Social Epidemics and the Business Cycle

Did the phrase "green shoots" cause the recent turnaround instead of actual green shoots?  Just as fear spread during the credit crisis and caused a downward spiral, confidence is now spreading and spiraling higher, even if the actual data hasn't yet confirmed it.  Robert Shiller wrote an interesting column in the Sunday Business section of the New York Times yesterday that discusses the important role that "social epidemics" play in the business cycle.  It's a great read and below is a brief passage from it:

What happened? Economic analysts often turn to indicators like employment, housing starts or retail sales as causes of a recovery, when in fact they are merely symptoms. For a fuller explanation, look beyond the traditional economic links and think of the world economy as driven by social epidemics, contagion of ideas and huge feedback loops that gradually change world views. These social epidemics can travel as swiftly as swine flu: both spread from person to person and can reach every corner of the world in short order.

As George Akerlof and I argue in our book, “Animal Spirits,” the business cycle is tied to feedback loops involving speculative price movements and other economic activity — and to the talk that these movements incite. A downward movement in stock prices, for example, generates chatter and media response, and reminds people of longstanding pessimistic stories and theories. These stories, newly prominent in their minds, incline them toward gloomy intuitive assessments. As a result, the downward spiral can continue: declining prices cause the stories to spread, causing still more price declines and further reinforcement of the stories.

At some point, of course, the process must end, as when the market falls so low that it becomes enticing, or when new stories emerge. Similarly, an upward movement in stock prices generates its own upward feedback.

As Shiller mentions later in the article, confidence that things are getting better can be a self-fulfilling prophecy.  An initial upward movement in the market for whatever reason causes confidence to increase that in turn causes the market to go even higher.  As the market goes higher and higher, more and more people become more and more confident, causing business activity to pick back up again.  This is one of the reasons that the stock market acts as a leading indicator. 

We contend that the current turnaround in markets and confidence has been so quick because information and news spreads so much faster now than it ever has.  With individuals able to communicate in real time through social networking sites worldwide, and with a 24/7 news cycle, the social epidemics that Shiller writes of can spread much faster.  In turn, this causes turnarounds to occur much faster.  Information traveled slower coming out of each preceding recession, which meant social epidemics took longer and longer to form.  As communication technology gets better and better, we could be setting ourselves up for sharper and more contracted business and market cycles.

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