As a recession looms over the country like a rain cloud, analysts have put in their two cents about what the economic climate will be. Headlines and news television stories alike have highlighted the possibility of an economic slowdown. A few weeks ago, this column even published a delineation of the problems emerging in our economy.
Yet, according to an article by The Economist, the media onslaught might actually be affecting developments, and perceptions of economic realities might be altered by analysts' slants on information. Their logic rests on one fundamental concept: expectations.
Look in any introductory economics textbook and you're bound to find some mention of expectations. Yet, the word and its meaning seem to float around discussions without careful explanation or any semblance of concrete, intuitive understanding. This is unfortunate, because some of the most unusual and fascinating developments in financial markets result from changes and shifts in expectations. Markets are driven by the minds of their participants, and without an understanding of this, much of what happens in the stock exchange, in the macro-economy, or even in classes at the University may go unnoticed.
Luckily, the concept of expectations is pretty simple, and a good way to start thinking about it might be to consider a typical class here at the University. Let's say that a number of students are taking a course offered by the history department, and the professor announces an upcoming examination. He states that the exam will be difficult but will be curved to fit a mean score.
In a way, students enrolled in classes with curved grades essentially all compete with each other. If enough of the students in the history class expect the test to be hard, they will study harder for it, and hopefully, their performance will reflect their extra effort.
But, since the grades are curved, with more people studying, it will become more difficult to achieve an A, and in real terms, the test will become more difficult. Thus, although this may not apply to all classes, if students think a test will be hard, and act appropriately, it will be harder.
Psychology affects outcomes and performances in any market is the fundamental idea behind expectations. Of course, it doesn't just apply to taking classes.
The stock market is perhaps the best example of how expectations influence outcomes in an economic sense. When a new company goes public and is about to issue equity shares on the stock exchange, expectations play a role in stock prices. If enough people think the stock will rise, and purchase it, the price will rise as demand increases.
In a way, there is a bit of mind over matter when it comes to financial markets. Psychological effects of equity ownership can outweigh earnings-based valuations.
The effects of expectations can be seen explicitly in the recent experiences of NASDAQ, from its unbelievable boom and to its subsequent nadir. When new dot-com companies started to issue stock in the late '90s, they surrounded their IPO's with notions of a new economy and the sex appeal of high-tech investing.
In many ways, the marketing of the "new paradigm" ideal altered investors' expectations. Thinking the revenues generated from the high-tech industry would grow exponentially, many investors sunk tremendous amounts in dot-com stocks, and their prices rose as a result.
More recently, criticisms of this new expectations-based economy philosophy have won out, and as dot-com startups are facing the reality that profits are necessary for their existence, their stocks have fallen as investors become more wary.
The implications of these mental effects can be stretched even further. What if you are a loan officer for the local bank? On your coffee break, your eyes catch headlines from The Wall Street Journal that suggest the economy is headed for the tank.
Your lending practices probably will change. You might not loan to riskier firms. You will stray from making investments in sketchy endeavors because, if a recession is coming, the loans your bank makes may not be repaid.
But this loan officer's expectation-based decisions ultimately will play a role in the economic slowdown. Since investments and loans were never made, firms suffer. They lay off workers, produce less, and the recession mentioned in The Economist happens.
The bottom line is that media expectations have an eerie way of manifesting themselves in reality. As the United States faces the possibility of an end to its period of record economic expansion, the biggest test it will face will be one of confidence. If enough people decide the economy isn't going to collapse and act on their convictions, the markets will bounce back from their lows, and the sluggish developments of late will improve.
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