Johan Fourie's blog

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Can Twitter predict the markets?

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Twitter-PPC

Ask anyone about the pitfalls of Twitter, and they might point to recent gaffs by a prominent South African politician as evidence that the dangers outweigh its benefits. But such warnings have not stopped many others, most notably the president of the United States, from tweeting on a regular basis: Twitter’s user base creates more than 500 million tweets a day, and it has added about 2 million new users in the last quarter of 2016.

Presumably this wealth of information must have some value. Twitter, sadly for its shareholders, struggles to turn such growth into profit: in the last quarter of 2016, revenue growth was only 1%. But because it captures public sentiment at a very granular level, it has attracted the interest of both scientists and entrepreneurs hoping to turn this information into public or private benefit.

The use of social media for prediction is, of course, not a recent phenomenon. Google Flu Trends, founded in 2008, used Google’s search engine to track the spread of flu in 25 countries. But excitement about the project waned as it struggled to make accurate predictions. A 2014 Nature paper noted the value of social media ‘Big Data’, but warned that ‘we are far from a place where they can supplant more traditional methods or theories’.

Twitter, though, seems to attract increasing attention. A 2014 paper uses Twitter to predict crime. A 2015 paper show how psychological language on Twitter predicts heart disease mortality. Another 2015 paper show how Twitter sentiment predicts enrollment of Obamacare. A 2016 paper show how Twitter could be used to predict the 2015 UK general elections.

But it is, understandably, the financial markets that has attracted the most attention. A 2016 paper by Eli Bartov (NYU Stern School of Business), Lucile Faurel (Arizona State University) and Partha Mohanram (University of Toronto) shows how Twitter can predict firm-level earnings and stock returns. They use a dataset of nearly a million corporate tweets by 3662 firms between 2009 and 2012, all tweeted in the nine-trading-day period leading to firms’ quarterly earnings announcements. The authors find, unsurprisingly, that the tweets successfully predicts the company’s forthcoming quarterly earnings, but find, more surprisingly, that the tweets predict the ‘immediate abnormal stock price reaction to the quarterly earnings announcement’. These findings are more pronounced for firms in weaker information environments, such as ‘smaller firms with lower analyst following and lower institutional ownership’, and are not driven by concurrent information from sources other than Twitter, such as press articles or web portals.

It makes sense that corporate communication provides information, but can public sentiment on Twitter also inform market activity? A 2017 NBER Working Paper, by Vahid Gholampour (Bucknell University) and Eric van Wincoop (University of Virginia), answers this question by looking at the Euro/Dollar exchange rate. They start with all Twitter messages that mention EURUSD in their text and that were posted between October 9, 2013 and March 11, 2016. There were 268 770 of these messages, for an average of 578 per day. What they hope to do, is to identify whether informed opinions about future currency changes can actually predict actual currency changes, so they eliminate all tweets that do not express a sentiment about the future behaviour of the two currencies. This reduces the sample to 43 tweets per day, or 27 557 in total. They then classify each of these tweets as positive, neutral or negative using a detailed financial lexicon that they develop to translate verbal tweets into opinions, and create a Twitter Sentiment index for each day. They also split the sample in two: those opinions expressed by individuals with more than 500 followers, which they call the ‘informed opinion’, and those with fewer than 500 followers, which they call the ‘uninformed opinion’.

So what do they find? It turns out that the 633 days of data they have is too short to calculate the Sharpe ratio, a measure of the risk-adjusted return. The annualized Sharpe ratio based on daily returns is 1.09 for the informed group and -0.19 for the uninformed group. The Sharpe ratio of 1.09 for the informed group is impressive, but it has a large standard error of 0.6. The 95% confidence interval is therefore very wide, ranging from -0.09 to 2.27. They then construct a model with a precise information structure, estimate the parameters and then recalculate the Sharpe ratio to average at 1.68 with a 95% confidence interval between 1.59 and 1.78. Success: ‘the large Sharpe ratios that we have reported’, they conclude, ‘suggest that there are significant gains from trading strategies based on Twitter Sentiment’.

If all this sounds terribly complicated, that is exactly the point. Translating opinions into numbers is not an easy undertaking, and discerning the ‘informed’ opinions from the noise is even less so. But there is no doubt that Twitter does offer some useful, perhaps even lucrative, insights. Whoever can exploit that knowledge first, stand to benefit most.

*An edited version of this first appeared in Finweek magazine of 20 April.

Written by Johan Fourie

May 16, 2017 at 06:24

Do CEOs deserve their high salaries?

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Whitey Basson

Late last year, Bloomberg reported that South African Chief Executive Officers earn the 7th most of any country in the world – a whopping R102 million per person per annum. This was equivalent to 541 times the income of an average South Africa. The study, understandably, caused some outrage.

These numbers have been disputed, mostly because they include CEOs who earn in foreign currency. A study by 21st Century Consultants found that the CEO salary of the median large cap South African firm in 2016 was less than R6 million, roughly 5% of the Bloomberg average. PwC found the median between R3.1 and R7.7 million.

But even at these lower levels, many ask whether CEOs deserve what they earn. Do the value that they add outweigh the millions spent on salaries and bonuses? This, of course, is an incredibly complex question. Economists have no laboratory where they can randomly assign CEOs their salaries, and see what the likely outcome might be. Instead, we have CEOs that respond to the firm’s internal and external demands in various ways, planning, strategizing, meeting and organizing. Which of these activities adds more value seems impossible to determine.

That is, until now. A new study by four economists – Oriana Bandiera (LSE), Stephen Hansen (Oxford), Andrea Prat (Columbia Business School) and Raffeala Sadun (Harvard Business School) – measure the behaviour of CEOs in Brazil, France, Germany, India, the UK and the US, and compare these measurements to their firm’s performance. They do this using a two-stage method: first, they collect the weekly diaries of 1114 CEOs in the six countries. These diaries include detailed information about the hourly activities of each CEO: with whom they met, the number and duration of plant/shop-floor visits, business lunches, how many people joined, and the functions of these participants (whether they were in finance or marketing, for example, or clients or suppliers).

Their finding is that CEO activities differ remarkably across firms. While CEOs spend most of their time in meetings, they ‘differ in the extent to which their focus is on firms’ employees vs outsiders, and within the former, whether they mostly interact with high-level executives vs. production employees’.

The authors then use a machine learning algorithm to create an index of CEO behaviour. At low values of the index, CEOs spend more time with production and in one-on-one meetings with employees and suppliers, and at high values CEOs spend more time with executives and in meetings with more participants.

The authors note that there is no theoretical reason for one type of behaviour to lead to better outcomes. That such different types of behaviour exist may just be a consequence of the fact that firms require different types of CEOs, i.e. some firms will do better with a low-index CEO while others would do better with a high-index CEO. When CEOs are perfectly matched – or ‘assigned’ – to the type of firm that suit their style, there should be no correlation between the index-value of a CEO and the firm’s performance. In other words, a low-index CEO matched to a firm that will benefit from a low-index CEO style would perform just as well as a high-index CEO matched to a firm that will benefit from this CEO style type.

The results, however, shows the opposite. High values on the CEO index are strongly correlated with higher firm productivity, a measure of firm performance. CEOs who spend most of their time in meetings with senior executives, engage in communication (phone calls, videoconferences, etc.), bring together inside and outside functions, and bring together more than one function of a kind are also more likely to lead more productive firms.

Their results also show that CEOs are often not matched to the right firm: “Our estimates indicate that, while low-index CEOs are optimal for some of the sample firms, their supply generally overstrips demand, such that 17% of the firms end up with the ‘wrong’ CEO.”

More importantly, it is in the two developing countries in their sample – Brazil and India – where this matching is especially bad: 36% of firms in those countries end up with the ‘wrong’ CEO compared to the only 5% in the four developed countries. “The productivity loss generated by the misallocation of CEOs to firms equals 13% of the labour productivity gap between high and low income countries”.

The authors do not speculate on why this difference exists. One likely reason is weaker competition for top jobs within a thinner talent pool owing to the unequal levels of education in these countries. Another may be that appointments happen for reasons other than merit.

What the study does show, though, is that the choice of CEO is critical for firm success. Appoint the wrong type of CEO, and productivity is likely to decline. Although some firms benefit from a CEO who frequently has one-on-one conversations and visits the production floor, most firms benefit from a CEO who spend their days leading large meetings with top executives from different fields.

That helps to explain the high salaries for CEOs in South Africa too. A mismatch between CEO and firm is costly and seems to happen quite frequently. The small talent pool means that most firms are willing to pay exceptional salaries to those rare individuals with a high CEO index-value. If they don’t, the firm is likely to suffer far more costly productivity losses.

It also points to the dangers of policies that hope to place an upper-bound on managerial remuneration. Lower levels of remuneration will likely lead to fewer CEOs with high index-value, and to higher levels of mismatch between CEOs and firms. That, as the authors show, will be devastating for firm-level productivity, and economic development. Beware the unintended consequences of policies made with good intentions.

*An edited version of this first appeared in Finweek magazine of 6 April.

Written by Johan Fourie

May 1, 2017 at 05:57

South Africa’s Great Leap Backward

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Great Leap Forward

Over the next few days, South Africa’s new Minister of Finance, Malusi Gigaba, will meet with representatives of the IMF, the World Bank, international investors, and ratings agencies in the US. His aim is to restore confidence, to steer the South African ship through the troubled waters of junk status.

This was a tough task a week ago, but his appointment of Chris Malikane, associate professor of Economics at Wits University, as adviser, has made this almost impossible. Malikane penned an 8-page manifesto early in April, which will apparently form the basis of his policy advice to Treasury. The document is available here: Chris Malikane – Concerning the Current Situation 2017. (Brace yourself: the phrase ‘white monopoly capital’ appears 58 times. The words ‘science’ or ‘innovation’, not once.)

I read the document just before I had to teach a class on China’s Great Leap Forward yesterday, and the similarities were startling. Malikane calls for the expropriation of ‘banks, insurance companies, mines and other monopoly industries, to industrialise the economy’. He wants to establish a state bank, nationalise the Reserve Bank, and ‘expropriate all land without compensation to the ownership of the state’. Oh, and he also wants ‘free, quality and decolonised education, free and quality healthcare, improved quality housing, community infrastructure, etc., affordable and safe public transport, and affordable and reliable basic services such as water, sanitation and electricity’.

An excellent Business Day editorial summed it up perfectly:

Malikane’s ideas are rooted in Marxist voodoo economics. For a finance minister to be taking advice from one with such outmoded and unorthodox ideas puts SA on the path towards such economic disasters as Zimbabwe and Venezuela. Doing so is an act of grotesque irresponsibility.

Just as we all borrow from banks to pay home loans, so South Africa borrows from international lenders to pay our expenses (which are more than our income, i.e. our budget deficit). If international investors do not believe we will be able to repay, they will make our loans more expensive by raising interest rates. It is not that these international investors want to exploit us – just as banks do not exploit us when we voluntarily go to them for loans – it is just that they want to make sure they get their money back. How an academic macroeconomist at one of South Africa’s top universities do not understand this, I do not know. One has to wonder what he teaches his students at Wits?

I hope the IMF, World Bank, investor and ratings agency representatives ask Gigaba about the economics of his new adviser. I hope they ask him what exactly Malikane will do in his capacity as adviser. I hope they ask him to state his own views about the market economy, about the interplay of fiscal and monetary policy, and, just for fun, about the role of Marxist economic thought in understanding international capital flows. And I hope they ask him whether he’s heard of China’s Great Leap Forward, and its consequences for the Chinese economy.*

*Spoiler alert: 43 million people died.

Can private schools save South Africa?

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NorthernAcademy

When I was an Economics student 12 years ago, the academic literature we read, by South Africa’s leading economic thinkers and social scientists, were lamenting the poor performance of the then South African school system. There was little doubt that what needed to happen was to improve the quality of the schools for the 80% South Africans who were still stuck, despite massive transfers of resources to these schools, in a system that had been crippled by apartheid-era policies.

Fast-forward to today.  A generation has now passed through the system, and there has been almost no improvement. Of 100 Grade 1-students that go to school, only 37 can hope to pass matric. With teacher trade unions opposing policies that might improve teacher quality, our Minister of Basic Education seems paralyzed. Corruption often means that budgets are either unspent or spent inefficiently. There is little hope that things will soon improve.

But there is an alternative. Over the last few years, private schools have become an alternative for middle-income families that want a better future for their children. Take Northern Academy in Polokwane, run by the JSE-listed Curro Group. Despite school fees that are around R21000 per year, with a similar amount for boarding, the school has more than 5000 students, 111 classrooms and 66 hostels. In the 2016 matric exams it was the top-performing independent school in the province.

Curro now has schools across all nine provinces. In the last four years, its share price has tripled. Its profit motive means that it must satisfy its client base: if it performs poorly by employing poorly-qualified teachers, its clients will go elsewhere. That is the miracle of the market-system that Adam Smith identified: profits are a way to signal that a firm is doing something right. If profits fall, the firm better improve its products or services or it will go out of business. If profits rise, like in the case of Curro, other firms will notice and enter the market, offering their own product and service which they hope will eat into the profits of the dominant firm.

One fear is that Curro will monopolise the market, charging fees that allow them to earn monopoly profits. This is unlikely in the education sector, though, as there are few barriers-to-entry. Consider the SPARK schools, with tuition also around R21000 per year, that have opened since 2013 in Gauteng and the Western Cape.

A second fear is that a well-run private school system will create further divisions in a country characterized by high levels of inequality; those that are able to afford the high school fees of good education will stand to benefit vis-à-vis kids from poor households forced to attend poor-quality public schools. This is likely to happen if private schools are limited to those that can afford to pay for them. But they need not be.

In Sweden, where equality-of-opportunity is almost a religion, more than 10% of kids are enrolled in private schools. A major education reform in 1992 allowed primary and secondary schools to receive public funding based on the number of students they have enrolled. These schools are not allowed to discriminate or require admissions exams, and they are not allowed to charge parents additional school fees. (They are allowed to accept donations, which are often used to expand school facilities or offer financial support for the poorest students.)

Anyone can start a for-profit school in Sweden. Many offer an alternative curriculum, or provide a service to international, religious or language groups. Others are designated sports or artistic schools. The point is simple: if a public school is not providing the services its community wants, an entrepreneur with the ability to identify a gap in the market will step in to deliver a better service.

This is what we need in South Africa too. The 2017 Budget allocated R243 billion to the Department of Basic Education, which is 16% of our total consolidated spending. With 11.2 million school-going kids in South Africa, that is slightly more than R21000 per kid.

What if every parent in South Africa received a government voucher of R21000 per student which they could deposit at any school they want, public or private? A larger amount could be given to those living in rural areas, and possibly those living in previously disadvantaged areas. This empowers parents to choose the schools which they believe will serve the interests of their kids best.

There are concerns with private education too, of course. One would want to make sure that facilities are of good quality, that teachers and curricula meet certain standards, and that there is some security that students’ interest will be served if a company that provides these services goes into liquidation. But those concerns pale in comparison to the atrocious outcomes of the current school system, where facilities are often non-existent and teachers unqualified.

Imagine the opportunities this will create for entrepreneurs. A community leader in an area with poor public schools can now take the initiative, appoint educators from within the community and use the vouchers to pay their salaries. Imagine Cricket South Africa partnering with an entrepreneur to build a chain of elite cricket schools, with CSA providing the facilities and coaches and the vouchers paying for high-quality education.

An important research literature suggests that mother-tongue education is critical for student success: with a voucher system, if there is a demand for secondary education in Sesotho in a specific community, expect an entrepreneur to spot the gap. Another concern for the near future is the dearth of university-trained teachers: private school chains will have an incentive to fix this, either by training their own teachers on the job, or by investing in teacher training colleges.

We need a new plan for education. I’d hate to see my colleagues 12 years from now write papers still lamenting the poor state of the South African education system. We keep throwing money at a problem that cannot be fixed by money alone. The Basic Education budget grew 7.3% in 2017. If we continue doing this, we are likely to fail a second post-apartheid generation.

*An edited version of this first appeared in Finweek magazine of 23 March.

Here we go again

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Gigaba (1 of 1)

Late last night, South African president Jacob Zuma fired Pravin Gordhan and Mcebisi Jonas as Minister and Deputy Minister of Finance, and appointed Malusi Gigaba (pictured) and Sifiso Buthelezi in their place. With this move, he has gained the keys to Treasury. Aside from Finance ministry, Zuma appointed 18 new ministers and deputy ministers, including Fikile Mbalula, the former Minister of Sport, as Minister of Police. Bathabile Dlamini, Minister of Social Development, whose incompetence was recently exposed when her actions risked the well-being of 17 million South Africans, remains in her portfolio.

It all sounds so familiar. In December 2015, Zuma fired then Minister of Finance Nhlanhla Nene and replaced him with Desmond van Rooyen. After the rand plummeted more than 5%, Zuma was forced to reverse his decision and appoint Pravin Gordhan in the position three days later.

I wrote a post immediately after the appointment of Van Rooyen. Most of the points I raised there are now valid again. Zuma has captured Treasury – with a Zuma-loyalist in charge, he can now sign off on projects that benefit him and his backers, the Guptas.

The question, again, is what to do. And again I have to say, I don’t know. I see calls on social media for mass action, but I am not too sure Zuma and his cronies would pay much attention. Blog posts, I fear, will also not have much of an impact. What I will do, however, is to encourage Treasury employees, many who are brilliant economists and also good friends, to remain in office, despite the obvious challenges that they will face with a Zuma-loyalist at the helm. How long, though, can one remain honourable and incorruptible in an environment where you might become complicit in whatever shady nuclear or other deals Zuma has up his sleeve?

What this reminds me of is a tweet by veteran Zimbabwean businessman Trevor Ncube:

If something doesn’t happen soon to reverse this process of decline – and this can only happen when Zuma is gone, although that will only be a start – we risk destroying the progress we’ve made since 1994. The irresponsible actions of last night will hurt the economy badly, from a weakening currency (which has already fallen by more than 3%) to almost definite downgrade, which means more money spent on paying loans than building roads, houses and clinics. And if Zuma’s pet projects, like a nuclear deal with Russia, is signed, the cost for South African taxpayers – and the opportunity costs for South Africa’s poor – will be horrific.

Prepare for a bumpy ride.

How to get good politicians

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South African President Jacob Zuma visit Berlin

Politicians can shape the fortunes of countries. Presidents, in particular, set the tone: balancing many stakeholder interests, their job is to create a unifying vision that should guide policy-making. Members of parliament act upon this vision, designing and implementing policies that affect the lives of millions of people. One would imagine, then, that those with the best aptitude for leadership get elected.

That is the theory. But in practice politics is a messy business. For many reasons, it is often not the smartest candidate who gets elected, or the most effective member who gets selected for higher honours. Some economic models even explain why it is not the most capable that move up: Someone without a proper education (but a charismatic personality) has a much higher chance to see greater returns in politics than in the private sector. (In technical terms, lower opportunity costs give the less able a comparative advantage at entering public life.) These selection effects are compounded by the free-rider problem in politics, where work effort is not directly correlated to political outcomes. In other words, according to this model, it is society’s ‘chancers’ that are more likely to end up in politics – and the hard-working, smart ones will tend to end up in the private sector.

Competency in public office is, of course, is not the only goal of a parliamentary system. Representation – having politicians that reflect the demographic and geographic make-up of society-at-large – is also a key concern. But competency and representation, at least theoretically, do not always correlate. Take the following example: a proportional representation system, like we have in South Africa, would require members of all districts to be represented. But what if one region – let’s call it Farmville – has few university-trained citizens, whereas another region – Science City – has many citizens with university degrees? A proportional representation system will necessitate some Farmville politicians also be elected to parliament, even though the Science City politicians will probably be best qualified for the job. In contrast, in a plurality rule system – where the candidate with the most votes gets the job – competency often trumps representation.

A new NBER Working paper – Who Becomes a Politician? – by five Swedish social scientists, casts doubt on this trade-off. Using an extraordinarily rich dataset on the social background and competence levels of Swedish politicians and the general public, they show that an ‘inclusive meritocracy’ is an achievable goal, i.e. a society where competency and representation correlate in public office. They find that Swedish politicians are, on average, significantly smarter and better leaders than the population they represent. This, they find, is not because Swedish politicians are only drawn from the elite of society; in fact, the representation of politicians in Swedish municipalities, as measured by parental income or occupational class, is remarkably even. They conclude that there is at best a weak trade-off between competency and representation, mostly because there is ‘strong positive selection of politicians of low (parental) socioeconomic status.

These results are valid for Sweden, of course, which is a country unlike South Africa. Yet there are lessons that we can learn. First, what seems to matter is a combination of ‘well-paid full-time positions and a strong intrinsic motivation to serve in uncompensated ones’. In other words, a political party in South Africa that rewards hard work for those who serve in uncompensated positions, are likely to see the best leaders rise to the top, where they should be rewarded with market-related salaries. Second, an electoral system which allows parties to ‘represent various segments of society’. Political competition is good. Third, the ‘availability of talent across social classes’. This, they argue, is perhaps unique to Sweden, known for its universal high-quality education.

This reminded me of our State of the Nation red carpet event, where the cameras fixated on the gowns and glamour of South Africa’s political elite. How do the levels of competency in our parliament, I wondered, compare to Sweden and other countries?

Let’s just look at the top of the pyramid. The president of Brazil, Michel Temer, completed a doctorate in public law in 1974. He has published four major books in constitutional law. The Chinese president, Xi Jinping, also has a PhD in Law, although his initial field of study was chemical engineering. Narendra Modi, prime minister of India, has a Master’s degree in Political Science. Former US president Barack Obama graduated with a Doctor of Jurisprudence-degree magna cum laude from Harvard University. Angela Merkel, chancellor of Germany, has a PhD in quantum chemistry. Most of these widely respected leaders gave up a top job in the private sector or academe to pursue a political career.

Politics is messy, but given the right conditions, it can still attract high-quality leaders. For that to happen, though, aspiring politicians must put in the hard yards, even if initially uncompensated, supported by a competitive political party system and broad access to quality education. South Africa, unfortunately, is still a long way from meeting these criteria.

*An edited version of this first appeared in Finweek magazine of 9 March.

Written by Johan Fourie

March 24, 2017 at 07:35

The economic stories we tell

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Economic stories

Story-telling is as old as civilization. Around the fire, in religious texts, and in children’s books, stories give us identity, teach us right from wrong, and inculcate us with the norms and values that help us make sense of the world around us.

Economists are beginning to understand that stories also shape our behaviour, and therefore our economic outcomes. In a new NBER paper, financial economist Robert Shiller, the 2013 Nobel-prize winner, calls for the study of what he calls ‘economic narratives’. He argues that the way we talk about certain events, the stories that were told during the Great Depression (of the 1930s) or the Great Recession (of 2007) or even the stories we tell of Trump’s economic policies today, affected (or will affect) the outcomes of these events. Business cycles, he explains, cannot only be explained by the rationality of numbers. The stories we tell, and how these stories spread, matter too.

Economic stories or narratives are simplified ways to help us understand the world. They can take many forms: from newspaper articles and books, to memes, anecdotes, and even jokes. They often appeal to us not because they account for all facts, but because they explain the world in a way that strengthens our existing biases and beliefs. And their success is unpredictable: consider how difficult it is to identify the next ‘hit’ on YouTube or cultural trend to go ‘viral’.

Shiller uses, well, a story to explain the impact of stories. One evening in 1974, at the Two Continents in Washington DC, economist Arthur Laffer had dinner with White House influentials Dick Cheney and Donald Rumsfield. They discussed tax policy, and Laffer took a napkin and drew an inverted-u graph. On the left side, tax rates were 0%, which means tax income was also zero. On the right side, tax rates were 100%, which meant that no-one would work and tax income would also be zero. The point of the curve was to show that there is an optimal tax rate where tax income cannot increase further, whether you increase or decrease tax rates.

This meeting in 1974 would not have been remembered, was it not for the story-telling powers of Jude Wanniski, who wrote a colourful article in National Affairs about the dinner four years later. The story went viral (see image), and had a massive impact on Ronald Reagan’s election as US president in 1980 and his commitment to cutting taxes. (He argued that cutting taxes could increase tax revenue because America was on the wrong side of the Laffer curve). This story was so powerful that a napkin with a Laffer curve is today displayed in the National Museum of American History.

Laffercurve

Shiller is, of course, not the first to argue that stories matter. A few years ago, Barry Eichengreen, professor of Economics at UC Berkeley, explained in his presidential speech to the Economic History Association that, while scientists use deductive or inductive reasoning in their research, policy-makers often rely on analogical reasoning. He knows this from experience: when the severity of the Great Recession became known in 2007, policy-makers realised they had to act fast. Had they followed a deductive approach, they would have had to agree on the theoretical reasons for the crisis. Eichengreen argues that this was almost impossible given the deep divides in the field of macroeconomics. Had they followed an inductive approach, they would have had to rely on statistical evidence, much of which was not available immediately.

So instead they turned to an event that they had studied: the Great Depression of the 1930s. Ben Bernanke, who was a student of the Great Depression, used analogical reasoning to ensure that the same mistakes were not repeated. Expansionary monetary and fiscal policy followed. The analogy with the Great Depression also made it easier to communicate their policy response to the broader public. Instead of trying to explain theory or statistics, they could construct a narrative that helped people understand why quantitative easing or fiscal stimulus was necessary.

If stories matter in shaping our response to economic events or in persuading us of the validity of some economic policies, what should economists do about it? Shiller suggests that we should incorporate textual analysis into our research: “There should be more serious efforts at collecting further time series data on narratives, going beyond the passive collection of others’ words, towards experiments that reveal meaning and psychological significance.” But this is difficult: “The meanings of words depend on context and change through time. The real meaning of a story, which accounts for its virality, may also change through time and is hard to track in the long run.” New techniques in data science may help.

Eichengreen proposes more emphasis on the study of history. Consider the case of a bank failure in South Africa today. What will we use as policy response: theory, statistics, or earlier bank failures, like Saambou and African Bank? Probably the latter. The problem, Eichengreen warns, is that there is not a single version of history. We all have our ideological glasses through which we look at the past. This is especially true when the facts of what had happened during these past failures are not widely known. The recent Bankorp saga comes to mind.

Because ‘historical narratives are contested’, Eichengreen suggests, we should see ‘more explicit attention to the question of how such narratives are formed’. In other words, if we want to improve our understanding of the world and our ability to predict the future, it’s time economists learn how people tell stories, and how these stories persuade us to behave differently.

*An edited version of this first appeared in Finweek magazine of 23 February.