Seeing false 'green shoots' causes recessions


It was known that an excess of optimism can have dire consequences for the economy, but there was no scientific proof of this. Precisely the father of welfare economics, the English Arthur Cecil Pigou, inventor of taxes on negative externalities (that is why they are called Pigouvian taxes), theorized in the 1920s that macroeconomic fluctuations may be due to the difficulties experienced by economic agents in correctly predicting the future. This theory is what is behind all those who think that they can prolong a period of economic boom by manipulating people's expectations.

The most recent case in Spain was that of the former president Rodriguez Zapatero that made the word 'crisis' taboo

because he believed that if he hid it, the economic difficulties would not worsen and the 'green shoots' would germinate everywhere. In October 2013, already out of power and on the occasion of the launch of his book 'El dilemma', he stated in an interview in La Sexta that "I was late in using the word crisis and it was a mistake, a clear mistake". And he added: "I don't think it affected what was the fight against the crisis, given the dimension."

Economic knowledge has come to overthrow his opinion. A study of economists Paul Beaudy Y Tim Willems, entitled 'On the macroeconomic consequences of over-optimism', has shown that over-optimism can prevent problems in the short term, but makes things worse in the long run. Studying the IMF's predictions for its 189 member countries, they conclude that "overestimating average annual growth by one percentage point reduces real GDP growth three years later by about one percentage point." They also found evidence of a causal link with a higher incidence of sovereign debt restructurings, banking crises, and economic downturns.

The mechanism confirmed by Beaudry and Willems would work as follows: excessive optimism would encourage a greater tolerance for debt, both public and private, which would introduce fragilities in the system that would be exposed to unmanageable over-indebtedness when (false) income expectations do not will materialize.

There are several recent examples. One is the case of the Portuguese crisis of 2010, which was very similar to the Spanish one. The imbalances were the result of large capital inflows resulting from the indebtedness of the Portuguese. These, according to the economist Ricardo Reyes, believed that "loans from abroad were the result of operations on account of future growth that convergence with Europe would generate." In Spain something similar was thought. The problems began to appear when mistrust of the euro tightened financing conditions. This mistrust was reflected in the famous 'risk premium'.

The case of Argentina is also cited. Investors, excited by the idea that Mauricio Macri would make deep reforms, they let him delay the fiscal adjustment and they allowed him to issue debt for 56,000 million dollars (9% of its GDP in 2017) between January 2016 and June 2018, including a 100-year bond! that the markets, pleased, swallowed. The flow of foreign capital raised the exchange rate and worsened the country's current account deficit. The situation of high external indebtedness with a twin deficit (current account and fiscal, similar to the one that occurred in Spain between 2009 and 2012) left the country exposed when financial conditions tightened and the IMF had to come to the rescue of Argentina, in June 2018, with the largest credit that has been given to a country in all of history.

Two ways are known that excess optimism can turn into a disaster. One is that expectations lead to overestimating the present value of wealth. This would facilitate over-indebtedness. This was the case of Argentina, Portugal and also of Spain. The other is the appearance of a false sense of security: the risks are underestimated. It also leads to over-indebtedness. In this last category, the authors cite a saying that is known in Spain: «The brick never goes down». This phrase was the Lord's Prayer of the Spanish real estate bubble at the beginning of the 21st century and of the famous 'subprime' mortgages in the US.

And what about those who underestimate expectations? Well, the authors suggest that being a bit more pessimistic could help avoid recessions. They cite, for example, the case of Chile, a country that was able to successfully overcome the aftermath of the 2008 financial crisis because it had made more modest predictions for the price of copper, its main export. The result is that the country entered the crisis with ample room for fiscal maneuvering, which allowed it to carry out countercyclical policies regardless of international financial conditions.

The effects of this study are seen much more clearly in emerging and developing countries because that is where the IMF's forecasts have more weight. The same does not happen in advanced economies, such as the US or Europe, where there are many more economic institutions pouring their predictions into the market.



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