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Smart consumers. stupid voters

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What do ordinary folk know about economics? This question has been revived by Simon, who argues that support for a no-deal Brexit is based upon “information failure” caused by our biased and inadequate media. This is in a similar spirit to Jason Brennan and Bryan Caplan, who argue in different ways that voters are irrational and/or misinformed. My chart offers a corrective to this view. It shows that the ratio of retail sales to share prices has been a fantastic predictor of equity returns since the current vintage of retail sales data began in 1996. The correlation between the ratio of retail sales to the All-share index and subsequent three-year changes in that index has been a whopping 0.76 since 1996. Ordinary people, then, know something very important. In aggregate, they know

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What do ordinary folk know about economics? This question has been revived by Simon, who argues that support for a no-deal Brexit is based upon “information failure” caused by our biased and inadequate media. This is in a similar spirit to Jason Brennan and Bryan Caplan, who argue in different ways that voters are irrational and/or misinformed.

My chart offers a corrective to this view. It shows that the ratio of retail sales to share prices has been a fantastic predictor of equity returns since the current vintage of retail sales data began in 1996. The correlation between the ratio of retail sales to the All-share index and subsequent three-year changes in that index has been a whopping 0.76 since 1996. Rsasi

Ordinary people, then, know something very important. In aggregate, they know where the stock market is going.

I’m not saying anything new or original here. My chart is merely a simplification of work by the Bank of England and by Martin Lettau and Sydney Ludvigson (pdf) which shows that consumer spending predicts equity returns.

There’s a simple reason for this. Consumer spending is forward-looking: if we expect good times, we’ll spend more than if we fear the sack or a pay cut. When spending is high, therefore, it predicts good times and when it’s low it predicts bad. For this reason, there’s also a strong correlation (0.48) between the retail sales-All-share ratio and subsequent three-yearly changes in manufacturing output, an indicator of cyclical conditions.

Of course, if you take any individual consumer, s/he might well be ill-informed or irrational. But across millions of them such errors will cancel out. There’s sometimes wisdom in crowds.

Now, you might object that my chart overstates this wisdom. Share prices tend to over-react, rising and falling too much. This means that their ratio to any stable indicator – even a time-trend – will also predict subsequent returns.

True. But irrelevant. The fact that shares over-react and can be predicted by consumer spending tells us that ordinary folk know more than the so-called expert fund managers who move share prices.

The people, then, can be smarter than elites.

How can we reconcile this with Simon’s depiction of many of them as know-nothings? Simple. There are, in my context, at least three big differences between consumers and voters.

First, consumers don’t need to know why things are happening. They only need a feel – often inarticulable – of what might happen. If we ask them in aggregate “where’s the economy going?” they can tell us. If we ask why, we might well get nonsense. David Leiser has shown one reason for this. People, he says, are terrible at making connections between economic events. For example, they fail to blame austerity for low returns on their savings. Instead, they often believe that good begets good. So, if you think Brexit is a good thing, perhaps for reasons independent of economics, you’ll be tempted to think it’ll have good economic effects: wishful thinking is powerful and ubiquitous.

Secondly, consumers have skin in the game whereas voters (as individuals) do not. If you spend too much or too little, you suffer. If you have a stupid opinion about politics, however, you don’t because your opinion doesn’t alter the outcome. In this way, consumers are incentivized to think whereas voters are not.

Thirdly, consumers’ errors are largely uncorrelated – except to the extent that there are peer effects or information cascades. Voters’ errors, however, can be correlated thanks to the influence of the mass media. One of the key conditions for there to be wisdom in crowds is therefore more likely to hold for consumers (at least in the circumstance I’ve described) than for voters.

All this poses a big and under-appreciated question: how might we change our political institutions so that we’ve more chance of mobilizing the disaggregated wisdom of people whilst filtering out the madness of crowds.

Representative democracy, with MPs acting as Burkean filters against poor judgment used to be one, albeit very imperfect mechanism. It’s now clear, though, that we need others which might well include some form of deliberative democracy (pdf). With a few honourable exceptions - such as Paul Evans - nobody seems much interested in this issue, however. As long as our side wins, we don't care about the rules of the game or its health. 

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