Economist Robert Shiller, author of “Irrational Exuberance” and now “Animal Spirits” with Nobel Economist George Akerlof, recently gave a lecture on animal spirits at the University of California Santa Barbara in the annual Snyder Lectures.

He attempted to explain to a packed audience why human emotions were such an important part of economic behavior. It is because we cannot know the future. And so we rely on either hunches or intuitive guesses for making decisions about the future—which are tied to our emotions. Hence we try to mitigate the uncertainty of future events with various degrees of optimism or pessimism.

In fact that should be no surprise to anyone in this recession. It is why one of the leading indicators of economic activity is consumer confidence, since how consumers feel about their prospects tends to determine what they both spend and save.

And consumers’ confidence has finally begun to rise in both the University of Michigan and Conference Board surveys after a record drop. The Conference Board’s Confidence Survey, a “representative sample of 5,000 U.S. households”, surged more than 13 points to 39.2, while Michigan’s index rose more moderately— 7.8 points to 65.1.

clip_image002

The Conference Board’s expectations index that predicts activity 6 months out soared 19.3 points to 49.5, signaling a jump in ‘animal spirits’ that Shiller and Akerlof are talking about. Why are consumers becoming more confident?

There are many signs of an improving economy, for one. Real disposable personal income (after taxes and inflation) is soaring, up 6.2 percent, according to the first estimate of Q1 Gross Domestic Product growth, which is being translated into more consumer spending. Just Durable Goods’ spending on more permanent products increased 9.4 percent in Q1, vs. a 22 percent drop in Q4 2008.

The increased income comes from lower inflation and taxes, with personal taxes down a huge $194 billion in Q1, vs. an increase of $19.7 in the last quarter, and no inflation in 2009 to date, as the enclosed chart shows.

clip_image004

Just as important is success of the credit easing moves by the Federal Reserve and Treasury. Almost all interest rates are at historic lows and lots of money is sloshing around with more than $2.5 trillion sitting on the sidelines in various money market accounts, which contributes to a growing feeling of wealth. This is also why the mortgage refinance market is booming.

And lastly, real estate is showing signs of life with property values back to 2004 levels. Pending existing-home sales, a forward looking indicator, is showing increased buyer traffic and even builders’ confidence is higher of late.

All of this doesn’t yet indicate that the recession is over. But just as irrational pessimism was generated by the loss of confidence in market institutions, whatever the cause, so can confidence be restored when the future looks more certain.

Harlan Green © 2009