Crisis of confidence

Robert Shiller writes that a failure of confidence - as a result of the crisis in Europe, the Gulf oil spill or something else - could push the economy into another recession as a self-fulfilling prophecy. Shiller's argument draws from the logic of his book Animal Spirits (written with George Akerlof). Much as I respect Shiller and Akerlof, I found the book - and Shiller's argument in this piece - profoundly unconvincing. Animal Spirits' argument consisted of nothing but a sequence of "post hoc ergo propter hoc" fallacies. Repeatedly the authors point to evidence that confidence was falling during such-and-such a crisis and interpret it as support for the proposition that the decline in confidence caused the crisis. Not convincing at all.

Robert Lucas warned us to "beware of economists bearing free parameters," and "confidence" is the mother of all free parameters. There's certainly a logical argument to be made that changes in confidence can result in confirming movements in the real economy ("sun-spot equilibria"), but I doubt the actual economy is that fragile. A collapse in confidence is unlikely to cause a recession unless it confirms trends already in place in the real economy. The crisis of 2008 occurred in an economy already in recession. By contrast, the LTCM crisis of 1998 and the stock market crash of 1987 did not lead to recession because the economic fundamentals were strong. The 1937 recession, cited by Shiller as evidence for his argument, occurred not only because of a drop in confidence, but because of a contraction in fiscal and monetary policy.

That's not to say that Europe couldn't plunge the US back into recession. But if it does it will be because of the effect it has on bank balance sheets and lending, not because of its effect on "confidence."