It's not something economists emphasise. Indeed, they prefer not to think about it because it reminds them of the limits of their so-called science. But the peregrinations of the economy are as much about psychology - moods and feelings - as tangible economic forces.
It's not something economists emphasise. Indeed, they prefer not to think about it because it reminds them of the limits of their so-called science. But the peregrinations of the economy are as much about psychology - moods and feelings - as tangible economic forces.
When you view the economy from outside, what you see is might and power.
Big corporations with towering offices, branches in every suburb, huge factories, gleaming shopping complexes, thousands of employees, annual turnover of hundreds of millions of dollars.
Then you have the big governments supposedly running the show. The federal government spending a budget of $360 billion a year.
The Reserve Bank moving interest rates up, or down, at will. The total value of all the goods and services Australia produces in a year is $1.4 trillion.
And against all that is me or you. No wonder we feel like pawns in a huge game, pushed this way and that by forces beyond our control.
But, last week, a student reminded me how bizarre it is that the world economy is built on something as nebulous as ''confidence''.
We may be as insignificant as ants, but when enough of us push in the same direction, we can make the global economy tremble. Take banks. They accept deposits from people who are free to withdraw their money at will, but then they lend that money to someone for 25 years.
So were it not for government protections, a run of depositors demanding their money back could bring the mightiest bank crashing down. When people see a queue forming outside a bank, all their instincts tell them to join it.
Take the sharemarket. If people are keener to sell a company's shares than to buy them at any moment, down comes the price - and, if it's one of our big companies, the retirement savings of people across the land take a dip.
If a company's shares fall, or if shares fall generally, the chances increase that the next move will be down rather than back up.
Take consumer confidence. When the economy looks like it's slowing and people worry about the possibility of losing their job, they postpone taking on new commitments and cut their spending on inessentials, just to be on the safe side. If enough people think and act that way, their fears become self-fulfilling and a self-reinforcing cycle develops.
Their reduced spending causes businesses to lay off staff, news of this causes others to become more precautious, and this, and the greatly reduced spending of the jobless, prompts another round of job losses and belt-tightening.
Our being social animals - our moods and actions are heavily influenced by the moods and actions of the people around us - means these swings easily develop momentum.
They work in both directions, of course. When we're confident, we spend, move to bigger or better homes and push up share prices with gay abandon.
When things are on the up, we can't imagine they'll ever stop rising when things are heading down, we can't imagine they'll ever stop falling.
These swings in consumer confidence are matched by swings in business confidence. Business people take their lead from consumers, but they're just as susceptible to the mood swings of their own class.
The availability of credit amplifies these swings.
Households and businesses borrow heavily to take advantage of the good times, get ahead of rising property prices and keep the party going. On the way down, their high levels of debt add to their fears, caution and cuts.
So the economy is driven by alternating waves of excessive optimism and excessive pessimism.
At all times it looks terribly tangible, huge and inscrutable. But the booms and slumps are being driven by the nebulous moods and feelings of the human animal. Note, it doesn't matter whether the fears that set off these chains of adverse developments - runs on banks, falls in share prices, loss of consumer confidence - are well-founded or ill-founded.
Their consequences are real, regardless of their origins.
Adding to the insecurity and uncertainty - especially at times like these - is one of the hallmarks of the human animal, our insatiable curiosity.
We always want to know what's happening, why it's happening, how the world works and what the future holds.
The economies of Europe have serious debt problems. They've been grappling with those problems for months without resolving them.
We have no idea how well or badly this episode will end, nor even when. But every other week the world's financial markets suffer another bout of nerves and drop share prices further.
This increases the pressure on Europe's politicians to find a solution, but probably also increases the likelihood of disaster.
Every time our shares take another dive, the saga moves to the media's centre stage and they attempt, yet again, to explain its complexities and ask more experts to predict how things will turn out.
Our crazy, unceasing urge to ask people who can't know to speculate about what the future holds arises from what psychologists call our ''illusion of control'' - our tendency to overestimate our ability to control events.
We want to know all about the events in Europe and elsewhere and how they will affect us because ''forewarned is forearmed'', and just in case there is something we can do to protect ourselves.
In truth, however, the main thing we are doing is putting the wind up ourselves long before it is possible to know what will happen and how seriously it will affect us in Australia.
My guess is, what will hurt us most is our fear of the possibilities, not the ultimate events.
The trouble with moods and feelings is their ability to influence hard economic facts.
Ross Gittins is economics editor.
Frequently Asked Questions about this Article…
What role does confidence play in the economy and why should investors care?
The article explains that the global economy is built largely on confidence. When people and businesses feel confident they spend, borrow and invest, which drives growth and lifts share prices. When confidence falls, spending and investment are cut back, which can reduce company earnings and push share prices lower. For investors, swings in collective confidence can create real, market-moving outcomes even if the original fears are unfounded.
How can changes in consumer confidence affect my investments and retirement savings?
According to the article, weaker consumer confidence leads households to delay purchases and cut non-essential spending. That lower demand can cause businesses to lay off staff and cut costs, which can hurt corporate profits and drag down share prices. Because many retirement funds are invested in large companies, broad falls in share markets can reduce the value of retirement savings.
What is a bank run and how does depositor confidence influence bank stability?
The article describes a bank run as a situation where many depositors try to withdraw funds at once. Banks typically lend long-term while deposits are withdrawable short-term, so if enough people lose confidence and demand their money back, even a large bank can fail unless government protections step in. Visible queues or panic can cause more people to join the run, making confidence itself the trigger.
Why do booms and slumps seem to happen in waves, and what amplifies them?
The article says the economy moves in alternating waves of excessive optimism and excessive pessimism driven by human moods. Availability of credit amplifies these swings: in good times households and businesses borrow heavily to join the upswing, while high debt compounds fears and belt‑tightening when the cycle turns, making downturns sharper.
How do sharemarket downturns become self‑reinforcing?
When more investors want to sell than buy, share prices fall; that decline raises the likelihood of further falls because investors react to price drops and negative sentiment spreads. The article notes that once shares start falling, the next move is often more likely to be down than back up, creating momentum driven by investor moods.
What does the article say about the Europe debt problems and market volatility?
The article points out that several European economies have serious debt problems and have been grappling with them for months. Each bout of market nerves tied to the saga causes share prices to drop again, increasing volatility. That market anxiety raises pressure on politicians to find solutions but also increases the risk of adverse outcomes.
What is the ‘illusion of control’ and how can it affect investor behaviour?
The article describes the illusion of control as our tendency to overestimate how much we can predict or influence future events. For investors this can show up as an urge to seek expert predictions or frantic attempts to ‘protect’ portfolios, which often leads to worrying prematurely and making decisions based on fear rather than on clear evidence.
How should everyday investors interpret headlines and market noise according to the article?
The author suggests that much of the market reaction is driven by moods and curiosity: people want to know what will happen and may alarm themselves before impacts are clear. The piece warns that fear of possible outcomes—not necessarily the actual events—can do the most harm. For investors, that means being mindful that media-driven uncertainty and sentiment swings can move markets regardless of underlying fundamentals.
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