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The Effect of Negative Sentiment on the Global Economy

Posted by
Swiss Finance Institute
on
Friday, November 11, 2016 - 09:00

In our interview with Prof. Philippe Bacchetta, SFI Chair from the University of Lausanne, Prof. Bacchetta discusses the impact of negative sentiment on the global economy. Negative sentiment means that economic agents become more pessimistic for no fundamental reasons, but may be influenced by the media or other public statements. Professor Bacchetta has written about the topic in the papers Self-fulfilling Risk Panics (with Tille and van Wincoop) and The Great Recession: A Self-fulfilling Global Panic (with van Wincoop).  

 

Negative sentiment and the spread of panic

Negative sentiment has had an important effect on markets and investors, especially in recent years.

 

Fundamental shocks in financial markets are not the only cause for economic downturns. In 2008, tight credit and a decline in consumer wealth did not fully account for the recession. Behavioral finance shows that investor sentiment also affects the markets.

 

Negative sentiment was one of the drivers of the global financial crisis and is a factor in understanding why the recession spread to so many countries. The recession started in the USA due to problems in the American subprime market. The crisis then spread to the world economy due to negative sentiment and global panic.

 

Negative sentiment creates self-fulfilling prophecies

The spread of negative sentiment seems to work like a self-fulfilling prophecy in both the financial market and in the real economy.

 

Self-fulfilling shock results from inter-linkages between expectations for the present and the future. Lower expected future income lowers current consumption. The present affects the future too. Lower current profit leads to an expectation of lower future profit and an increase in uncertainty about future production.

 

For example, consumers who feel their job security is threatened reduce their consumption. This lower consumption reduces demand for firms, which in turn actually threatens jobs, in a self-fulfilling cycle.

 

Information is more universal than it used to be historically. This means that sentiment is more easily shared across countries and that the recent recession had the ability to spread global panic in a way that was not seen in previous economic downturns.

 

In modelling a recession based on self-fulfilling shock, it was found that business panic is synchronized across two countries as long as they have a minimum level of financial integration because the “threshold level of economic integration does not need to be high.” It was also found that global panic is more likely to occur in situations where credit is tight, interest rates are low and fiscal policies are rigid.

 

How to combat negative sentiment

With increased global integration and the finding that integration need not necessarily be high in order for panic to spread, the potential for global panic to circulate is significant.

 

The cycle can be prevented by spreading optimism, for example through communication. People are more likely to be convinced of optimistic messages if the economy is strong. A solid economy is less affected by negative sentiments.

 

The best way for governments to prepare for difficult economic times is to focus on having a sound economy. Safeguards are also important. For example, following the financial crisis, countries are trying to make progress with macro-prudential regulation in the banking sector in an attempt to avoid systemic risk.

 

Effective communication strategies are crucial in attempting to manage any negative sentiment that is created and to ensure that panic is contained.

 

Faculty expertise provided by Prof. Philippe Bacchetta

 

To view the full interview, please click here.

 

Read the other posts in this series:

The Importance of Communication in Financial Markets.

How Does Managerial Tone Affect Market Reactions?

How Does the Use of Vague Words Affect Market Reactions?