US economy

Why Our Beliefs Don’t Predict Much About the Economy


Focusing on the stock market, Professor Gennaioli and Professor Shleifer demonstrate how changeable expectations for the future really are. People tend to believe that recent trends will continue, whatever they may be, and then, when things shift, they change their expectations again.

These authors, referring to previous research with Robin Greenwood at Harvard, examined six separate surveys of expected returns on the stock market, some looking at individuals, and some focusing on professionals. The surveys correlated substantially with one another, showing that they were actually measuring popular beliefs about the stock market.

But Professor Gennaioli and Professor Shleifer also showed that these expectations for future returns were systematically wrong, showing no ability to predict what actually happened.

These kinds of mistakes tend to follow certain psychological laws. Professor Gennaioli and Professor Shleifer stress that people have what they call “diagnostic beliefs,” a concept related to the “representativeness heuristic” described in 1974 by the psychologists Daniel Kahneman and Amos Tversky.

Diagnostic beliefs work like this: A physician, in trying to diagnose a patient’s illness, orders a blood test that reliably gives a positive result for all patients who have a certain disease. Unfortunately, the test also gives many false positives. It is easy to assume the patient has the disease. But the test may just be a false positive.

The market boom leading to the 2008 financial crisis was the result of mistaken beliefs like the doctor’s diagnostic errors, the researchers say. These diagnostic beliefs were based on what seemed to be a “kernel of truth,” Professors Gennaioli and Shleifer say: Investors had a high return in the market. But they exaggerated the meaning of that kernel of truth, creating a market bubble.

More broadly, fundamental beliefs about the economy change through time. Thus, for example, the remarkable performance in the United States stock market since 2009 and in the housing market since 2012 are a result of a newly emergent belief system, reinforced not just by presidential statements or even by tax cuts but by a psychological dynamic that operates according to well-defined psychological principles, based, erroneously, on the belief that past growth in market prices is strong positive evidence for more growth in the near future.

The problem for economics research today is to try to clarify these changing belief systems, their impact on the economy, and their duration. Further study may well show that the economic effects of beliefs founded on false premises can be profound for decades after the initial changes take place.



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