‘Animal spirits’ update

Recall that the theory of “animal spirits” that we channel from an obscure article in the Journal of Economic Psychology in 1996, “Adaptation level and ‘animal spirits,’ callously and dishonestly ignored in Shiller and Akerlof’s book on “animal spirits,” posits that the general level of confidence or “animal spirits” in America is largely determined by where the unemployment rate is relative to a recent adaptation level represented by an exponential moving average relative to the standard deviation of the unemployment rate over the past 48 months:

A = – (U – UMEAN)/Sigma(U)

where the minus sign makes the measure a positive confidence measure.

Currently the adaptation level of the unemployment rate is 8.8 percent, while the current reading is 9.0.  The adaptation level is also rising.  So the possibility that I have mentioned before of a secular exhilaration in 2012 is still before us; if the reported U3 unemployment rate falls to 8.8 or below before the election, “animal spirits” as proxied in this model will “go positive:”

As can be seen from the history, when the A metric crosses below the zero line from above the economy has generally been at the onset of recession (an acceleration and change of sign of the real growth rate).

The situation today, with the abysmal levels of survey-reported consumer confidence (the Michigan sentiment series is in green) most resembles late 1971-1972, when there was a brief swing into positive “animal spirits” during the election year, followed by up-till-then most serious recession of the postwar period.

In 1972 the A metric went positive in exactly the election month of November and continued upward until October 1973, almost exactly coincidental with start of the severe early ‘Seventies recession (when I was working my first job out of college, and was required to take a ten percent cut in pay from $8,000 annually in New York City—I went to graduate school).  Note the anticipatory pattern of the Michigan index, then created quarterly.

By whatever means—civilian labor force participation rate shrinking faster than employment contracts—the psychologically sensitive unemployment rate may decline in coming months enough to trigger a secular exhilaration, that is likely to be followed by deepening depression unless the unbalanced nature of the U.S. distribution is altered quickly, which appears unlikely.

2012 is going to be an interesting year.