Economics of Emotions: Revival of the psychological explanation of business cycles and possibility of boosting the economy by "brain training"
Consulting Fellow, RIET
Business cycles and psychological factors
Almost a century ago, several economists argued that business cycles are caused by changes in the psychological state of people. According to this argument, economic booms occur because people become overly optimistic and risk-loving, leading to an increase in investment, consumption, speculation, and bank lending; whereas recessions occur because people become excessively pessimistic, resulting in a decrease in the same areas. This type of argument was advocated by Arthur C. Pigou and Frederick Lavington, both British economists of Cambridge, while a similar argument was put forward by John M. Keynes using the term "animal spirits."
However, for many years thereafter, main stream economists gave little consideration to psychological factors in business cycles. Although It seems unclear whether or not main stream economists think that psychological factors are irrelevant to business cycles, it seems clear that the recession we face now is influenced by psychological factors; consumers become insecure and thus tighten their purse strings, companies become pessimistic and cut back on investment, investors are reluctant to purchase stocks due to pessimism, and banks hesitate lending money due to the fear of bad loans. Recently several economists, such as George A. Akerlof, Robert Shiller, Roger Farmer, and Paul De Grauwe have revived the psychological explanation of business cycles, referring to "animal spirits."
Economics of emotions
Data to validate the psychological explanation of business cycles is hard to come by due to the subjective nature of psychological states. Yet recent psychological and economic researchers have managed to come up with some circumstantial evidence.
First, within the realm of economics it is possible to explain that, to some extent, aggregate demand is larger when people are more risk-loving than risk-averse. Second, several psychological studies have found that people with negative emotions such as anxiety and depression tend to become risk-averse*1. Third, some evidence has been presented suggesting that emotions are contagious, i.e., when someone experiences anxiety, this emotion tends to spread to other people*2. These findings lead to the following hypothesis. Once seeds of anxiety are sown in a society, more and more people grow anxious due to emotional contagion and society as a whole becomes risk-averse. As a result, the economy slips into a recession. Reversely, when positive emotion spreads and people's anxiety is reduced, society becomes risk-loving, leading to an upswing in the economy.
In what follows, I would like to explain this economics of emotions in more detail, using a simple mathematical formula. Although there are various kinds of emotions such as anxiety, depression and anger, for the purpose of this study, I will simplify the classification of emotions into two categories - negative (depressed, anxious, pessimistic) and positive (happy, optimistic) - with the standard emotional level indicated by the numeric value of E. It is to be assumed that the lower the value of E, the more negative people's emotions become and the higher the value of E, the more positive people's emotions become. Furthermore, Y is national income measured from the viewpoint of demand, C is consumption, I is investment, R is interest rate, and G is government expenditure. It is assumed that the greater the value of E, or the more positive people's emotions become, the greater the values of C and I become. In terms of economics, this can be set out in the following formula:
Y=C(Y,E)+I(R,E)+G, ∂C/∂E>0, ∂I/∂E>0
According to economics of emotions, when E decreases for some reason, this decrease results in a fall in the values of C and I, which in turn would lead to a shortfall in demand, resulting in a recession. Increasing G would reduce the gap between supply and demand, thus stimulating the economy. However, unless the value of E rises, demand would fall below supply again when the increase of G ceases. In other words, a temporary boost in government expenditure for pump-priming the economy, unless it leads to an increase in E, would only be effective as a stopgap solution and the economy would once again slip into stagnation with the decrease of G. An increase in G unaccompanied by an increase in E, though meaningful in terms of making use of otherwise underutilized human and natural resources, would not be effective as a means of putting the economy back on track towards a full-fledged recovery. In order to bring about a full-fledged recovery, it is imperative to increase E. Conversely, this means that by implementing measures that will lead to an increase in E, a government will be able to lift the economy without increasing - or even when decreasing - its expenditure.
Stimulating economy by brain training
So, how can we improve the level of E?
A typical approach to this question would be to change external factors in order to alleviate negative feelings such as anxiety. A typical example of this approach is establishing a safety net system under which people are assured of collecting unemployment benefits when they lose their jobs and/or a generous and stable pension system that provides reasonable benefits. However, there is no guarantee that such changes in external factors will improve E for the whole population. Raising the level of unemployment benefits or pension benefits means that someone has to pay the resulting additional costs. People in their prime working years would end up footing the bill. But then, they would start worrying at the prospect of being forced to shoulder greater burdens and this might push down the overall level of E.
Actually, recent studies in the areas of psychiatry and clinical psychology have found that people's emotions are determined, not by external factors themselves, but by how the information processing system of human beings, notably the brain, reacts to external factors. A typical approach based on this finding is called cognitive therapy.
The basic idea of cognitive therapy can be found in the words of the Greek philosopher Epictetus, who wrote: "We are disturbed not by what happens to us, but by our thoughts about what happens." In other words, it is not an external event itself but people's thoughts in response to it that causes anxiety. For instance, media reports on the laying-off of temporary workers may cause some people to think, "I will be laid off too" and this thought leads to feelings of anxiety. Without this thought, there is no anxiety.
It has now become possible, at least to some extent, to increase E (people's emotions) without changing external factors by training the information processing system of human beings. Hereinafter, I will call this type of training "brain training." Cognitive therapy is a typical example of brain training; a cognitive therapist attempts to alleviate a patient's anxiety by helping them examine their thoughts which lead to anxiety.
The above explanation may be better understood using a flying phobia as an analogy. Some people are unable to travel by plane because they have a fear of flying. In a corner of their mind, they believe the plane carrying them will crash and this belief causes fear. How can we encourage them to take a flight? We would not try to reassure them by further improving the safety of airplanes. Airplanes are already safe. Danger of flying resides in the minds of the people who are afraid of flying. So, we would work on something inside them which made them feel anxious. Many types of brain training are used in order to alleviate a flying phobia or other negative emotions, including depression and pessimism.
Based on these considerations, it is theoretically possible for a government to increase E and bring about economic recovery, without resorting to massive fiscal measures, simply by spreading brain training in our society.
Challenges for economics of emotions
In reality, however, there are many challenges that must be overcome. First, a consensus has yet to be reached on which E-boosting (brain training) measures are truly effective and can be implemented at a reasonable cost. There are many methods which have been developed to alleviate negative feelings such as depression and anxiety. Many of them do not need any equipment in order to perform them. For example, in order to do cognitive therapy, all we need is a pen and a piece of paper. On the other hand, some methods need equipment. For example, an IT technology called neurofeedback requires a PC and some other equipment, therefore costs will vary depending on which method we apply. Regarding the effectiveness of these methods, there is medical evidence to support the effectiveness of cognitive therapy. However, it has been developed as a treatment technique for counseling professionals to help patients suffering from depression or anxiety on a one-to-one basis and we need a breakthrough in order for ordinary people to practice such techniques on their own on a wide scale. In addition, Japan has very few counseling professionals capable of using cognitive therapy. There is a range of potentially effective E-boosting measures other than cognitive therapy. However, most of these measures have been developed and offered by private companies and NPOs outside the medical world and the effects of such measures have not been statistically proven, although there have been many testimonials about their effectiveness. Extensive verification work needs to be undertaken to determine and identify measures that can be used relatively easily by ordinary people at a reasonable cost and it may become necessary to develop new technologies.
Second, even if we successfully identify some measures that can effectively increase E, we have yet to verify whether these measures are effective in increasing C (consumption) and/or I (investment). This verification is necessary because the psychological explanation of business cycles could be faulty and people with anxiety might turn out to be big spenders, drinking lots of expensive alcohol and going on shopping sprees to combat stress. It would not be easy to verify the effectiveness of the psychological explanation of business cycles on the whole population. However, once we manage to identify effective E-boosting measures, we can seek help from experts in experimental economics and psychology to carry out the remaining work. With their help, we would be able to verify, at least to some extent, the effectiveness of the measures. This can be done by comparing two sets of samples. First, we would identify two substantially similar population groups, one as a test group and the other as a control group. Then, we would ask only those individuals in the test group to practice a specific E-boosting measure, and examine whether and how their consumption and investment behavior differs from that of individuals in the control group.
Third, even if we manage to verify that a certain E-boosting approach is concretely effective in increasing the consumption and investment expenditure of individuals, this does not necessarily warrant the effectiveness of the approach as an economic stimulus. The measure needs to be practiced by a fairly large number of individuals in order to have a meaningful impact on consumption and investment expenditure on a nationwide scale. The question is whether such a large number of people would cooperate. Those suffering from serious depression or anxiety might be willing to cooperate, but those with mild symptoms may not.
Fourth, many people may dislike the idea of attempting to increase E under a government initiative and some may even regard such an initiative as brainwashing. Although I do not associate myself with this argument, I agree that it is preferable that an extensive and in-depth discussion takes place on this issue.
As discussed above, economics of emotions faces many challenges. However, if elevating the mood of the populace is the only way to bring about a full-fledged economic recovery, we cannot afford to avoid dealing with these challenges and should seriously look into economics of emotions including the possibility of using brain training. At the moment, the Japanese government makes almost no budgetary allocation for this kind of research and very few specialists seem interested in this area. I do hope that more people - not only members of academia and policymakers but also the general public - take greater interest in this area.
- *1 See, for example, George F. Loewenstein et al., "Risk as Feelings,"Psychological Bulletin, Vol. 127, No. 2 (2000), pp. 267-286; and Jon K. Maner et al., "Dispositional Anxiety and Risk-avoidant Decision-making." Personality and Individual Differences, Vol. 42, pp. 665-675.
- *2 See Hatfield, Elaine, John T. Cacioppo and Richard L. Rapson, Emotional Contagion: Studies in Emotion & Social Interaction (Cambridge University Press, 1994).
May 26, 2009
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