Tuesday, May 19, 2009

Creating Optimistic Beliefs Key to Tackling Global Recession

Posted by: Ananish Chaudhuri

(A version of this blog appeared as a "Viewpoint" article in the University of Auckland News on Friday, May 15, 2009.)

During this on-going economic crisis, a number of commentators have urged consumers to keep spending. Except, it’s not that simple. An individual consumer increasing spending makes no difference to the recession. What is required is for all consumers to increase consumption simultaneously. As a consumer, I might clearly understand that we can make a difference if we increase consumption, but how do I know if others will actually increase their consumption if I do so?

A wide variety of economic situations require coordinated action on the part of individuals or groups in order to achieve a successful outcome. Economists refer to these as ‘co-ordination problems’ and they arise, for instance, in any industry engaged in team production along an assembly line such as in steel mills and automobile factories.

Even if everyone works at speed, just one individual or group lagging behind is needed to slow down production significantly to the detriment of everyone else. This may not seem like a large problem, but in reality getting a large group of individuals to successfully coordinate their actions often poses a difficult challenge for many organisations.

While coordination failures at individual organisations may only be of passing interest, when they apply to the economy as a whole, all of us are affected. Economic recessions are to a large extent an outcome of wide-spread pessimism among businesses and individuals, rather than the result of inherent systemic problems. Creating appropriately optimistic beliefs is a key to addressing such crises.

One fundamental problem in deep recessions is that the economy gets caught in an under-employment trap...a situation where no firm wishes to expand production unless it can be assured that others will do the same - yet not doing so leads to an outcome that is worse for everyone concerned. The crux of the issue here is that taking a risky action makes sense if - and only if - everyone matches that action. If they don’t, then the individual or firm taking that risk is worse off and makes no difference.

Such a lack of coordination can also lead to a run on banks if depositors lose faith and rush to withdraw their money, even though everyone is better off if they keep their money where it is. Such loss of faith, which often tends to be self-fulfilling, can have devastating financial consequences.

Along with Andrew Schotter of New York University and Barry Sopher of Rutgers University, I recently used economic decision-making experiments to understand whether it was possible for groups to “talk” themselves out of such an under-employment trap. To do so we developed an innovative ‘inter-generational’ paradigm in which one group of players - after playing the game - could leave advice for their successors. This continued for a number of generations.

We found that allowing one group to pass advice to the next could indeed create the optimistic beliefs that led to coordination on the risky action, but with a twist. When the advice was private and given from one participant to his immediate successor, this advice tended to be pessimistic, suggesting following the least risky course of action.

In order for the advice to make a difference it needed to be public and common knowledge, in the sense that everyone in the group must get the same advice and must also know that everyone else has got the same advice. So if a political leader makes a public announcement heard by everyone, and everyone knows that everyone else has heard it, then a necessary condition has been met for successful coordination.

We conclude that getting a message to coordinate was not enough; each person must be convinced that others have received the same message and interpreted it in similar ways. A shared comprehension of the message is absolutely crucial to solving such coordination problems. Thus, in combating our financial crises, we really need to think of innovative actions or social processes that generate optimistic beliefs. This, in turn, suggests that economic stimuli packages might need to be accompanied by exhortative messages that clearly highlight the aims of these packages and are designed to reduce consumer pessimism.

These results appear in the January 2009 issue of the Economic Journal, which is published by the Royal Economic Society and is a leading international scholarly journal in economics.

In the context of the current crisis, an example of such a commonly perceived public announcement might be the one made by the British government early on of a plan for major equity injections into British banks, backed up by guarantees on bank debt that should get lending among banks going again. This may have gone a long way towards calming jittery financial markets.

The recent “jaw-boning” by Alan Bollard about banks passing on rate cuts to consumers and companies keeping prices down should also help. Another example of this is the recent announcement by the US Federal Reserve that not only was it cutting interest rates, but aiming to keep it at that level for the foreseeable future. In this regard, New Zealand may be well situated, given the population’s generally high trust in the government and other social institutions which makes public pronouncements more credible.

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