Economic recessions may be primarily an outcome of widespread pessimism among businesses and individuals rather than the result of inherent systemic problems. Creating appropriately optimistic beliefs is a key way of tackling such crises. These are the conclusions of new research by Professors Ananish Chaudhuri, Andrew Schotter and Barry Sopher, published in the January 2009 issue of the Economic Journal.
Chaudhuri and his colleagues use economic decision-making experiments to simulate an extreme example of a real-life problem of coordinating people''s actions. Their findings lead them to conclude that:
''Getting a message to coordinate is not enough. Each person must be convinced that others have received the same message and interpreted it in similar ways.
''A shared comprehension of the message is absolutely crucial to solving such coordination problems.
''Thus in combating crises, we really need to think of innovative actions or social processes that generate optimistic beliefs''.
In the context of the current crisis, an example of such a commonly perceived public announcement might be the one made by the UK government early on of a plan for major equity injections into UK banks, backed up by guarantees on bank debt that should get lending among banks going again. This may have gone a long way towards calming jittery financial markets.
A fundamental problem in deep recessions is that the economy gets caught in an ''under-employment trap'', where no firm wishes to expand production unless it can be assured that others will do so, yet not doing so leads to an outcome that is worse for everyone concerned. Such loss of faith, which often tends to be self-fulfilling, can have devastating financial consequences. The question then arises as to how this faith can be restored.
In the experiment these researchers conducted, participants are formed into groups and have to choose one of multiple actions. There is one particular action that yields the maximum profit to each participant. But this choice is risky in that if even one group member deviates and chooses a different action, then each of the participants who has chosen the risky option loses money. So the challenge is to get all the participants to coordinate on the risky action.
The researchers find that groups often find it difficult to do so and fall into an under-employment trap. Even very small amounts of doubt in the minds of participants that someone in the group may not choose the profitable but risky action is enough to cause massive coordination failures.
The authors then analyse whether it is possible for groups to ''talk'' themselves out of such an under-employment trap. They develop an innovative ''inter-generational'' paradigm in which one group of players, after playing the game, can leave advice for their successors. This continues for a number of generations.
The authors find that allowing one group to pass advice to the next can indeed create the optimistic beliefs that lead to coordination on the risky action, but with a twist. When the advice is private and given from one participant to his or her immediate successor, the advice tends to be pessimistic, suggesting following the least risky course of action.
For the advice to make a difference, it must be public and common knowledge in the sense that everyone in the group must get the same advice and must also know that everyone else is getting the same advice. So if a political leader makes a public announcement that is heard by everyone and everyone knows that everyone else has heard it, then a necessary condition has been met for successful coordination.
''Talking Ourselves to Efficiency: Coordination in Inter- Generational Minimum Effort Games with Private, Almost Common and Common knowledge of Advice'' by Ananish Chaudhuri, Andrew Schotter and Barry Sopher is published in the January 2009 issue of the Economic Journal.
