Narrative Economics — How Stories Influence Decision-Making

Narrative Economics — How Stories Influence Decision-Making

The economic behavior of people is rational, however, human rationality has limits. This is clearly seen in the example of financial bubbles, the emergence and stability of which can not be explained by accidental mistakes of traders — the process of making investment decisions is influenced not only by logic and rational calculation, but also by psychological and social factors, such as ethnicity of counterparties. Moreover, it often makes sense to model market interactions, like other economic processes, as complex systems with internal dynamics, and not as equilibrium mechanisms driven by external shocks only.

 

Similar reasoning has formed the basis for behavioral finance, a section of the financial economy in which markets are viewed from the perspective of cognitive limitations of the economic agents interacting with them. One of the most influential researchers in this field, Robert Shiller, Professor at Yale University and Nobel Prize winner in Economics (2013) for his work in Behavioral Finance, took the next step in the development of these arguments by proposing a new research program — narrative economics.

 

Stories, emotions and scenarios: what narrative economics is all about

 

 

The basic idea of narrative economics is that people make economic decisions under the influence of narratives — stories telling about certain events through which people perceive reality and where they find the reasons for their actions.

 

Most economic decisions are based on expectations about the future. However, since the future, by definition, does not yet exist, making economic decisions one can not be guided by facts alone: expectations, forecasts and images of the desired or undesirable development of events are always mixed in this process. More often, these “implicit models” are narratives or stories.

 

Narratives become even more relevant in situations of uncertainty where a rational calculation of risks is not possible in principle. In this situation, they can act as scenarios that people follow. For example, one of the key rules of institutional investment in the US — the so-called prudent person rule — prescribes investing in the way an imagined “prudent investor” would do, that is, to proceed, first of all, from the need to preserve the capital entrusted to them. Investment fund managers cannot rely on their own risk assessment, which may be erroneous, even if they are convinced otherwise, but are required to act as a “prudent person” would act.

 

Another example is the investment proposal of a technological startup or cryptocurrency ICO. Such projects offer investors to rely on a certain scenario of the future, the chances of implementation of which are difficult to assess in strict accordance with rational criteria. In such situations, the credibility of the history of future events is crucial. For example, this may be a story about how the progressive reduction in the cost of silicon production will allow solar panels to drive out traditional mechanisms of energy production, or that in the next 10 years rent from the Internet of things will be spread through the use of technologies that generate passive income: from unmanned vehicles running as taxis to the same solar panels.

 

 

It is these stories and their impact on economic behavior that Shiller proposes to study. It gives a simple example: recession is a recurrent phenomenon in the economy, when many people decide to reduce their expenses, that is, spend less, and therefore buy less, postpone substantial purchases (new home or car) and investments (starting a new business).

 

Of course, on the one hand, these decisions of individuals can be feedback — they react to the recession that has already begun. However, according to Shiller, in order to understand why recessions and other similar cyclical processes (for example, speculative demand for certain financial assets) begin at all. If you look closely, the depth and scale of any recession are influenced by certain stories, which are convincing in their appeal to human emotions.

 

How emotions affect expectations from the stock market

 

In 2016, Shiller and co-authors conducted a study that found that institutional investors and just rich people tend to exaggerate the risk of falling stock market under the influence of alarmist narratives. Thus, a survey of investors showed that even such an event as an earthquake can significantly affect their assessment of the probability of a fall in the market: respondents who lived within 30 miles of the epicenter of the earthquake that occurred in the previous 30 days estimated the probability of falling the market higher than the rest of the survey participants, the difference being statistically significant. Similarly, the results of world sporting events sometimes have significant effects on investor confidence.

 

 

Being influenced by strong emotions caused by a significant event, people spontaneously begin to experience the same feelings with respect to other events, phenomena and processes not related to the original trigger. In psychology, such a mechanism is known as affective heuristics.

 

How narratives generate epidemics

 

However, it is not only about psychology as such, but also about the way in which narratives are constructed, as well as the rhetorical power of the categories they use. A good example here is the history of BRICS — a group of countries with fast-growing and large-scale economies (Brazil, Russia, India, China, South Africa). Today, the BRICS abbreviation is firmly entrenched in politics and journalism and is perceived as something natural; however, it was invented by a specific person — Goldman Sachs analyst Jim O’Neill. In 2001, he prepared an analytical note on the development prospects of the largest developing economies in the world - BRIC (at that time South Africa was not yet among them). The grouping of countries by this principle was part of a broader narrative telling about the future: Goldman Sachs analysts predicted that in the next 50 years these countries would become the new core of the world economy. Of course, these findings were not overlooked by the BRICS leadership, whose regular summits confirmed the reality behind the catchy abbreviation, which, in turn, was rapidly becoming part of applied economic analysis and was mentioned in government programs and speeches of politicians, thus taking root in the imagination of the general public. The BRICS and the narrative of economic ascent behind this acronym have become “viral”, spreading like an epidemic — through mentions, quotes, databases, and analytical reports.

 

Participants of the BRICS Summit in Johannesburg on July 26, 2018 // Kremlin.ru

 

Sociologist Leon Wansleben studied in detail the process of creating and positioning this category, having conducted a series of interviews with key persons, including O'Neill himself. The category he created was conceived as a rhetorical technique and was intended to replace the alternative designation of this group of countries, “emerging markets”. O’Neal offered a vivid image of stability, reliability (BRIC is spelled and sounds almost like the English word “brick”) and unlimited possibilities related to the size of the territory, population, and the size of the markets of the BRIC countries. The forecast of O'Neill and his colleagues had quite a tangible effect: as Wansleben shows, over the 10 years from 2001 to 2010, portfolio foreign investments in the BRIC countries have grown from $240 million to $1.95 trillion, significantly outstripping the growth rate of investments in countries of a wider group of “emerging markets”.

 

Since the narrative economics is forming before our eyes, it is too early to talk about the final results. However, even at the initial stage, there are several conclusions:

 

First, economic agents make decisions under the influence of narratives, which are particularly important in situations of uncertainty that exclude the possibility of reliable probabilistic assessment of future events.

 

Second, narratives have serious economic consequences, as they appeal to emotions and images — for example, they can change investment expectations or even redirect investment flows from one group of countries to another.

 

Thirdly, narratives circulate like epidemics, passing from person to person and even more through media, analytical publications and political speeches that give these narratives greater persuasiveness. However, it must be understood that the sustainability, reproducibility and distribution of narratives are not necessarily related to the fact that they are true or accurate as descriptions of certain realities. Persuasiveness does not mean truth, therefore, as Shiller writes, the long-term effects of narratives are not related to their correctness, but to how "contagious" they are.