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Peter Atwater: Of Course Consumers Hoarded Their Gas Savings


Why underconfidence and the "Income effect" matter.

Last December, the message from Wall Street was clear: lower gas prices would act as a huge tax cut for the Middle Class, creating a big tailwind for Spring retail sales.

Instead, the savings rate soared while retail sales sputtered. Consumers simply stockpiled the benefit of lower gas prices or paid down debt.

To many economists, the behavior remains a mystery.

Where economists failed in their forecasts was in their disregard for the current confidence level of the middle class. Instead of considering how the mood of consumers would impact action, they focused on how lower gas prices would impact confidence. Rather than seeing mood as an input to consumers' decision making, they viewed it only as an output.

Our level of confidence greatly impacts our preferences, decisions and actions.

When it comes to economic decision making, we act as we feel, not the reverse.

When our confidence is low, we exhibit a clear pattern of "me, here, now" behaviors. Self-interest, close geographic, and short-term time preferences dominate our preferences and choices.

Last fall, when gas prices began their sharp decline, average American economic confidence, as measured by Gallup, was decidedly negative. Many more people viewed current and future economic conditions negatively than they did positively. 

But weak economic confidence wasn't a sudden phenomenon. Per the Gallup chart above, the average American felt the same about the economy in the fall of 2014 as he did in the summer of 2009.

Coming into the decline in gas prices, consumers had experienced five years of consistent negative moods. Those for whom the cut in gas prices would be most beneficial were chronically underconfident.

Rather than behaving like highly confident consumers and spending their gas savings, middle-class Americans exhibited extreme "me, here, now" preferences.  They saved or paid down debt to reduce uncertainty. They acted as they felt.

Through the fall, consumer confidence increased as economics condition improved and a virtuous cycle began to take hold, especially as middle-class Americans (like many investors) perceived the decline in gas prices to be more and more permanent. 

Once prices at the pump turned up, that cycle reversed. Economic confidence is now at its lows for the year. A few months ago, oil prices were viewed as low. Now, they're "volatile."

Even without further price increases at the pump, the fear of price volatility is likely to be a further drag on consumer spending.

Beyond economists' failure to value consumers' confidence level, there is another important lesson to be learned from this latest "mystery.". 

When confidence is low and "me, here, now" preferences dominate, what happens to our "net" income (wages as well as food, gas, housing and healthcare costs) takes on far greater importance than many economists realize.

It is the "income effect" that matters most to us. 

The "wealth effect" is strictly a high confidence experience. It only occurs when we perceive price increases to be permanent and real in nature. That takes confidence -- something middle-class America lacks.

Rather than focusing solely on asset prices and the wealth effect experienced by the highly confident, economists and policymakers need to appreciate the enormous significance of the "income effect" to the underconfident. 

A study by the New England Complex Systems Institute, for example, linked the Arab Spring and other spontaneous social uprisings to high food price inflation. More recently, while low interest rates may have helped to boost financial asset prices, they crippled the confidence of savers and many retirees because of the extreme negative "income effect."

To make accurate forecasts, economists and policymakers must better appreciate the current human condition. 

We act as we feel. 

Our level of confidence is a critical input in our preferences, decisions and actions. With middle-class American confidence still negative despite five years of unprecedented monetary policy actions and record financial asset prices, it is time economists better understood the chronically underconfident, their extreme "me, here, now" behaviors, and the enormous importance of the "income effect."

Real economic growth starts is the result of confidence -- not the reverse.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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