The importance of confidence to the economy

Keynes talks a lot about confidence and the animal spirits of firms and people when making decisions. So how important is confidence to the economy?

Without confidence businesses wouldn’t invest. This can be seen in the present climate, many firms have a lot of spare cash on their balance sheets, which could potentially lead to high investment which would be a massive boost to the economy and would provide thousands of jobs. So why aren’t they doing so, they aren’t making any returns leaving their money in a bank account (in fact they may be receiving a negative real interest rate on their savings), the alternatives to saving money for firms is to either return it to shareholders in the form of dividends (which would result in the government gaining capital tax gains as well as stamp duty, and the investors are likely to either spend it or invest this money in other assets thus increasing their value) or to spend. Spending for a business can be considered investment as they will increase their capital stock in order to increase their potential maximum output level.

But because they are choosing not to do these alternatives (mainly, it is remaining in bank accounts) shows that they believe they aren’t going to receive a better rate through investing their money (by giving the money to the shareholders they won’t make any money, so we don’t need to worry too much about why this isn’t occurring!). Does this mean that the economy is in such dire straits that firms wouldn’t be able to recoup their investments, or is this more of an issue with confidence.

Although the economy is lacklustre, and we have experienced recently a double-dip recession, I don’t believe it is that bad that businesses wouldn’t make a return on their investment. It is more likely that the risk of the investment going bad (and them losing money) is higher than it used to be. This and the economic news and forecasts reported by the press are leading firms to hoard their cash as they don’t have the confidence to invest it. If this is the case then confidence plays a huge part in the economy. During booms when confidence is high, investment is also high, and bubbles occur. This shows that confidence is important to the economy. Low confidence can be negative and bad for the economy as it results in low growth, and over confidence can be negative if it leads to asset bubbles which will eventually burst. If all firms invested their cash now rather than spent it, they could create jobs (they would need to hire people to provide the service or make the good, as well as hiring builders to make the new factories, etc, etc). If they created jobs then these employees would have money to spend on the items that the firm (they now work) is producing and hence contribute to the profits of that firm. Meanwhile they would also be buying other goods and thus creating more jobs and wealth through the multiplier effect. This is effectively the circular flow model, and the only thing that would prevent this cycle is the withdrawals. Hence the fact that firms could get us out of the economic mess we are in, if they were more confident, shows how important this feeling is.

Similarly confidence also determines how much consumers spend. If they are confident that they will remain in their job, then they may be more inclined to take a loan out to purchase expensive goods, and they would feel less of a need to save their money and may instead spend it (they are likely to have a higher propensity to consume). If they are confident that they will receive a real wage increase then they may also increase their consumption. An increase in consumption (which is a component of aggregate demand) will lead to a rise in AD and hence there would be economic growth. Therefore confidence also ties in with the consumption component of aggregate demand.

Finally, confidence can also affect the actions of the government. If the government is confident that the economy will grow (and hence it will receive more taxes and will have to payout less benefits) then it may increase its spending as it believes that taxes will rise and hence increasing spending won’t increase the budget deficit. Increased spending would provide an economic boost and therefore confidence also affects the governments actions.

So we have concluded that confidence is very important to the economy, and if there was more of it then there would likely be economic growth, but how do we increase confidence? For this to happen I first believe there needs to be some data to show that economic growth may be occurring. If the media was then more upbeat about the future possibilities then this may also increase confidence. However, in reality, firms and consumers are only likely to be more confident if they see for themselves more money coming in. Its all well and good there being economic growth but if a firm doesn’t see a rise in its revenues or a consumer in their real wage then they are unlikely to be confident and optimistic about the future.

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