Stumbling and Mumbling

Author: chris dillow   |   Latest post: Tue, 26 May 2020, 2:30 PM


Narrative Economics: a review

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For years, thinking about economics has been heavily influenced by the idea of homo economicus - that people are rational and well-informed. Robert Shiller's latest book, Narrative Economics, is an attempt to replace this conception with that of people as homo narrans (pdf) - story-telling animals. He writes:

Ultimately, the mass of people whose consumption and investment decisions cause economic fluctuations are not very well informed. Most of them do not view or read the news carefully, [and they'd be little better informed if they did - CD] and they rarely get the facts in any discernable order. And yet their decisions drive aggregate economic activity. It must be the case, then, that attention-getting narratives drive these decisions.

Much of the book (which is an extension of an earlier paper (pdf)) is an enjoyable and well-informed description of such narratives. I especially liked his discussion of bimetallism, wherein he shows that Brexit is not the first debate about an abstruse issue which triggered a culture war - although bimetallism has the advantage of bequeathing us the Wizard of Oz. Wizard-of-Oz

There's one Big Fact which is consistent with the idea that narratives drive economic activity. It is that asset prices are prone to momentum. This is especially the case in the housing market. Since Nationwide monthly data began in 1991, there has been a significant correlation (of 0.45) between annual inflation in one period and in the next. And Meb Faber has shown that a simple rule of buying equities when prices are above their ten-month moving average and selling when they are below it has beaten a buy-and-hold strategy - something which applies to UK and emerging market stocks as well as the S&P 500.

One reason why momentum exists could be that prices are driven by narratives and that these spread like epidemics - a point previously made (pdf) by Christopher Carroll. A story that's driven prices up in one period can infect other investors and so drive prices up in the following period.

Perhaps, then, homo economicus is itself an example of narrative economics, a story that has gained hold - - as Katrine Marcal has argued.

For me, this raises three issues.

One is: what causes some narratives to go viral whilst other don't? It is not merely their truth-value: the Laffer curve and the Great Moderation were both popular stories too. Shiller says there's a big random element to whether a story will take hold:

Just as it is difficult or impossible to predict which motion picture will be a box office hit, it is difficult to predict which narrative will eventually have economic impact.

Again, a Big Fact is consistent with this. It is that economists have consistently failed to forecast recessions - which might be because they've under-rated the role and spread of narratives.

A second issue is: how consistent is all this with homo economicus?

On the one hand, it might merely add substance to max U stories: it is narratives that form our tastes (not least for risk) and shape expected returns; think of the stories that drove up tech stocks in the late 90s.

On the other hand, though, stories are dangerous. They encourage us to see patterns and to overlook randomness. We thus get an illusion of knowledge and hence overconfidence. And so we take on more risk and buy more speculative stocks than a rational investor might. In this way, homo narrans is at war with homo economicus.

My third issue is: if narratives matter to people in their economic lives, when their own money is at stake, might they be even more influential in areas where individuals have less skin in the game? Perhaps narratives matter more in politics than in economics. Which, given that their popularity is not a function solely of their truthfulness, might be a problem.

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