Interest Rates


There’s an important link between the state of confidence and trust in the economy and the sorts of narratives or stories that are being told about current economic conditions. One way to think about Australia’s near-term economic outlook, for example, is as a kind of contest between two competing narratives. The optimistic one is the story told by the RBA, of a stronger labour market, higher investment rates and continued economic growth. In contrast, the pessimistic narrative describes sluggish wage growth, falling housing prices and stressed consumer balance sheets. Which of these two narratives wins out will go a long way to determining the trajectory of the economy over the coming year. Of course, to a large extent the ultimate victory of one narrative over the other will reflect actual economic outcomes – what happens to the unemployment rate, wage growth, business investment, and house prices, for example – but it’s useful to keep in mind that there will also be a significant role for sentiment in determining the outcome.

We can also apply this style of analysis to longer-term views on Australia’s economic performance. Again, we can think of two broadly competing narratives here. Call the upbeat one of these ‘the Australian model’ and the downbeat version ‘the Australian bubble’. Until recently, the Australian model has been the winner in this contest of competing stories, despite a series of wobbles. But under current circumstances believers in the Australian bubble narrative will – once again – be hoping for their long-awaited vindication.


In the previous Weekly, we noted that the Westpac-Melbourne Institute Index of Consumer Sentiment (pdf) had fallen 4.8 per cent to 98.8 in March, its lowest level since September 2017. With the index back below 100, pessimists (slightly) outnumbered optimists, reflecting a significant deterioration in near-term expectations for the economic outlook, weaker views on family finances and a sharp increase in concerns about unemployment.


While these kinds of monthly indicators provide a useful gauge of economic sentiment, how much do big shifts in consumer or business confidence drive the overall economic outlook? In the narrow sense, we know that causality tests have found that measures of confidence such as consumer and business surveys do have some predictive power in terms of future economic activity. But we should keep in mind that it’s not clear that this is down to shifts in confidence per se, as it’s possible that these surveys might also be capturing views on current and expected future incomes, for example.

One interesting perspective on the general theme of confidence and the economy can be found in a short book by the economists George Akerlof and Robert Shiller which was published in the aftermath of the global financial crisis. In Animal Spirits: How human psychology drives the economy and why it matters for global capitalism the authors look back from the Great Recession of the early 21st Century to the Great Depression of the 20th Century to revisit a key diagnosis advanced by John Maynard Keynes: that much economic activity is driven by so-called ‘animal spirits’ and that these animal spirits are an important driving force behind observed economic fluctuations, particularly in times of economic dislocation.

Keynes used the phrase animal spirits to capture the swings in human emotions that influence consumer and business confidence in times of economic volatility, and he saw them as a key aspect of the decision making under uncertainty those times required. Decisions to invest or whether to buy or sell a (financial) asset were not simply the product of a weighted average of quantitative benefits and quantitative probabilities, Keynes argued, but were also influenced by emotions. Theory might say that investment decisions are driven purely by a rational calculus based on potential payoffs and the associated probability distribution, but in practice many decisions will also include an important element of sentiment or ‘gut judgment’.

Akerlof and Shiller build on this Keynesian idea to emphasis the economic role played by confidence and by the presence of feedback mechanisms between confidence and the overall economy. Traditional economic analysis often links confidence to the idea of multiple equilibria. For example, in their book the authors use the example of a possible dual equilibria applying to New Orleans after the disaster of Hurricane Katrina: there’s a negative equilibrium in which a lack of confidence that the city will recover would mean that little new building would take place and therefore few people would return to the city, and a positive one in which confidence in a future recovery is high, rebuilding therefore takes place and people move back. In this example, confidence can be thought of as making rational predictions about the future. But Akerlof and Shiller emphasise that it’s important to go beyond this idea of rational prediction to incorporate the idea of trust as intrinsic to confidence. That is, sometimes (maybe often) we might trust or believe that something will happen based on factors other than a probabilistic forecast: perhaps someone has given us their word, for example.

If the level of trust and confidence in an economy varies over time, that variability can itself play an important role in explaining overall economic fluctuations. In good times, levels of trust and confidence will be high, and people will tend to be more inclined to dismiss their suspicions and take more on faith. In this kind of environment, asset prices will tend to be bid up. But when trust declines, caution and suspicion will increase, people will be more inclined to investigate any claims or promises, and asset values may fall to lower levels.

Akerlof and Shiller also adopt and expand on the Keynesian multiplier concept, suggesting the existence of a ‘confidence multiplier’, which they define as the change in income resulting from one ‘unit’ change in confidence. Like the fiscal multiplier, this raises the possibility of chain effects, whereby a shift in confidence leads to a change in income which in turn leads to subsequent rounds of changes in income and confidence.

This approach to thinking about the economy includes a critical role for stories. We know that the human mind is keen on narratives, that is sequences of events with an internal logic and dynamic that fit together, and stories and storytelling are a fundamental part of human nature. We also know that politicians and media commentators (and economists!) tell stories about the economy all the time. To the extent those stories become accepted and gain traction among the wider community, it’s possible that confidence in the economy will be influenced by the prevailing stories that are being told about it. Akerlof and Shiller point out that one particularly popular set of stories in this context revolves around the idea of a ‘new economic era’ – often but not always associated with technological change, think the tech boom – which describes an historic shift that is seen as propelling the national economy into a new age of economic developments.

It’s possible to think about the spread of these kinds of economic narratives (which could be about a new economy, but could also be about the future of house prices, or about the prospects of a looming economic downturn) as similar to the spread of an epidemic, such that confidence (or its lack) can also spread through contagion-like effects. Real estate markets seem to be particularly prone to these kinds of effects, with large bubbles and substantial price volatility revolving around stories such as FOMO (fear of missing out in a rising property market) or FONGO (fear of not getting out in a falling one). More generally, economic recessions or depressions can be associated with fundamental changes in the level of confidence in the economy where the causality runs in both directions.

In more recent work (see his 2017 address to the American Economic Association – pdf or video), Shiller has continued to build on these ideas, making a case for what he calls ‘narrative economics’, which he defines as the study of the spread and dynamics of popular narratives, and their role in economic dynamics. Shiller argues that ‘narratives are major vectors of rapid change in culture, in zeitgeist, and ultimately in economic behaviour.’

But what does all this have to do with Australia’s economic outlook?

Well, one way to think about current economic prospects is in terms of a conflict between two conflicting narratives. The first and more optimistic narrative is the story that has been told by the RBA. This story says that the Australian economy is benefiting from a labour market that is delivering decent growth in employment, a significant upswing in public infrastructure investment along with prospects of stronger business investment, and a lift to external prospects from a competitive currency and strong income gains from resource exports. The second, and more pessimistic, story is that heavily-indebted Australian households are being squeezed by an extended period of sluggish wage growth and a decline in housing wealth, and that the consequent fall in consumer confidence – and ultimately consumer demand – will also serve to drag down businesses’ investment plans and growth overall.

We saw an interesting example of how this is playing out in the consumer confidence numbers discussed back at the start of this piece. Remember, those numbers showed a fall in consumer sentiment in March, which moved into ‘cautiously pessimistic’ territory. It turns out that one factor behind that drop was the release of the December quarter national accounts on 6 March and the subsequent media commentary about Australia falling into a so-called ‘per capita recession.’ According to Westpac, responses over the week of the survey showed a marked drop-off after the national accounts release: responses collected before 6 March had a combined index read of 100.7 while those collected after had a combined read of just 92.7, a fall of eight per cent that at least in part might have been driven by the ‘per capita recession’ story.

Another indicator of the scope for changes in the prevailing economic narrative comes in the form of google trends, where we can see a sharp spike in interest in the idea of a recession in the week beginning 3 March.


Which of these two competing narratives wins out will go a long way to determining the trajectory of the economy over the year ahead. Of course, to a large extent the victory of one narrative over the other will reflect actual economic outcomes – what happens to the unemployment rate, wage growth, business investment, and house prices, for example – but there will also be a significant role for sentiment. So, while things might not be quite so simple as the idea that we should be careful not to ‘talk ourselves into a recession’, we do need to be mindful of the potential economic consequences of marked changes in popular narratives about the economy.

Finally, it’s worth noting that this approach can also be applied to longer-term thinking about Australia’s economic performance. In their book, Akerlof and Shiller describe a series of big swings in the narrative around the Mexican economy as an example of the importance of national economic stories. In the case of Australia, we can think of two very different interpretations of our economic experience since the global financial crisis, and even before1. We can call the first of these stories the Australian model. This is an upbeat tale of how a flexible and adaptive Australia has been able to thrive in a turbulent global economy in which economic weight has been shifting to Asia. While other developed economies have struggled with crises and recessions, we have clocked more than a quarter of a century of recession-free growth (‘per capita recessions’ aside). The competing story is a much more cynical narrative, which claims that Australia has done little more than ride its luck and benefit from a series of – what would ultimately prove to be temporary – price booms, both in global commodity markets (thanks mainly to China) and in the domestic housing market (thanks again in part to China, but mostly due to low interest rates, lots of debt and the distorting impact on incentives from negative gearing and capital gains tax discounts. And maybe a housing boom narrative). Call this alternative story the Australian bubble.

Arguably, versions of these two stories have dueling each other in the media and in public debate more generally for well over a decade. Until relatively recently, the Australian model story has mostly been in the ascendant despite periodic media spasms claiming that the lucky country’s luck was about to run out. But the current housing market adjustment and the more recent shift to growth pessimism is now providing a new lease of life for the darker version of our economic narrative, and advocates of the Australian bubble view of the world will once again be searching for their moment of vindication.

1 This typology draws on a piece I wrote for the US magazine Pacific Standard back in 2013.