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:
- In countries with efficient capital markets, positive sentiment shocks increase economic activity only temporarily and without affecting total factor productivity. Sentiment shocks predict modest increases in consumption, employment, and income for two years.
- In countries with less efficient capital markets, sentiment shocks predict more prolonged economic growth and a corresponding increase in total factor productivity. Sentiment shocks predict large increases in consumption, employment, and income for four years.
- These effects are driven largely by financial markets: with positive sentiment driving up stock prices, investors are quick to take advantage of the lowered cost of capital. The authors observe increased capital investment and their associated rate of return following sentiment shocks.
- Countries with efficient capital markets exhibit a faster mispricing correction, lending support to the authors’ hypothesis that such markets are more efficient. As a result, sentiment is a negative predictor of returns.
- By contrast, countries with less efficient capital markets exhibit a slower mispricing correction because investors misinterpret consumer optimism as a signal about better investment opportunities. As a result, sentiment is a positive predictor of returns.
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.