In a chapter of their new book, recommended by FP Big Thinker Paul Collier, George A. Akerlof and Robert Shiller explain why stories -- the human narratives we use to make sense of a complicated world -- are vital to understanding economics.
The human mind is built to think in terms of narratives, of sequences of events with an internal logic and dynamic that appear as a unified whole. In turn, much of human motivation comes from living through a story of our lives, a story that we tell to ourselves and that creates a framework for motivation. Life could be just "one damn thing after another" if it weren’t for such stories. The same is true for confidence in a nation, a company, or an institution. Great leaders are first and foremost creators of stories.
Social psychologists Roger Schank and Robert Abelson have argued that stories and storytelling are fundamental to human knowledge. People’s memories of essential facts are, they argue, indexed in the brain around stories. Facts that are remembered are attached to stories. We keep in mind a story of those memories, a story that helps define who we are and what our purpose is.
Politicians are one significant source of stories, especially about the economy. They spend much of their time talking to their public. In doing so they tell stories. And since much of their interaction with the public concerns the economy, so also do these stories.
A good example of this was the waxing and waning of economic confidence in Mexico, as analyzed by Wharton School doctoral student Stephanie Finnel. She finds that economic confidence in Mexico over the past 50 years reached a peak under the presidency of José López Portillo, who served between 1976 and 1982. He made Mexico itself the subject of an "underdog" story. López Portillo had published a novel in 1965 entitled Quetzalcóatl. Quetzalcóatl was an Aztec god, who, like Christ, was expected to make a reappearance at a time of great transformation. The novel was reissued in 1975, on the eve of López Portillo’s election campaign, and it became a story for Mexico’s future greatness, itself regenerated from the ancient Aztec tale. The presidential jets were named Quetzalcóatl and Quetzalcóatl II.
The story was all the more convincing because of two fortuitous events. First was the discovery of new oil reserves throughout the 1970s just before López Portillo’s presidency. As a succession of wells was drilled, proven reserves steadily rose. Expectations ran wild. Some even claimed that Mexico would eventually be second only to Saudi Arabia, with no fewer than 200 billion barrels of proven reserves. A second stroke of luck came with the second oil crisis, as the price of oil reached a peak in 1980 that was more than double its level compared with the early 1970s.
The idea of undreamt-of Mexican wealth took hold of people’s imaginations. Starting with his state of the union address in 1976, López Portillo stressed the importance of oil: "in the current era, countries can be divided into those who do and those who do not have oil." And he began to act like the president of a wealthy country, offering a Global Energy Plan to the international community, joining with Venezuela in the 1980 Pact of San José to sell oil at preferential rates to the nations of Central America and the Caribbean, and even offering foreign aid. In 1979 Pope John Paul visited Mexico, and the visit was widely interpreted as a sign. Mexico had become rich and important.
The confidence that López Portillo fostered led to economic prosperity. Mexican real GDP rose 55 percent over his six years as president.
Unfortunately growth faltered at the end of his term. When López Portillo left office in 1982 Mexico had 100 percent inflation and unemployment was growing. Corruption and outright theft reached unheard-of levels. In his effort to create the new Mexico, López Portillo had borrowed heavily against the oil still in the ground, driven the country deeply into debt, and brought about a severe economic crisis after oil prices fell in the mid-1980s. Yet he lived the story while it lasted.
It is generally considered unprofessional for economists to base their analyses on stories. On the contrary, we are supposed to stick to the quantitative facts and theory — a theory that is based on optimization, especially optimization of economic variables. Just the facts, ma’am. There is good reason to be careful about the use of stories. The news media are, after all, in the business of creating stories that people would like to hear.
But what if the stories themselves move markets? What if they themselves are a real part of how the economy functions? Then economists have gone overboard. The stories no longer merely explain the facts; they are the facts. To really explain Mexico in the 1970s, and indeed the ups and downs of most economies, one must look at the driving stories.
In fact, the confidence of a nation, or of any large group, tends to revolve around stories. Of particular relevance are new era stories, those that purport to describe historic changes that will propel the economy into a brand new era. Shiller’s Irrational Exuberance detailed the importance of the story of the invention and exploitation of the Internet (which became available to the public in 1994) in producing the stock market boom that lasted from the mid-1990s to 2000, which in turn led to an economic boom. This new technology was especially salient because of its presence in our daily lives. The stories of young people making fortunes were a contemporary reenactment of the nineteenth-century Gold Rush.
Confidence is not just the emotional state of an individual. It is a view of other people’s confidence, and of other people’s perceptions of other people’s confidence. It is also a view of the world — a popular model of current events, a public understanding of the mechanism of economic change as informed by the news media and by popular discussions. High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich. New era stories have tended to accompany the major booms in stock markets around the world.
The complexity of the different new era stories through time suggests that differences in confidence have had many effects on the economy beyond an impact on consumption and investment. Changes in these stories will affect the expectations for personal success in business, for the success of entrepreneurial ventures, and for payoffs to human capital investments.
We might model the spread of a story in terms of an epidemic. Stories are like viruses. Their spread by word of mouth involves a sort of contagion. Epidemiologists have developed mathematical models of epidemics, which can be applied to the spread of stories and confidence as well. For these models the essential parameters are the infection rate (a measure of the ability of the disease to be communicated from one individual to another) and the removal rate (a measure of the speed at which people lose their contagion). The essential initial conditions are the number of people who have the disease and the number of people who are susceptible to the disease. Given these, a mathematical model of epidemics can predict the whole course of the epidemic. But there is always uncertainty, as various factors, such as mutations of the virus, can change the contagion rate over time.
Just as diseases spread through contagion, so does confidence, or lack of confidence. Indeed confidence, or the lack thereof, may be as contagious as any disease. Epidemics of confidence or epidemics of pessimism may arise mysteriously simply because there was a change in the contagion rate of certain modes of thinking.