A growing body of evidence shows that sentiment and economic growth tend to rise and fall together. However, the channel of this correlation and potential causality are unresolved. Is sentiment related to fundamentals? Is sentiment a signal of future productivity but does not cause it? Does sentiment exert an immediate and lasting effect on economic growth through a self-fulfilling feedback loop? Given the many factors that impact economic activity, isolating the effects of consumer sentiment poses a challenge.
The authors propose a novel way to address these questions by analyzing data across sixteen countries with varying degrees of efficiency in their capital markets over the period 1975 to 2019. They hypothesize that countries with less efficient capital markets respond more strongly to sentiment shocks because investors are unable to distinguish between a change in fundamentals and a change in sentiment unsupported by fundamentals, a prediction that they exploit in their research design. The authors apply four different measures of efficiency of capital markets: inclusion in the G7 group, inclusion in the Eurozone, stock turnover over GDP, and per capita GDP. The authors study how economies of varying efficiency of capital markets respond to changing sentiment, and find the following:
This paper offers new evidence on how sentiment impacts the economy. At least in countries with less efficient capital markets, sentiment appears to be a driver of economic booms. By contrast, sentiment shocks in countries with efficient capital markets leads to only short-term fluctuations that are unrelated to productivity. More broadly, this paper demonstrates how the financial sector influences economic growth.