Confidence may just be a trick of the mind

As the world economy emerges from the downturn, many assume there will be a corresponding growth in positive consumer sentiment.

There are conflicting theories whether consumer spending is directly hinged on current economic conditions.

With a Dubai World settlement having effectively been reached, the hope is that the fortunes of the UAE economy will start to recover. The indications are that growth last year was already not as slow as had been feared, with real GDP increase of 1.3 per cent reported over the weekend, and forecasts of up to 3.2 per cent growth for this year from the Ministry of Economy.

Central to these expectations is that confidence will begin to improve. As the clouds of uncertainty shift the theory goes that consumers, businesses and investors will be more prepared to make that marginal purchase or investment that they had previously held back from. But will this necessarily happen and, more to the point, is consumer confidence as important an ingredient in economic activity as one might believe it to be?

Consumer confidence or consumer sentiment is measured via surveys of consumers. In recent years a plethora of consumer confidence surveys have proliferated, starting in the US with the University of Michigan reading of consumer confidence and the Conference Board measure. Now such survey's have gone global, run by the likes of Mastercard as well as the Nielsen Company, analysing sentiment in virtually every country of the world.

The instinctive appeal of believing in consumer confidence as central to economic prospects is reflected in a recent book by the economists Robert Schiller and George Akerlof entitled Animal Spirits: How Human Psychology Drives The Economy And Why It Matters For Global Capitalism, a precis of which, by Schiller, appeared in The New York Times under the more succinct headline, "What if Recovery is all in Your Head?".

Schiller's basic argument was that if people start to think it's time for a recession to end, the very thought of it could start to make the recovery happen. In other words, a rise in consumer confidence will lead to consumers spending more freely at the shopping mall, buying more cars and refurbishing their homes. In economics terms, however, the arguments behind this idea are the subject of much debate. As ever, economists are divided on the issue. Standard theories of consumer behaviour attribute changes in consumer spending to current and expected fluctuations in income, wealth and interest rates, with little or no independent role for fluctuations in consumers' confidence.

As such, while measures of confidence can be analysed, the precise role of confidence in influencing consumers' decisions is difficult to pin down. Some theories suggest that sentiment independently causes economic fluctuations, while others hold that sentiment only forecasts economic fluctuations. In other words, sentiment may not be the cause of recessions or expansions but is, at best, a reliable predictor of them.

Other approaches ascribe an even more limited role whereby sentiment only reflects current widely known economic conditions. Unsurprisingly, studies have failed to convincingly come down in support of any of these hypotheses. In the past, a lack of consumer confidence has often been no barrier to consumer spending at the beginning of a recovery, just as the presence of rising consumer confidence particularly towards the end of a growth cycle is not necessarily a guarantee of continued spending.

Political developments may also alter consumer confidence in ways that have no effect on consumer's willingness or ability to spend, with sharp swings often seen in sentiment surveys following pivotal political and historical events such as wars and catastrophes. Yet economic arguments alone, with assumptions about rational behaviour, may also be crucially missing something. Accordingly, psychologists naturally contend that life is more complicated than simple economic theories suggest.

"There is no economy without psychology, so there can be no economic recovery without psychological recovery," according to Stephen Lea, an economic psychologist writing in a recent issue of the New Scientist magazine. Recessions make us all less well off on average but their impacts are very unevenly distributed. Some people suffer major effects such as losing their jobs or businesses, while the majority usually suffer only relatively marginal effects such as higher taxes.

Others may be affected only indirectly, by the mood of the recession as reported through the media, while others are hardly affected at all. As such, the impact of sentiment on each of these groups can be very different, determining very different economic responses. The art for policymakers, though, is to build confidence in those who can afford to act most confidently, so that the multiplier effects can also be more powerful in keeping money circulating and the economy growing. In applying these thoughts to the US, a fundamentally optimistic nation, it is even more appealing to believe in the power of psychology or positive thought.

Having lived and worked in the US 10 years ago, I can testify to the energy and exuberance that goes a long way to overcoming national challenges, be they economic, physical or political. Elsewhere, however, where trend growth rates are declining and population growth is slowing (such as in Japan or western Europe) the danger is of negative sentiment reinforcing sub-par economic trends. Of the 10 most confident countries in the Nielsen Global Consumer Confidence Survey Q1 2010, is it a coincidence that eight were emerging markets where trend growth rates are much higher and population trends still rising?

Against this background it is perhaps relatively unsurprising that consumer confidence in the UAE held up better than might have been expected though the crisis, even after Dubai World took centre stage. The UAE became the 10th most confident country in the world in the first quarter of this year, according to the Nielsen survey, up sharply from the fourth quarter of last year and even before a Dubai World settlement was proposed early last month.

Other surveys have provided similar evidence, showing that the UAE was among the most confident countries in the region as this year got under way. This might suggest that the UAE is also fundamentally an optimistic and positive nation as well, which should, perhaps, not be such a surprise either. With a young population uniquely drawn from all over the world, the default position of most people gathered here should be to look forward with a degree of optimism and confidence, at least for as long as they remain here.

Whether this confidence will translate into tangible economic recovery remains to be seen, however, and depends crucially on a number of other variables. Economists will no doubt continue to argue about the issue but from my experience it is probably better to have confidence on your side rather than not. Tim Fox is chief economist at Emirates NBD but is writing here in a personal capacity