The Independent Market Observer

1/16/13 – Narrative Economics

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 16, 2013 9:18:31 AM

and tagged Yesterday's News, On My Bookshelf

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One of my favorite authors is Terry Pratchett, best known for a series of novels about the Discworld, a fantasy world (very) loosely based on medieval London and Europe. When you hear “fantasy,” though, don’t think unicorns and rainbows; instead, think folklore and Charles Dickens. Pratchett’s writing is an interesting combination of Dickens and Douglas Adams (The Hitchhiker’s Guide to the Galaxy), with more than a bit of P. G. Wodehouse thrown in. The series is worth a look, but the later books are better than his earlier ones, in my opinion.

One of the tropes of Pratchett’s universe is “narrative causality,” the notion that stories are entities that actually shape behavior in the real world. As he writes in The Last Continent, “. . . the proliferation of luminous fungi or iridescent crystals in deep caves where the torchlessly improvident hero needs to see is one of the most obvious intrusions of narrative causality into the physical universe.” Obviously, narrative causality doesn’t extend into the physical universe here, but it does extend into the behavioral universe. Therefore, it’s worth considering in terms of economics, which, after all, is just human behavior writ large.

I consider myself more of a narrative economist than anything else, particularly as opposed to a quantitative economist. Economics largely started out as storytelling, rather than math, and many of the discipline’s foundations are essentially nonmathematical. Unlike, say, physics or chemistry, economics isn’t a hard science; it deals with extremely unreliable basic elements—people—that change their behavior in response to changing conditions, which numbers or atoms will not. For a soft science based on people, narrative is better suited to describing the basic unit of analysis than math is.

Because of that, narrative economics is the best big-picture indicator of what is really going on. The risk is that you lose precision, but that’s also the benefit. Attempted precision can come at the cost of general accuracy—for instance, when the Fed failed to see the housing bubble building.

I’m writing this today because the narrative on the world and U.S. economy is changing, and this will have disproportionate effects going forward. Regarding the economy as a whole, today alone we see “Global Economy Brightens With Modest Growth Ahead, World Bank Says” and “Reports Signal Rising Strength in Consumer Spending” in the New York Times, and, in the Wall Street Journal, “Mercedes, BMW Count on Resilient U.S. Car Buyers” and “BofA Takes a Mortgage Mulligan,” which addresses the bank’s plan to take another run at the residential mortgage business. Consumers are starting to spend more, based on their perception of a healthier economy, and business is starting to bank on stronger U.S. growth, even as the rest of the world recovers. The narrative is shifting, and this is becoming a self-fulfilling prophecy, as we have already seen with the housing market.

Here’s another set of examples, also from today’s headlines: “2 Makers Press the Case for Electric Cars” in the NYT and “Nissan Races to Catch Up in Hybrids” in the WSJ. Again, the story has moved on from “electric/hybrid cars don’t work/aren’t cool,” and companies are responding, which will further reinforce the narrative. Expect to see this story continue to grow into the future.

I’ve highlighted numerous examples of this type of changing narrative in the past, particularly in the housing and energy areas, but I haven’t made an explicit connection to the notion of narrative causality. Other examples might be the role of the financial sector in the economy, which has certainly changed, or the role of the car in the life of a U.S. citizen. One of the financial speakers I respect highly, John Quinlan, gives a speech in which he translates the story of American growth to developing countries—another use of this technique.

Here’s a question for you: What stories are you seeing out there right now, and what will they mean going forward?

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