What economic shocks mean matters as much as the shocks themselves

“The stories firms, households and investors tell themselves about the economy can shape growth, investment and unemployment as much as policy or market structure. Biagio Bossone argues that this is not just a theoretical argument for macroeconomists. It has relevance for firms, investors and policymakers. When beliefs, not frictions, drive the economy those who shape the dominant narrative can influence the conventional belief that prevails, and with it the direction the economy takes. In business and economics, we often assume outcomes are driven by “fundamentals” including productivity, interest rates , institutions, incentives and policy . But there is another force at work: the beliefs through which people interpret those fundamentals. Frank Hahn , a British economist, made this point sharply in the 1980s. Criticising the monetarist challenge – the argument, advanced by Milton Friedman and the Chicago School during the stagflation crisis of the 1970s, that Keynesian demand management had caused more instability than it cured – Hahn noted that such critique only held if people actually formed expectations according to monetarist doctrine; otherwise, he joked, society might have done better to tax monetarist writings and subsidise Keynesian ones. A decade later, reflecting on Britain under Margaret Thatcher, prime minister between 1979 and 1990, Hahn argued that once monetarist ideas became the dominant public narrative, the same policy impulse could have different effects because firms, workers and consumers began to read economic signals through a different lens. This observation matters because it suggests that economic outcomes depend not only on structures and policies, but also on the shared beliefs through which people interpret prices, output, employment and policy announcements. This is the core idea behind recent research on conventional beliefs : even a fully neoclassical economy with flexible prices, rational agents and no frictions can generate persistent Keynesian outcomes, including involuntary unemployment, if people interpret economic signals through a Keynesian belief system. What is a conventional belief? A conventional belief does not need to be objectively correct; it only needs to be widely shared. Once enough firms, households, investors and policymakers accept a particular view of how the economy behaves, they act in ways that reinforce it. Shaped by institutions, experience and policy regimes, these beliefs become powerful anchors of behaviour, influencing how people form expectations, respond to shocks and judge whether a disturbance is temporary or likely to persist. Take a simple example. Falling prices can be interpreted in two opposite ways. In one view, they signal adjustment: markets are clearing, the economy is moving back toward equilibrium and recovery is near. In another, they signal weak demand: firms expect weaker sales, households fear lower income and both become more cautious. The observed fact is identical but the meaning attached to it is different. And the difference matters because meanings attached to signals shape expectations, and expectations in turn shape behaviour. Two economies with the same fundamentals To see the point, imagine a stripped-down neoclassical economy: perfect competition, flexible wages and prices, rational agents, no institutional rigidities and no financial frictions. Now imagine that this economy can operate under two different belief regimes. Under a Walrasian belief regime (named for the French economist Léon Walras ) people assume markets are inherently self-correcting. Deviations from equilibrium are read as temporary. Falling prices are taken as evidence that excess supply will soon be eliminated. Firms expect profitability to recover through adjustment. Households expect labour demand to return. Investment decisions remain broadly consistent with a rebound. Under a Keynesian belief regime (for British economist John Maynard Keynes ), people assume the economy is driven by effective demand. Falling prices and output are interpreted as signs of deteriorating sales prospects and a more persistent slowdown. Firms scale back hiring and investment. Households increase precautionary saving. What, in the first regime, looked like adjustment now looks like deterioration. Preferences, technology, policy and institutions are identical. Only the interpretive framework differs. Yet outcomes are shown to diverge sharply: in one case shocks fade, in the other they persist. The point is not that the real world is frictionless, but that even holding frictions constant, beliefs can generate very different macroeconomic trajectories (Chart 1). Chart 1. One Shock, Two Belief Regimes Why business should care This is not just a theoretical argument for macroeconomists. It has relevance for firms, investors and policymakers. Business decisions are always partly interpretive. A company does not respond mechanically to lower prices, weaker demand or lower interest rates. It responds to what managers believe those signals imply about future sales, margins, financing conditions and the likely persistence of a slowdown. If firms believe the downturn will be short, they may postpone investment but retain staff, protect supplier relationships and prepare for recovery. If they believe the downturn signals a lasting deterioration in demand, they cut more aggressively, conserve liquidity and suspend expansion plans. When many firms do this at once, pessimism deepens the downturn that firms feared in the first place. This helps explain why similar policies can produce different outcomes in different countries or at different time periods, why some recessions fade quickly while others linger and why confidence matters. It also helps explain why communication matters so much for policymaking. Market participants do not only respond to policy changes. They respond to the narrative that surrounds those changes. Beyond the Lucas critique This perspective also challenges one of macroeconomics’ most influential propositions: the Lucas critique. In 1976 Robert Lucas , an American economist, argued that policy cannot reliably affect real outcomes because rational agents adjust their expectations, while deep structural parameters remain stable. But this argument assumes that the reference model agents use to form expectations is fixed. Once conventional beliefs are allowed to shift, that assumption becomes much less secure. Expectations may still be rational in the standard sense, yet the model to which they are rational can change. If so, parameters governing behaviour, persistence and adjustment are not fully policy-invariant. They are belief-contingent. This does not merely alter outcomes at the margin. It suggests that changes in dominant beliefs can alter the effective structure of the economy itself. Rethinking policy effectiveness The policy implications are substantial. In a self-correcting belief environment, stabilisation policy is likely to appear weak. Fiscal expansion may be discounted because firms and households expect private adjustment to do most of the work. Monetary easing may have little traction if price flexibility is believed to restore equilibrium automatically. In a Keynesian belief environment, on the other hand, policy can be much more powerful, but only if it is credible and consistent with the way people interpret events. Policies that stabilise incomes, wages, prices or investment expectations can interrupt pessimistic feedback loops and shorten downturns. In that context, nominal stability is not a distortion but rather a co-ordination device. This is a different claim from standard New Keynesian economics : the key issue is not whether prices are sticky, but whether policy supports or destabilises the dominant belief system. There is, however, an important limit. In structurally weak economies, demand support alone may not deliver durable recovery and may instead create inflationary, exchange-rate or debt pressures. Here Keynes’s broader idea of a lasting public influence over investment regains importance: stabilisation must be combined with measures that strengthen productive capacity. The economy responds to meaning For business leaders, the broader lesson is straightforward. Narratives are not peripheral to economic performance. They are part of its transmission mechanism. How firms interpret weak demand, lower prices, interest-rate shifts or fiscal expansion affects whether they invest or retrench. How investors interpret those same signals affects capital flows, financing conditions and policy space. In my work on the Portfolio Theory of Inflation , I argue that these interpretive dynamics are especially consequential in financially integrated economies, where global investors can shape domestic adjustment paths. Economic policy, then, is partly a contest over interpretation. Those who shape the dominant narrative can influence the conventional belief that prevails, and with it the direction the economy takes. The economy does not simply respond to shocks. It responds to what people believe those shocks mean for the future. Author’s note: I am grateful to Tom Palley and Roger Farmer for their encouragement to pursue this line of research. Any remaining errors and the views expressed are solely my responsibility. This article gives the views of the author, not the position of LSE Business Review or the London School of Economics. You are agreeing with our comment policy when you leave a comment. Image credit: Gannvector provided by Shutterstock. The post What economic shocks mean matters as much as the shocks themselves first appeared on LSE Business Review .

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