RDP 2016-10: The Effect of Consumer Sentiment on Consumption 6. Implications for Macroeconomic Models

To this point we have taken the changes in consumer sentiment at changes of government as given, and sought to identify their effect on consumers' spending intentions and postcode-level motor vehicle purchases. Here we discuss whether this variation could reflect mechanisms identified by existing macroeconomic models.

The sharp changes in sentiment at changes of government represent variation plausibly unrelated to changes in current economic conditions, suggesting that changes of government may act as news shocks (Beaudry and Portier 2006). Barsky and Sims (2012, p 1371) have argued that ‘fundamental news is the main driving force behind the observed relationship between confidence and subsequent economic activity’.

We do not believe that the shifts in sentiment at changes of government reflect unbiased expectations of changes in future incomes. Changes of government could lead to systematic changes in the income distribution, benefiting supporters at the expense of opponents, but consumers disagree on both expected personal and general economic conditions. Supporters of the winning party expect both their own and national economic conditions to improve substantially, while supporters of the losing party expect the opposite. Any explanation based on changes in future incomes would have to reconcile these conflicting beliefs about national economic conditions. We also find it difficult to think of systematic changes in government economic policy that could cause the magnitude of revisions to beliefs about personal economic conditions that we see in the sentiment survey at changes of government. Furthermore, controlling for a wide range of economic and demographic groupings to which economic policy could be targeted does little to reduce the difference in sentiment between supporters and opponents of the government.

Another possibility is that the variation in sentiment we use represents noise shocks, which Barsky and Sims (2012, p 1345) define to be ‘… optimism or pessimism that, while not ex ante irrational, is erroneous from the point of view of an outside observer with knowledge of the shocks’. Lorenzoni (2009) develops a model in which noise shocks cause consumers to temporarily over or underestimate the economy's productive capacity, generating aggregate demand-like features. Consumers receive a noisy signal about changes in aggregate productivity, but learning is sluggish because idiosyncratic supply shocks and dispersed information create a high degree of uncertainty about current productivity. In our setting, this would equate to particularly slow learning, with sentiment responding predictably at each change of government, and disagreement between supporters of the government and opposition party persisting for the entire term each party holds office. This suggests that voters hold strong priors about the superiority of their party's economic management, and face strong frictions filtering the contribution of their party's economic policy from other influences on economic outcomes. The evidence from Bartels (2002), discussed earlier, indicates that there are even substantial frictions limiting learning by voters about past economic conditions.

In a departure from the news-noise view of business cycles, there is a literature looking at how agents can coordinate on market equilibria. Matsusaka and Sbordone (1995) find that a model with strategic complementarities can lead to multiple equilibria with sentiment influencing which equilibrium is reached. Angeletos and La'O (2013) develop a unique-equilibrium model in which aggregate fundamentals and preferences are known by all agents to be unchanging but sentiment shocks can nonetheless cause variation in aggregate demand. Sentiment shocks generate correlation in higher-order beliefs, such that optimism (pessimism) is justified by signals that others are also optimistic (pessimistic). The variation in sentiment at changes of government that we document could be a result of higher-order belief dynamics along the lines of Angeletos and La'O, but this is necessarily speculative because only first-order beliefs are observable. Furthermore, there is nothing in the theory proposed by Angeletos and La'O that would generate strong positive within-group correlation in beliefs and strong negative between-group correlation in beliefs.

Considering these possibilities, we believe that the partisan variation in sentiment most likely represents noise. But we remain surprised that barriers to learning are sufficiently strong for these difference in beliefs to be so persistent and predictable. While difficult to explain from a theoretical point of view, it is these features of the sentiment data that are so useful from an econometric identification point of view.