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CATCHING FEELINGS

Will the next recession be a self-fulfilling prophecy?

Reuters/Russell Boyce
Having a bad day.
  • Natasha Frost
By Natasha Frost

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Published This article is more than 2 years old.

CEOs are worried.

In a recent survey of some 1,400 global business leaders, the biggest fear of C-suite executives in 2019 is a recession. Another survey, by the Boston Consulting Group, found that 82% of investors were preparing for an economic slowdown, while a further 73% anticipated a recession in the next two years.

Gauges of consumer confidence in the US point to a general growing pessimism (paywall) about the state of the economy. Meanwhile, rattled Chinese consumers are swapping iPhones for cheaper alternatives, putting off car purchases, and opting not to travel as much.

If you share these concerns about the future, what’s the next step? It seems straightforward enough: You cover your back by reducing spending, in case you lose your job, your house loses value, or markets take a nosedive. If you run a company, you might do something similar: An anticipated drop in revenue spurs a push to cut costs and possibly even staff. General Motors, to give a recent example, offered voluntary buyouts to 17,700 employees late last year, before slashing 14,000 jobs.

Instead of preparing for a slowdown, careful spending can actually cause it.

But what may seem sensible in isolation adds up in aggregate: When consumers and businesses start spending less en masse, it creates the conditions that can spark a slump. Instead of preparing for a slowdown, it causes it. The next recession may be a self-fulfilling prophecy.

That’s despite the fact that consumers or businesses may have little to worry about. As the Conference Board, a think tank, recently observed, “economic indicators do not point to imminent recession risks” outside of the UK. In the US, GDP expanded by 3.4% last quarter, after the third quarter’s whopping 4.2% growth. Even taking into account the effect of ongoing trade tensions, it’s an undeniably healthy figure. Unemployment is the lowest it’s been in almost a half-century, and inflation remains under control.

Still, a lack of faith in what the Conference Board calls “traditional levers of power”—public policy and political institutions—is manifesting itself as a fear that leaders aren’t equipped to manage a potential economic crisis. Ironically, defensive spending tactics could be the quickest way to test that theory.

If you can dream it

Genuine crises, manmade or otherwise, often precipitate economic recessions. The drought that caused the Dust Bowl of the 1930s or the sudden drop in military spending after World War II are two examples. But sometimes it doesn’t take a shock of this magnitude to fluster consumers and investors.

In the summer of 2007, Ben Bernanke, then the chair of the US Federal Reserve, anticipated a modest economic decline, followed by growth throughout 2008. But investors, thrown by what they perceived as dangerous risks building up in the system, saw it differently—and decided to take matters into their own hands. The S&P 500 peaked in October 2007 and would bottom out nearly a year and half later.

“The increased risk that they had imputed to the system became a reality,” economist J. Bradford DeLong wrote in Project Syndicate. “Like triage nurses in an emergency room, they quickly assessed the patient and then ran with their initial diagnosis as if there were no other option.”

As the old Wall Street saying goes, it all comes back to greed and fear.

All over the world, people were spooked. Contrary to Bernanke’s prediction, output, consumption, and investment declined by similar magnitudes around the globe, even without the same impetus as the subprime-laden US. While some of this was due to how closely global financial markets are now linked, it doesn’t go far enough to explain the sharp shift in business cycles and expectations that followed.

Writing in the American Economic Journal, economists Philippe Bacchetta and Eric van Wincoop suggested that a much more important factor was “a demand collapse resulting from a self-fulfilling shock to expectations (or panic).” Even though their situations were different, policymakers and consumers around the world seem to have expected a similar nosedive in income and economic activity as in the US; when they adjusted their behavior accordingly, the predicted slump became a reality. This phenomenon is known as contagion—though there are those who argue that the effect of market interdependence (or how intertwined global markets are) is not given its due.

As the old Wall Street saying goes, it all comes back to greed and fear. But do we have to veer so sharply between the two?

Social psychologist Stephen Worchel, who works on fear and ethnic violence, describes the overlap in the type of fear that precipitates violence against a group and the kind that tanks markets. It’s circular, he says: “We begin to develop fear on an issue or about a group, and then we need to justify that fear.”

But because nobody wants to hold irrational fears, we seek out information that justifies our own fear-inspired belief, whether that’s selectively reading news stories or focusing only the outlets that hold similar views to our own. “They’re not looking for data,” Worchel says, “they’re really looking for stories that justify their fear.”

In the case of economic recessions, a whispered rumor about house prices weakening or company earnings underperforming might set off a chain reaction, where consumers seek out stories that confirm what they’ve already been told. It’s not enough to simply tell people that they’re wrong, Worchel says, or that they’re nothing to be scared of. “I’ll get further if I tell them, ‘yes, there can be that fear, and that can be dangerous, but here’s what you can do to reduce your fear. Here’s what you can do to try to address the issues that you’re fearful of.’”

How the threat of recessions begets recessions

In the US, where personal consumption accounts for almost 70% of GDP, any cut to household budgets has significant implications for the economy. China’s push to become a more consumer-focused economy (paywall) makes sentiment there similarly important to global growth. As confidence drops, spending goes with it.

A whispered rumor about house prices weakening or company earnings underperforming might set off a chain reaction.

Alan Greenspan, the former Fed chairman, generally adhered to the belief that people act according to rational self-interest. He warned of “irrational exuberance” as the dot-com bubble inflated, but nobody took it seriously, and stocks continued their climb. A few years later, once he had left the Fed, the bottom fell out of the US economy and the fingers of blame turned his way, Greenspan was forced to reckon with how the economic theory he espoused failed to account for the full scope of what took place.

In a 2009 Financial Times opinion piece (paywall), Greenspan described how he underestimated the human propensity to panic, and its effect on markets. When it comes to spending, there is “an innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own,” he wrote. “In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.”

What happens now?

Though we’re not facing an imminent recession, it might not take much to push people over the edge.

There are a number of events which could be enough to tip the balance, says Roger Farmer, an economist at UCLA and the author of Prosperity for All: How to Prevent Financial Crises. “Slowing growth in China, political tensions with China, events in Europe which could easily trigger a recession in Europe that then spreads,” he says. “We’ve got the Brexit debate going on in the UK right now, plus turmoil in France, immigration issues everywhere. Any one of these things could panic markets at some point.”

Although profit growth has been strong overall, earlier this year bellwether companies like Caterpillar and JPMorgan missed their fourth-quarter earnings targets. For the first quarter, analysts have been lowering their expectations across the board, predicting that profits for S&P 500 companies will shrink for the first time in a long time.

Simply telling people not to worry doesn’t seem to have much effect.

Mohamed El-Erian, chief economic adviser at Allianz, says that last year’s robust results shouldn’t necessarily be expected to be the new norm. “Last year was exceptional,” he told CNBC. “We had returns, no volatility, and every single correlation worked for the investor.” Being overly concerned about not matching those sparkling figures could mean “talking ourselves” into a recession, he said.

But simply telling people not to worry doesn’t seem to have much effect. One traditional way that central banks respond to potential downturns, giving confidence to markets and consumers, is by cutting interest rates. “But interest rates are so low now that they don’t have that ammunition,” notes Farmer of UCLA. Instead, “I think you should look out for unconventional responses to the next recession,” he says.

Creative actions following the 2008 financial crisis, including lending widely and purchasing risky assets, prevented the value of assets from dropping even more abruptly. Next time around, we may need even more ingenuity, especially when it comes to counteracting the narratives that risk becoming self-fulfilling.

Already, the Fed has been more explicit about its goals for inflation and is much more voluble than it was under Greenspan. It is not the only institution with the power to dent or boost confidence, but the unpredictability of the current administration in the White House has not made it a reliable partner. Still, the Fed does what it can: the hope is that people will listen to its carefully worded assessments, and that the information will make them feel less buffeted by forces outside of their control. In doing so, the goal isn’t just to tackle fear, but to take preemptive steps to stop the crisis this fear may trigger.

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