Michael C. Lovell

English

Research Papers in Economics

MICHAEL  C.  LOVELL 
Wesleyan  University 
Why  Was  the  Consumer 
Feeling  So  Sad? 
THE  INDEX  of consumer  sentiment,  compiled  quarterly  by the University 
of Michigan's  Survey  Research  Center  since 1953,  dropped  to an unprece- 
dented  low of 71.8 in the third  quarter  of 1973;  by the beginning  of 1975  it 
had slumped  to 58.1  Why  was  the consumer  feeling  so sad?  Certainly,  there 
was no lack of provocation.  Watergate,  widespread  unemployment,  dou- 
ble-digit  inflation,  and the collapse of the stock market  provided  cause 
enough for consumer  despondency.  Investigations  by Hymans and by 
Juster  and Wachtel  had suggested  that inflation  and fluctuations  in real 
income are of prime  importance  in explaining  consumer  sentiment;  but 
they did not include  the unemployment  rate  in their  regressions.  This  note 
updates  their  studies  in the light of recent  experience.2  Because  the mood 
of the consumer,  as measured  by Katona's  index of consumer  sentiment, 
has been identified  by Suits and Sparks,  by Hymans,  and by Juster  and 
Wachtel  as an important  determinant  of consumer  spending,3  a study of 
Note: I am indebted  to Eric  Postel for efficiently  executing  the computations  reported 
in this paper  on the Wesleyan  DEC-10  computer. 
1. First quarter  1966 =  100. 
2. Saul H. Hymans, "Consumer  Durable Spending: Explanation  and Prediction," 
BPEA,  2:1970,  pp. 173-99; F. Thomas  Juster  and Paul Wachtel,  "Inflation  and the Con- 
sumer,"  BPEA, 1:1972, pp. 71-114. The literature  on the consumer-sentiment  variable 
is critically  summarized  in R. William  Thomas, "The Effect  of Averaging  Components 
on the Predictability  of the Index of Consumer  Sentiment,"  Review  of Economics  and 
Statistics,  vol. 57 (February  1975),  pp. 684-91. Back data on the index are tabulated  in 
Business  Conditions  Digest (January  1975), p. 110. 
3. Daniel B. Suits  and Gordon  R. Sparks,  "Consumption  Regressions  with Quarterly 
473 474  Brookings  Papers  on Economic  Activity,  2:1975 
the factors  in the disillusionment  of consumers  may help to explain  the 
severity  of the current  recession. 
The simplest  explanation  for consumer  disillusionment  is the economic 
discomfort  index, obtained  by summing  the unemployment  rate and the 
annual  rate  of inflation.  This  index,  discussed  in the past in the Wall  Street 
Journal,  which  attributed  it to Arthur  Okun,  and published  by Data Re- 
sources,  Inc., is plotted  in figure  1 along  with  the index  of consumer  senti- 
ment.4  Regressing  the index  of consumer  sentiment  (ICS) on the economic 
discomfort  index  (EDI) yields5 
(1)  ICS  =  113.5  -  2.987EDI  +  e, 
(1.8)  (0.201) 
R2 = 0.746; standard  error =  5.299; Durbin-Watson  statistic = 0.547; 
number  of observations  = 76. 
where 
EDI=  U+tP 
U =  the unemployment rate 
P =  100 (CPI/CPI  4-  1) =  the  annual percentage change in  the 
consumer  price  index 
e =  error term. 
Data," in James  S. Duesenberry  and others,  eds., The  Brookings  Quarterly  Econometric 
Model  of the United  States  (Rand  McNally, 1965);  Hymans,  "Consumer  Durable  Spend- 
ing"; Juster  and Wachtel,  "Inflation  and the Consumer." 
4. This index is not without precedent.  Rostow constructed  a "social tension"  index 
for England  covering  the years 1790-1850  by summing  an index of the severity  of the 
business  cycle and an index of the level of wheat prices,  both coded on a 1-to-5 scale. 
He noted that intervals  of "high social tension"  identified  by the index coincided with 
known symptoms of unrest. See W. W. Rostow, British Economy  of the Nineteenth 
Century  (London: Oxford University Press, 1948), pp. 123-25. The DRI economic 
discomfort  index is analogous to Earl C. Thom's temperature-humidity  index (THI), 
introduced  by the U.S. Weather  Bureau  in 1959: 
THI  =  15 ?  0.4 (t +  tw). 
Here  t is fahrenheit  temperature  and tw  is wet-bulb  temperature;  the lower the humidity, 
the more rapid  the evaporation,  the lower tw,  and the more comfortable  the level of the 
THI. With THI = 70, 10 percent  of the population  feels uncomfortable;  at THI =  75, 
50 percent  complain. 
Another measure  is the sum of the current  year's inflation rate and the preceding 
year's unemployment  rate, plotted by the Committee for Economic Development in 
Highl  Employment  without  Inflation:  A Positive  Program  for Economic  Stabilization  (CED, 
July 1972),  p. 12. 
5. There  are  only seventy-six  observations  for the regression  period  of 1954:1  through 
1975:1 because  the ICS data are available  only sporadically  in the earlier  years. :00  U-~~~~~~~~~~~~~~~~~~~~~~~- 
C4.  El~~~~~~~~~~~~~~~~~~.U 
*  ~~~~~~~~~~~lp0, 
0~~~~~~~~~~~~~~~~~~~~~~~~0 
ON  ~ : 
Ln  -Z  .0~~%, 
U..  /~~~~~~~~~~~~~~~~~~~~~~~~~~~~~C 
*  .0~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 
oo2r 
-I  ~~~~~~~~~~~~~~~~~L  ~~~~~~~~cU 
*  (~~~~~~~~~~~~~~~~~~~~~C 
-  *  Z~~~~~~~~~~~~~~oo 
I  -~~~~~~~~~ 
0  *  S~~~~~~~~~~~~~~~~~~~ 
4-0 
0  -~~~~~~~~~~~~~~~~~~~~ 
-  ~~~~~~~~~~~~~~~~~~~~~~rC 
'-U.~  ~ ~  ~ ~~~~~~ 
-0  ~  ~  ~  ~  ~  ~  ~  ~  ~  ~  ~  0 
PC*  -  0 
o  -  ON~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~e 
ON~~~~~~~~~~o  5  ~  ~  ~  ~  ~  ~  U  , 
.P.4~~~~~~~~~~~~~~~~~~~~~~~~~~0~ 
Pk,- 476  Brookings  Papers  on Economic  Activity,  2:1975 
Here  and  in subsequent  equations,  the  numbers  in parentheses  are  standard 
errors.  Evidently,  the assumption  that unemployment  and inflation  con- 
tribute  equally  provides  a useful  first approximation  in explaining  move- 
ments  in the index  of consumer  sentiment.6 
The discomfort-index  regression  is recommended  primarily  by its sim- 
plicity.  The following  regression  distinguishes  the effects  of the unemploy- 
ment  rate  (U) and inflation  (P): 
(2)  ICS =  41.28 -  1.23P -  0.883 U +  0.0886SP +  0.627ICS-1 +  e. 
(10.17)  (0.31)  (0.499)  (0.0429)  (0.086) 
I=  0.902; standard  error =  3.34; Durbin-Watson  statistic = 2.27; 
number  of observations  =  64. 
The  effect  of movements  in the stock  market  is captured  by SP, the annual 
percentage change in the Standard and Poor index of stock prices. Last 
quarter's  value of the index  of consumer  sentiment  (ICS-1)  is included  to 
capture  two types  of lags:  First,  the impact  of adverse  economic  conditions 
upon a consumer's morale is likely to be stronger the longer those condi- 
tions have persisted. Second, disillusionment is contagious, and a larger 
proportion of consumers may "catch" it as time passes, possibly by reading 
about last quarter's index of consumer sentiment in the newspaper. Ob- 
serve that the index of consumer sentiment is much more sensitive to infla- 
tion than to fluctuations in the stock market. Thus, in 1974:4, when SP  = 
-33.0  percent  and  P =  12.2  percent,  the regression  suggests  that double- 
digit  inflation  reduced  ICS by 15.0  points  while  the stock-market  collapse 
cost 2.9 points.  Taken  at face value, the regression  suggests  that a rise of 
1 percentage  point  in the unemployment  rate  cuts  0.883 point off the ICS. 
However,  the coefficient  on the unemployment  rate is less than twice its 
standard  error,  and, it turns  out, does not differ  significantly  from  the co- 
efficient  for  P; that is to say, looking  at the ability  of the discomfort  index 
to explain  the index of consumer  sentiment,  one finds  no reason  to reject 
the simple  assumption  that the contribution  of unemployment  and infla- 
tion to consumer  disillusionment  is proportional  to their  sum.7 
The  coefficients  of this last regression  reveal  the short-run  determinants 
of consumer  sentimnent,  given  ICS-1. In the long run, when the index of 
consumer sentiment has stabilized so that ICS =  ICS-1 at an equilibrium 
value, ICSe, then 
6. When  the rate of inflation  is computed  by taking the quarterly  change at annual 
rates  rather  than the annual  change,  the regression  yields F2 = 0.584. 
7. The standard  error  of the 0.347 difference  (1.23 -  0.883) is 0.470. Michael  C. Lovell  477 
(3)  ICSe  =  110.67  -  3.30P  -  2.37U  +  0.238SP. 
This  suggests 
(4)  ICSt =  0.373ICSe  +  0.627ICS-1  +  e, 
or 
ICSt  -ICSt-1  =  0.373(ICSe -  ICS-1). 
Thus, contagion  and inertia  are gradually  overcome  as the index of con- 
sumer  sentiment  converges  toward  its equilibrium  level, eliminating  about 
37  percent  of the gap  between  equilibrium  and  actual  ICS each  quarter.  The 
ICSe series, also plotted in figure 1, may measure  consumer  discomfort 
more  precisely  than the EDI. 
The unemployment  rate  reflects  directly  the condition  of only the unem- 
ployed  fraction  of the labor force;  but indirectly  it may capture  the effect 
of a shortened  workweek  and the uncertainty  generated  by the threat  of 
layoffs.  An alternative  to the unemployment  measure  is the GNPGAP,  the 
percentage  by which actual GNP falls short of the economy's  potential 
output. 
(5)  ICS =  34.8 +  1.138P -  0.197GNPGAP +  0.080SP 
(8.8)  (0.306)  (0.155)  (0.044) 
+  0.656ICS-1 +  e. 
(0.086) 
.2  =  0.899; standard  error =  3.38; Durbin-Watson  statistic =  2.312; 
number  of observations  =  64. 
The GNPGAP,  like the unemployment  variable  it replaces,  has the appro- 
priate  negative  sign; it is also less than  twice  its standard  error.  The equa- 
tion is not quite  as tight as it is when  the unemployment  variable  is used, 
but the difference  is not marked. 
Several  variations  on regression  equation  (2) were  considered  in an at- 
tempt to find out more about the determinants  of consumer  sentiment. 
First,  the annual  rate  of change  in the weekly  real  wage  was added  in order 
to determine  whether  the depressing  effect of inflation  may be offset by 
compensating  changes  in the money  wage,  as might  be achieved  by index- 
ing;  however,  the  real-wage  t-coefficient  of -0.056 suggested  that  during  in- 
flationary  episodes  the consumer  becomes  depressed  regardless  of whether 
real wages are maintained.8  Second, the rate of  anticipated  inflation, 
S. Of course,  even  if the money  wage is adjusted  so as to keep pace  with inflation,  con- 
sumers  who are net creditors  may nonetheless  suffer  from unanticipated  capital losses. 
In his earlier  study  Hymans  used a measure  of the rate  of change  in aggregate  disposable 478  Brookings  Papers  on Economic  Activity,  2:1975 
rather  than  recent  inflationary  experience,  might  be critical;  when  a Survey 
Research  Center  estimate  of anticipated  inflation  was added  to the regres- 
sion it had an unexpected  positive  coefficient,  but it was small  relative  to 
its standard  error.9  Third,  quadratic  terms  were  added  to equation  (2) in an 
attempt  to capture  nonlinearities,  but without  success.'0  Fourth,  in an at- 
tempt  to determine  whether  a general  post-Vietnam  and post-Watergate 
malaise  might  explain  the despondency  of the consumer  better  than eco- 
nomic  factors,  a dummy  variable  was added  that equaled  zero except  for 
the post-1973:3  observations;  it had an unexpected  positive  sign and was 
very  small  relative  to its standard  error. 
Finally,  following  a suggestion  of Lawrence  Klein,  the change  in the un- 
employment  rate was added,  yielding11 
ICS  =  46.08'-  1.35P -  0.55 U -  2.97(Ut -Ut1) 
(10.07)  (0.31)  (0.50)  (1.32) 
+  0.053SP +  0.561CS-1 +  e. 
(0.0445)  (0.088) 
PI = 0.908; standard  error =  3.20; Durbin-Watson  statistic = 2.09; 
number  of observations  =  64. 
real income net of transfer  payments,  but not the unemployment  rate, in studying  the 
determinants  of the ICS; the strongest  result for this variable  involved  a t-coefficient  of 
1.72 and an R2 of 0.796. Refitting  regression  (2) over Hymans' sample period led to 
RI =  0.  822; the regression  coefficients  were  essentially  the same  as over  the  longer  sample 
period.  See Hymans, "Consumer  Durable  Spending,"  p. 177. 
9. Adding anticipated  inflation  did make the t-coefficient  of U larger  and increased 
the magnitude  of the coefficient  of realized  inflation.  Juster  and Wachtel  used  the antici- 
pated  rate of inflation  in their  study  of the determinants  of the ICS; they also obtained  a 
perverse  positive  sign. Their  largest  R2 was 0.903; when equation  (2) is refitted  over their 
sample period, an RI of 0.907 is obtained. They excluded unemployment  as well as 
Hymans'  real output  measure  from their  regressions.  See Juster  and Wachtel,  "Inflation 
and the Consumer,"  p. 97. 
10. At face value  the linear  form of equation  (2) implies  that the 1929-33  collapse  was 
not so bad after  all, in that record  unemployment  was partially  offset by deflation;  how- 
ever,  the sample  period  for the present  study does not include  sufficient  observations  on 
price declines. Lepper's  study of voter behavior indicated that the direction of price 
change  was critical  over her 1896-1964  sample  period.  See Susan  J. Lepper,  "Voting  Be- 
havior  and Aggregate  Policy Targets,"  Public  Choice,  vol. 18 (Summer  1974),  pp. 67-81. 
11. F. Gerard  Adams and Lawrence  R. Klein report  a t-coefficient  of -4.09  on the 
change in unemployment  for the 1953:3-1970:1 estimation period in "Anticipations 
Variables  in Macro-Econometric  Models," in Burkhard  Strumpel,  James N. Morgan, 
and Ernest Zahn, eds., Human Behavior in Econiomic  Affairs: Essays in Honor of George 
Katona  (Jossey-Bass,  1972),  p. 299. Michael  C. Lovell  479 
Evidently,  abrupt  increases  in unemployment  are particularly  distressing, 
but the public  may eventually  become  numb  to continued  stagnation. 
To sum  up, consumer  despondency  is not to be explained  by the general 
social malaise  in the aftermath  of Vietnam  and Watergate.  The primary 
explanation  lies in the inflation;  unemployment  and the collapse of the 
stock  market  play  lesser  roles.  Fluctuations  in the rate  of growth  of the real 
wage  are  not critical.  And if consumer  sentiment  does have a strong  influ- 
ence on durable  spending,  the analysis  suggests  that the cost-push  forces 
contributing  to double-digit  inflation  may have made  a decisive  contribu- 
tion to the severity  of the current  recession. 
One possible  moral of this story  is that it may be good politics  for the 
President  to worry  more  about  inflation  than  unemployment.  This  might  be 
a mistake,  for Mueller's  study  of survey  data  on presidential  popularity  and 
follow-up  work  by Kalos indicate  that unemployment  is the more salient 
variable."2  The acid  test is at the polls, and  Kramer  reports  that  unemploy- 
ment  consistently  enters  with  the wrong  sign in explaining  the outcome  of 
congressional  elections.  Real income did most of the work, but George 
Stigler  argued  that this result arose from errors  in the income series."3 
Stigler,  with an argument  from Okun, asserted  that the policies of the 
parties  with  regard  to income  distribution  should  be the critical  factor  be- 
cause  Democrats  and  Republicans  are  identically  committed  to the pursuit 
of full employment  and growth  in real  income.14 
12. Mueller's  only economic variable  was a slump measure.  Kalos reports  that be- 
tween  2.5 and 3 points of presidential  popularity  are sacrificed  for each percentage  point 
of increase  in unemployment;  a 1 percent  drop  in the rate  of change  in real  income  would 
cost between  0.8 and 1.5 points; an increase  of 1 percentage  point in the rate of inflation 
would cost between  0.3 and 0.8 point. See John E. Mueller, War,  Presidents  anld  Public 
Opiizion  (Wiley, 1973); and Stephen  H. Kalos, "The Economics  of Presidential  Popu- 
larity:  An Empirical  Test" (B.A. thesis, Wesleyan  University,  1973). 
13. Gerald H. Kramer,  "Short-Term  Fluctuations  in U.S. Voting Behavior, 1896- 
1964,"  Americani  Political  Scienzce  Review,  vol. 65 (March 1971),  pp. 131-43; George J. 
Stigler,  "General  Economic Conditions  and National Elections," Americaiz  Economic 
Review,  vol. 63 (May 1973),  pp. 160-67. 
Ray C. Fair reports  that the growth  rate of current  real GNP per capita is the best 
variable  for explaining  the outcome of presidential  elections; see "On Controlling  the 
Economy to Win Elections," Discussion Paper 397 (Cowles Foundation, 1975; pro- 
cessed). 
14. See Stigler,  "General  Economic  Conditions,"  and Arthur  M. Okun,  "Comments 
on Stigler's  Paper,"  American  Economic  Review,  vol. 63 (May 1973),  pp. 172-77. 

Why Was the Consumer Feeling So Sad?

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Why Was the Consumer Feeling So Sad?

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Research Papers in Economics