Self-fulfilling economies

In my 26 years as a professional economist I have never experienced such widespread pessimism about the economic outlook as now. We are entering the fourth year of the largest real income squeeze seen in the UK since the Second World War while GDP remains 4 per cent below the peak it reached in early 2008 and something like 12 per cent below where it ought to be if based on the pre-crisis trend.

On top of that, the situation in the euro area marks a clear and present danger. Muddling through has avoided catastrophe for now, but a collapse of the European banking system is a real possibility in 2012.

But to invoke Franklin D Roosevelt, perhaps the greatest thing to fear is fear itself, especially when much of it stems from disappointment. As the chief economist of the International Monetary Fund Olivier Blanchard pointed out recently, this time last year we were in recovery mode. Most forecasts were pointing to solid if unspectacular growth in 2011. But then the eurozone tanked and our collective spirits sank.

Blanchard draws a couple of important conclusions. First, he says: “Post the 2008-09 crisis, the world economy is pregnant with multiple equilibria - self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.”

Second, he says: “Perception moulds reality.” He was talking about the euro crisis, where fears of government default threaten to become self-fulfilling when markets send bond yields to levels that render governments insolvent. But the point also applies more generally: the fear of ­recession can push economies into recession.

Now this is quite racy stuff for economists (we don’t get out much). We tend to focus on ’fundamentals’, measurable things such as productivity or aggregate demand. We imagine that ’shocks’ to those fundamentals cause booms and busts. That approach doesn’t leave much room for ephemera such as ’confidence’ to affect the economy independently and so we end up assuming that no one can ’talk the economy up or down’.

But I suspect that ’talking the economy down’ has been an important factor in the most recent leg of the slowdown. Now, don’t get me wrong, I’m not saying the dangers aren’t real. The euro area is crocked, the financial crisis has left the economies of the West in a very fragile state, and key decision makers have messed up (take note, the European Central Bank). But that very fragility also leaves economies vulnerable to waves of pessimism, so there’s a very real danger of talking ourselves into depression.

In these circumstances, policy makers bear an unusually heavy burden. Not only must they get policy right, but they must ensure their communication is honest and even-handed. Whisper it, but some of the very latest data suggest the world economy might be entering the New Year in better shape than seemed likely only a month ago. On second thoughts, don’t whisper it. If I’m right, the more people hear the good news as well as bad, the more likely it is we all avoid a slump.