The Economic Consequences of Emotion

By Richard A. Posner

Economists refuse to call the economic downturn that began in the last month of 2007 a "depression" because it is not as serious as the 1930s depression as measured by decline in GDP, unemployment rate, and deflation. That is absurd. It would be like refusing to call the Korean War a war because there were fewer casualties than in World War II. But, the root error of the economists is failing to consider the emotional consequences of an economic downturn and how those consequences in turn generate both direct economic effects and indirect economic effects via politics. Behavioral economists such as Robert Shiller do talk about the effects of emotion on economic behavior, but their focus thus far as has been on booms ("irrational exuberance") rather than on busts. Keynes--ignored until the current crisis--discussed the economic dimensions of busts perceptively, emphasizing the dampening effect of economic uncertainty on investment and consumption; and we have seen that in the present crisis. Private investment has fallen precipitously, and consumption has flattened because fearful consumers are allocating more of their income to savings than in earlier years.

But there is another way in which emotion is affecting the economy. It is brought out in a striking article on the front page of The New York Times today on the growth of the most extreme element of the "tea party" movement--the element that believes the depression was deliberately contrived by the federal government in collusion with international finance. The article makes clear that the growth of this ultra-extremist fringe reflects anger over unemployment, foreclosures, and bank bailouts.

A fringe it will undoubtedly remain, but it is symptomatic of a deep public anxiety that is contributing to the inability of the federal government to deal with the nation's economic problems, grave as they are. It is becoming apparent that the Obama administration's response to the economic crisis has been a public relations disaster. I read somewhere that only 6 percent of the American people believes that the $787 billion stimulus program enacted last February has reduced the unemployment rate. This is almost certainly false, but reflects the administration's inability to explain the theory behind the stimulus, and its clumsy efforts to quantify the stimulus's effect. The administration has been unable to explain the bailouts of what it calls "fat cat" bankers, and the president compounded the difficulty recently by gratuitously approving publicly the multimillion dollar bonuses awarded leading bankers for their speculative 2009 profits, including the infamous (in the eyes of the public) CEO of Goldman Sachs.

It was inevitable that the depression was going to increase America's public debt, which had grown rapidly in recent years because of the Bush administration's fiscal incontinence. But had the administration not decided to ask Congress to approve a $1 trillion health care reform, the deficit would not have achieved the salience in public discourse that it has achieved. It is somewhat, though not completely naive, of people to think that running a high and growing deficit is as dangerous for a nation as for a a family (unless the nation is Greece), but it is an understandable reaction and again one the administration has been unable to counter. The administration is tongue-tied when it comes to explaining its economic policies, perhaps because it has no effective spokesman.

Public anger and fear are, I think, major factors in the congressional deadlock. The public has no confidence in any governmental measures, and this gives free rein to lobbyists to use their considerable skills, and the financial resources of their clients, to block legislative action.

At this writing (an important reminder--because at present U.S. politics are exceedingly volatile), it seems unlikely that significant further economic recovery measures will be enacted, because they would add to the deficit, at least in the short run, and because of public skepticism of stimulus. At the same time, it is unlikely that any measures will be taken to bring future deficits down. The slower the recovery, the greater the deficit; but recovery measures are deficit spending; and economic science has not evolved to the point at which the net contribution of further recovery measures to the deficit can be calculated. So there are no compelling reasons that can be offered pro or con further measures. Meanwhile the deficit swells, but apart from inflation it can be brought down only by higher taxes, reduced government spending, or a higher rate of future economic growth. None of these seem politically feasible at the moment; and the president's recently announced budget proposal to Congress essentially accepts the indefinite continuation and augmentation of an uprecedented federal deficit.

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