Narrative economics

Economists, financial market pundits and forecasters often think they are just observers of the facts. Most, I presume, would regard the assumption that the way they think about the world can also change it as being fanciful. Yet it only takes a bit of reflection to see that a lot of economics concerns self-fulfilling (or self-averting) phenomena.

An economy can go into recession when enough people think it will, for instance. Therefore, forecasters of all stripes have a responsibility. The economist Robert Shiller suggests that economics should be expanded to include the serious quantitative study of changing popular narratives in causing fluctuations in economic activity. As Shiller shows, the economics profession has had little to say about the role of narratives compared with other social sciences.

According to Shiller:

[The] human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.
Lack of information creates a vacuum for stories to breed, an environment in which a compelling narrative can capture the imagination. The more imprecise the estimate of the fundamental value of an asset, the more room there is for “stories” and “new economy” thinking to justify speculative prices. This same need for information redux is what pundits of all shapes feed on, whether in commodity markets or anywhere else.

Are narratives becoming increasingly based on false ideas or, at least, “alternative truths”? In an information vacuum, such as that which exists in commodity and other asset markets, then this is possible. According to Shiller, “A phishing equilibrium with a certain equilibrium acceptable level of dishonesty in narrative is established.”

False trends can arise when a narrative is founded on untrue assumptions, but the narrative is so strong it moves price action anyway. Then, as prices rise, it confirms the narrative in the minds of investors, which in turn reinforces the view they should buy into the increase in prices.

In the wrong hands, narratives can spread like wildflowers.

Related article: Batteries now included: You’ll meet a bad fate if you extrapolate

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