Can pessimism on the economy actually help trigger an economic decline?

My post on Quora:

More broadly, expectations can play an important role in economic decisions and can sometimes be self-fulling.

Economic Decisions and Expectations

From the demand side, an economy can be thought of as a series of spending, saving, borrowing and investment decisions by people, companies, investors, national governments, city councils, etc.

These decisions can be made on housing and schooling, on food and transportation, on building factories and manufacturing goods, on renting office space and designing services, on going to the movies, on investing in a start up, on putting money in your 401k, and so on, and so on.

In turn, many factors influence those decisions. If you are thinking about buying a house, you may consider how hot or cold the housing market is, how low or high mortgage rates are, how much you have saved up for a down-payment, how likely you are to keep your job, how likely you are to get a raise next year, etc. If an investor is thinking about investing in a factory that a company wants to build in a new location, she may consider how likely the final goods that the factory produces will sell in the market, how likely the company building the factory can offer the investor a decent return, the timing, the risks, etc.

The examples are endless, though there is something in common with most of them: they depend on expectations of the what the future may hold.

Self-Fulfilling Expectations

Now suppose, all of a sudden, everyone begins to expect an economic recession. Suddenly, one might reconsider taking out that mortgage if housing prices are expect to fall, or investing in that factory if its returns become riskier, or buying those cool new jeans because you’d rather save just in case your companies foregoes your bonus.

If all of a sudden everyone pulls back their spending and investing because they expect a recession around the corner, then that expectation and subsequent drop in demand could then itself trigger an economic slowdown or even recession.

In the extreme scenario, if everyone panics and suddenly pull back their spending and stop lending their savings, then a crisis could follow. See the Great Depression that was triggered when people panicked and ran to their banks to withdraw their deposits all at once. See the Great Recession that was triggered when investors panicked and stopped lending on a massive scale in short-term money markets, where some very large banks and companies had grown reliant on.

 

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