The Importance of Perception in the Economy

It's amazing how important perceptions are. I would argue that in many ways perception is more important than reality. In some circumstances, perception is reality. If enough people perceive something as true than it becomes true. There's really a lot of areas this could be applied to, including individual personalities. Perhaps I'll cover some of those other areas in a later blog. For now, let's think about the economy.

The economy today, more so than at any point in history, is dependent on perception. The purpose of the economy, in essence, is to allocate resources in the most efficient way possible. Before the adoption of currency, barter systems ensured that items involved in all transactions were useful to the individuals who were on the receiving end of the trade. When currencies were later adopted, currency had a set exchange rate to something of value, usually gold because of its relative global scarcity and perceived value. When the world left the "gold standard," a fairly unpopular decision led by the United States, the world's currencies became valued only by their exchange rates to other currencies. No longer could a U.S. dollar be exchanged for a set value of gold, its value now rested solely on faith in the United States government. Perception. People perceived the dollar to have continued value because everyone else did too. In other words, if suddenly everyone in your community lost faith in the U.S. economy and perceived little to no value in carrying U.S. dollars, your cash would be worthless.

The banking industry is another aspect of the economy heavily dependent on perception. Many banks collapsed during the Great Depression because depositors lost faith in them. Hence the creation of the FDIC to help prevent 'runs' on the banks by individuals unnerved by the hint of bad news. One of my favorite stories illustrating this is one I learned in economics class in college. I don't have my notes readily available from freshman year and so I don't remember the details but the big picture is still fresh in my mind. Back around the Great Depression there was a bank that was rumored to be running out of cash. With no such thing as the FDIC to calm people down, a massive crowd began to form in front of the bank after the rumors had circulated. Everyone was fighting to be first in line to get their money out before the bank crashed. The problem: the bank WAS low on cash! They weren't low enough to be in danger of failing, most of the bank's assets were loaned out... but they did not have enough to give depositors back all their savings [no bank does, banks use their deposits to make loans, so banks only have a small fraction of deposits available at any given time]. The bank manager called the local Federal Reserve office. In an attempt to save the bank, the Fed rushed over a truck full of government cash. When the bank opened, the manager showed off the vault full of cash to the nervous crowd. Assured by the sight of cash, most depositors left their money in the bank. The extra cash was returned to the Fed, and the bank was saved because the bank was no longer perceived to be in danger of failing. If enough people believe a bank will fail, it WILL fail.

Another crucial aspect of the economy dependent on perception is the stock market. The stock market is where investors buy and trade shares of public companies. A company's stock price represents the market's (i.e. investors) collective valuation of that company. A stock price is theoretically equal to the present value of all future profits of a company combined with a few other things, such as assets-liabilities. Since the present value of a company is by no means perfectly scientific (unless you can read the future) then in essence a stock price represents investors' perceived value of a company. This is why when companies don't meet their expected earnings, EVEN IF those earnings were higher than last year's earnings, the stock price will go down. The company didn't do as well as expected. Stock prices are continuously fluctuating as "the market" (investors) digests a never-ending stream of information. Hence, the total value of the stock market is the perceived value of all companies publicly traded on a particular stock exchange! Since exchanges such as the NYSE and NASDAQ list such a large number of companies, the value of the stocks on those exchanges is an excellent barometer of the perceived value of the United States economy. When the stock market goes down, this usually means the perceived value of the U.S. economy has gone down. When the stock market soars, new information has given investors the perception that the expected future performance of the U.S. economy has improved. If enough investors believe a company (or all companies, i.e. the stock market) will fail, then the chances of that company failing significantly increase. When a company's stock price plummets, the ability of that company to raise cash by selling ownership rights to the company (equity/stock) is severely diminished.

Few people have a thorough understanding of the stock market, or the economy for that matter. This is a very dangerous fact that I may address in another blog. However, even people who do not understand how the stock market works understand that the stock market is important. They see green arrows or red arrows every day on CNN and in the newspaper. Regardless of someone's understanding of the stock market, people know that poor stock market performance is bad. Therefore, stock market performance, which is rooted in the perception of the economy by investors, then affects overall perception of the economy. A crashing stock market tells people the economy is bad. Those people get nervous. They invest less, they spend less, they save more. Companies make less money, investors see this nervousness and diminishing profits and they sell. The stock market continues to go down, creating a vicious downward spiral. Sound familiar?

There are so many other areas of the economy where perception is important, but I think I've covered what I believe to be the most important. In my next blog I'll tie my ideas on economic perception to the current economic situation that we've seen during the past year or so.