The Problem with Measuring "Consumer Sentiment"

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Published : July 03rd, 2020
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According to the University of Michigan, the US consumer sentiment index rose to 78.1 in June from 72.3 in May. Many experts see the increase in the index as an important indicator regarding the likely course of the US economy in the months ahead.

To gain insight into the economic future, many economists follow a variety of consumer and business surveys. In these surveys, randomly selected consumers and businesspersons are asked to provide their views about where the economy is heading.

If a survey shows that the majority are optimistic, this is supposed to be good news for the economy. Conversely, if the majority of the surveyed are pessimistic, it is seen as a bad omen for the future.

Is it valid to assume that surveys can tell us where the economy is headed? Defenders of surveys argue as follows. Knowledge regarding future economic conditions is dispersed, so the chances of any one particular individual obtaining an accurate picture of the economy are very low. However, a large group of people selected randomly is more likely to yield the most accurate picture possible.

It is quite possible that a group of people will have in its possession more information than any given individual. However, more information does not necessarily mean that the information will be qualitatively more accurate. To separate the wheat from the chaff, the information must be processed by means of a theoretical framework.

Data without Theory Is Useless

Whether a forecast "makes sense" is determined not only by the amount of information available, but also whether a theory, or a thinking process, is in tune with the reality. As long as the individuals surveyed have not disclosed the theories behind their views, there is no compelling reason to regard various confidence or sentiment surveys as the basis for an accurate assessment of the future state of an economy.

Given the idea that expectations are the key driving force of the economy, many economists hold that "positive" thinking and a large dosage of "good" news can prevent bad expectations from developing. Individuals are seen as driven by a mysterious psychology that is susceptible to wild swings. It then becomes crucial not to upset this psychology in order to keep the economy prosperous.

This is why when the economy falls into a recession, economists quoted by the press are often very guarded in their speech. On this Rothbard wrote in “Economic Depressions: Their Cause and Cure,”

After the disaster of 1929, economists and politicians resolved that this must never happen again. The easiest way of succeeding at this resolve was, simply to define "depression" out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937-38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: "recession". From that point on, we have been through quite a few recessions, but not a single depression.

But pretty soon the word "recession" also became too harsh for the delicate sensibilities of the American public. It now seems that we had our last recession in 1957-58. For since then, we have only "downturns", or, even better, "slowdowns", or "sideways movements". So be of good cheer, from now on, depressions and even recessions have been outlawed by the semantic fiat of economists; from now on, the worst that can possibly happen to us are "slowdowns". Such are the wonders of the "New Economics."

Again, this gentle talk stems from the fear that harsh language will upset people's confidence. If people’s confidence is kept stable, then stable economic activity will follow.

The Problem with Basing Everything on "Expectations"

What matters is not the stability of expectations as such but whether these expectations correspond to reality. What is to be gained if every individual has been brainwashed to believe that things are fine while in reality the economy is falling apart?

Stable expectations are said to imply economic stability, so many economists strongly recommend that government and central bank policies be "transparent." If policies are made known in advance, surprises will be avoided and volatility will be reduced.

Let us assume that the government presents a plan to raise personal taxes. How can the mere fact that this plan is made known to everybody prevent an erosion of individuals' living standards? Even if politicians could succeed in convincing people that the tax increase is good for them, they cannot alter the fact that individuals' after tax incomes will be reduced. Alternatively, let us say that the central bank makes it public knowledge that it will dramatically increase the money supply. How can the simple publication of this information prevent capital consumption and the development of a boom-bust economic cycle?

Stable expectations cannot undo the damage caused by loose monetary policies or by higher taxes. Moreover, irrespective of whether individuals are successful in identifying the facts of reality, opinions about facts do not change the facts themselves.

If we identify that people's real incomes are declining, this is a fact of reality. Regardless of people's views and their confidence, it is this fact that will force the decline in consumer outlays. The fall in consumer outlays is not caused by the fall in consumer confidence, as the popular thinking appears to have it, but by the fact that consumers can no longer afford their previous level of outlays.

Experactions in a Free Economy vs. a Hampered Economy

Consumer expectations do not emerge in a vacuum, but are part and parcel of every individual's evaluation process, which is based on his views regarding the real world. In a free and unhampered market economy, whenever individuals form expectations that run contrary to the facts of reality this sets in place incentives for a renewed evaluation and different actions. The market will not permit prolonged mistaken evaluations.

Let us assume that as a result of incorrect evaluation too much capital was invested in the production of cars and too little invested in the production of houses. The effect of the overinvestment in the production of cars is to depress profits, because the excessive quantity of cars can only be sold at prices that are low in relationship to the costs that went into making them. The effect of underinvestment in the production of houses, on the other hand, will lift their prices in relation to cost and thus will raise their profit.

This process will lead to a withdrawal of capital from cars and its channeling toward houses, implying that if investment goes too far in one direction and not far enough in another, counteracting forces of correction will be set in motion.1 In a free market the facts of reality will assert their dominance fairly quickly through people's evaluation and therefore their actions.

This is, however, not so in a distorted market economy. By enforcing their policies, governments and central banks can set a platform for a prolonged deviation of expectations from the facts of reality. However, neither the government nor the central bank can indefinitely defy these facts. A classic case of this is the artificial lowering of interest rates by the central bank, which results in boom-bust cycles.

We can conclude that in a free, unhampered market economy, individuals' expectations will have a tendency to change in tandem with real market conditions. This is in contrast to a hampered economy where government and central bank policies give rise to expectations that are out of sync with reality. Furthermore, what matters is not whether government and central bank policies are transparent, but whether these policies hurt individuals' well-being.

The popular view, that by means of opinion surveys one can discern the future direction of an economy, is problematic. The fact that a large group of people has expressed an opinion regarding future economic conditions does not make that view more accurate than the view expressed by any particular individual.

What matters here is not how many people have participated in an opinion survey, but the framework of thinking they have employed in backing up their views. As long as their framework of thinking is not disclosed, we should ensure that we are not too swayed by opinion surveys.

Source : mises.org
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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.
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