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Are recessions contagious?

We're in one of the longest economic expansions in history right now. So of course the forecasters are jumping off the bandwagon to predict the next recession.

The only thing though: economists are tragically unsuccessful at predicting recessions. According to the IMF, in the 1990s private economists only predicted correctly 2 of 60 recessions one year in advance. The US Federal Reserve has never correctly predicted a recession until the country was actually in one.  In a recent 2015 survey not a single major central bank could provide an example of a correct forecast. The survey covered the Federal Reserve, European Central Bank, BOE, BOJ and the Bank of Canada.

Hmmm so much for the study of economics. As I recently posted, the same resounding lack of success has also occurred in forecasting the outcome of M&A transactions. (“Behavioral M&A – Yahoo Needed It But Too Late Now”). So the failure applies to both macro- and micro-economics.

How do you explain the failure to predict recessions? The yield curve doesn’t work – you know the old joke about it forecasting 12 of the past 2 recessions right? So it looks like when you use traditional economics and finance techniques they just don’t work. Is there else something going on here? Do recessions occur as a result of something else that isn’t economic so isn’t captured in the normal economic data that all economies and countries use?

Many of you will be familiar with Occam’s razor – take the most simple way you can to solve a problem. The ways that economists use are anything but. There is a phenomenon to be predicted so use the simplest explanation not the most complex. But so far no-one has come up with anything.

It reminds me of what was, at the time, seen as Einstein’s biggest failure. He could see gravity at work but he couldn’t explain why. So he invented something to explain it – the ether. For years scientists saw it as somewhat dishonorable fudge until one day they discovered dark matter and dark energy. Voila he was right. Occam’s razor worked again!

So is there a parallel insight in economics? We need look no further than grand old man Lord Keynes. His explanation was simple – animal spirits. But this has always been seen as whimsical, again a dishonorable fudge that is unscientific because it can’t be defined and measured, except by surveys of consumer sentiment that don’t work anyway, at least not in advance.

So what might animal spirits be? Let’s say there’s something actually there. What is the essence of animals in the human view that might give us a better handle on them? Here’s a stab – irrationality. Could animal spirits refer to the level of irrationality in our collective thought compared with the level of rationality? Could the changing balance between the two explain when things go off the rails?

If it could it brings us to some exciting insights. First the Grand Old Man had already thought of behavioral economics and finance before Tversky and Kahneman. He had already understood that we can’t just explain economic phenomena by reference to rational human decision-making. He understood that sometimes our decisions will go into a period of irrational responses like irrational exuberance and then irrational depression that will overturn the economic system until we get our wits back again.

Second Keynes probably understood very well that irrationality was a prime mover, but he couldn’t figure out how to define and measure it. It was certainly beyond the scientific levels of the times, just as it still probably is now. So he gave it an airy answer just like Einstein. But that doesn’t mean he was wrong. Far from it.

The biggest thing he would have had to explain was, even if you could define and measure the level of irrationality in the collective decisions of consumers and business, why did it happen just at that particular time? Why not all the time? Or none? What caused it to happen just at that particular time and no other? Why does it happen every 5 years or 7? Why is there an economic cycle anyway? Or supercycle? What actually precipitates it?

We are probably no nearer to discovering that now than we were in Keynes’ time. But I am going to make a crazy, maybe intellectually suicidal stab. But first another thought about animal spirits.

Most commentators have interpreted the term as being about humans feel and act. And so it might be if we are talking about the level of irrationality in their collective decisions. But there could be another component. What component of these animal spirits were due to exactly that - the spirits of animals? Could there be a biological cause such as an infectious or contagious agent?

We have only recently become aware that many so-called mental diseases are actually caused by viruses. So until recently we didn’t even have the tools to research any connection between viruses and economic phenomena, even if we had thought of the connection, which we hadn’t. As of now our knowledge of the direct connection is still sketchy but the evidence is growing every day – see my blog post “The Invisible Pandemic”.

But here’s another angle. There’s now emerging evidence that there’s a new kind of infectious agent much smaller than a virus which can also cause disease. They’re called prions. They cause mad cow disease inter alia. There is emerging evidence they might be involved in causing Alzheimer’s. There’s also tantalizing evidenced that they might also cause other mental disease. But it’s very difficult to detect prions, and of course, no-one has been looking for them as a cause of recessions. But could prions be the animal spirits that Keynes had intuited?

I think it’s a reasonable hypothesis that Keynes was actually referring to the quality of decisions and the balance between rationality and irrationality in them when talking about animal spirits. But he wouldn’t have had a clue about infections or biological causes.

But now we know a lot more than we did now. We could actually do research to check out if prions (or some other biological agent) cause the change in mental state that precipitates recessions. Could a recession actually be caused by a pandemic of depressive thinking caused by a virus or a prion?

If so we would be able to move the study of recessions from the field of economics to that of public health. Recessions would be seen as being caused by them just as Zika can cause mental problems. Maybe insects are the vector for the biological agent that causes recessions? Or maybe it’s just us.  If so we would be able to solve the problem by well-established public health approaches.

Now of course you might think this is a crazy idea. Well, yes. But first let’s note that the combined efforts of thousands of very smart people with the best education on Earth doing a huge amount of research, much of it unbelievably esoteric hasn’t been able to solve this problem yet. Second I am giving an idea which can be tested empirically.

Maybe Keynes really was right about animal spirits, in all senses of the words, after all.

 

 

 

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Saturday, 18 November 2017

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