Arthur Salter was the transmission vector.

[Candas]

I found this via the FT’s Alphaville where they have a daily must read column. Today they linked to the following article in americanaffairsjournal.org "The Financialization of the American Elite”:

"Legal scholar Lynn Stout has argued that shareholder primacy’s rapid advance towards general acceptance is the result of a convenient alignment of interests between disparate interest groups during the 1980s and early 1990s.12 The first group to latch onto the idea was academics—business and law professors as well as economists like Jensen—who saw that “shareholder primacy offered a simple story about corporate structure and purpose that could be easily taught to students who innocently asked the complex question, ‘what are corporations for?’”13 The idea also gained steam among researchers, for it offered a seemingly elegant way to measure the results of business strategies or initiatives: a corporation’s share price either went up or down.”

Some stories have lasting effects that we can’t even fathom.

https://americanaffairsjournal.org/2019/08/the-financialization-of-the-american-elite/