Using Narrative Economics To Better Understand Markets

Economics lags other social sciences, such as history, anthropology, and sociology, in understanding the ways narratives (stories) affect human actions. In his paper and book “Narrative Economics”, Nobel laureate Robert J. Shiller describes how economic events ranging from the Great Depression to the Bitcoin craze can be explained by narratives and not just economic data.

What is Narrative Economics and Why Study it?

Put simply – it is a study of how popular stories and theories begin, spread evolve and live on. It also involves how these stories alter people’s economic decision making. It drives major economic events like recessions or asset price bubbles through collective behavior.

At the micro level, individuals are constantly making decisions. These could include: should I consume now or wait for growth to pick up? Should I hire additional workers? Should I Invest in Bitcoins? And rather than using economic data and analyzing data to make these decisions, people discuss ideas, gossip and share stories. Therefore, storytelling is central to human actions. Economists have overlooked the power of narratives relative to other social sciences. In fact, economics and finance are the worse fields for incorporating narrative (Figure 1).

Figure 1

Source: Page 6 of “Narrative Economics” by Robert J. Shiller

How Stories and Fake News Go Viral

Stories are contagious just like diseases. They can spread within an economic system from one person to another via conversations. These conversations could be in-person, by phone, social media, internet, and even press. For instance, during an investment bubble – the rising share price is broadcast in the media and discussed among colleagues – this accelerates demand. This increase in demand sequentially leads to more stories, which results in a bigger economic bubble and the feedback loop continues.

Narratives do not need to be true to go viral. For example, the Laffer curve theory – lower taxes spur economic growth –was apparently written on a napkin by the economist Arthur Laffer. Indeed, this part of the story helped the spread of the idea of the Laffer curve. Yet, according to Laffer, the incident never happened.

To understand the spread of such narratives, Shiller likes medical epidemiology models – the study of how the disease spreads and occurs in people.  One such model,  developed by Kermack and McKendrick (1927)  can be applied to narrative “epidemics” of economic theories. These models give a realistic framework for understanding the dynamics of infectious diseases which are similar (in distribution) to how stories spread and mutate over time.

Figure 2 shows an application of the Kermack-McKendrick model. During an actual epidemic, the number of infected follows a bell-shaped curve skewed to the right. This implies not everyone will ever catch the disease. Some completely escape as they do not interact with an infected person, and gradually it gets safer because the number of infected people falls. Eventually, the disease disappears.  This can be applied to the Laffer curve example which follows a similar hump-shaped distribution (Figure 3). Its popularity peaked in 1978 as the napkin story went viral. Eventually the story started to lose its punch, not least because as a policy tool it was ineffective.

Economic Phenomena’s Explained via Narratives Epidemics

• Great Depression of the 1930s and the Market Crash of 1987 more similar than we think

Shiller highlights that there may be multiple factors, whose confluence caused people to cut back on their expenditures and hence caused the great depression. The most notable factors were narratives around the stock market drop on October 28, 1929. The narrative contagion was building through repetition. That is, the more an economic topic is discussed, the more likely it is that the underlying story will go viral.

He believes in the 1930s, Americans began following stock prices. A tendency reinforced by casual conversations and news coverage leading to more expenditure cuts as stocks fell. He further highlights the narrative of the 1929 crash was so strong that the 1987 stock crash reignited the same memories and the similar narrative was resurrected (Figure 4)

Figure 4

Source: Page 24 of “Narrative Economics” by Robert J. Shiller

• The recession of 2007-2009 was also “Great”

The figure below suggests far more attention was paid to the Great Depression  in 2009 than during the Great Depression itself. This could be due to representativeness heuristic- a principle that people judge current events by their similarity to memories of representative events. The Great Depression could be a model that is exaggerated in people’s minds because of its ill status.

In 2007-09  this narrative was reignited and could have resulted in a self-fulfilling prophecy – resulting in a mirror image of the Great Depression itself. Which in effect caused the stock market to crash and run on banks (eg Northern Rock).

Shiller further argues that the very name “Great Recession” could be interpreted as evidence of a narrative epidemic. Naming the financial crisis after the Great Depression could not  have been a choice of any one individual.

Figure 5

Source: Page 32 of “Narrative Economics” by Robert J. Shiller

• Bitcoin Mania

In his book, he highlights that the rise of Bitcoin could be explained via a constellation of narratives which can create a powerful overarching story rather than a single story. These factors included:

– The notion of irresponsible management by central banks stemming from older anarchist and bimetallism narrative

– Tales around missed opportunity and regret aversion. For instance, in 2009, singer Lily Allen refused to accept payment for a concert in bitcoins. If she had accepted and held onto it – she would have been a billionaire.

– Part of the appeal of the Bitcoin is his founder (Satoshi Nakamoto) who has remained a mystery. This gives him a hero status as he never has been identified (the government can not tax him if they can not even find him).

Rise of Trump

Nobel Laureate believes Trump’s public persona from his lifelong effort to promote himself as a business genius , someone who makes hard decisions and strike deals through his reality television show (The Apprentice) is a part of his narrative – led to his political success.

Bottom Line

Shiller argues that economists need to look beyond economic data like GDP, wages, interest rates and taxation levels to understand economic and market dynamics. He argues that analyzing personal letters, religious sermons (gauge shifts in thinking), social media, archival newspaper and books may provide qualitative accounts that our traditional data points may be missing. Additionally, incorporating models from epidemiology may help us explain phenomena like the great depression of the 1930s. In fact, some of these ideas are already being adopted with the rise of alternative data. But the value of Shiller’s work on narrative economics is to apply a framework to this type of data.

Recommended Listening: Narrative Economics (LSE Public Lectures and Events, 78 min listen)

Mehdi is a research analyst at Macro Hive. He’s currently pursuing an MSc in Finance & Investment at Nottingham University Business School and he is a CFA level 3 candidate. Mehdi has previously pursued roles as an Equity Research Analyst, Junior Economist & in Proprietary Trading.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)