The transmission and impact of sentiment shocks

July 15, 2022 | Blog
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by Ali Kabiri (University of Buckingham and Financial Markets Group, London School of Economics) and Harold James (Princeton University) 

This blog post is based upon the authors’ article (co-authored with John Landon-Lane, David Tuckett, and Rickard Nyman) forthcoming in the Economic History Review.


The current volatility in financial markets appears to be driven by fear or uncertainty about future developments rather than by concrete economic news. We do not know about the future trajectory of central bank interest rate moves, or the degree of disruption to supply chains caused by the war in the Ukraine, but people are nervous.


In the 1930s, finance looked to psychology. The financial analysts Benjamin Graham and David Dodd lamented the exuberance of the 1920s and the undervaluation of the US stock market during the market trough in 1932. Irving Fisher, in 1932, cited ‘pessimism’ as one of the factors prolonging the slump: ‘Everybody’s opinion is largely guided by the opinion of everybody else, even the people with the coolest heads will at least “fear the fears of other men” and contribute to the panic of which such fears are a part’. New ideas about the role of human psychology in the economy were given greater credence following the publication of Keynes’ General Theory and his famous evocation of animal spirits.


In our forthcoming article in the Economic History Review, we use a uniquely calibrated lexicon to examine the entire content of the Wall Street Journal and test it for its emotional impact: our new index measures the balance between two emotion groups that are broadly analogous to excitement (approach) and anxiety (avoidance) in text data.


We devised a statistical method of testing these theories for the period before the Great Depression by an ordering process: the business-sentiment variable is ordered last in the testing process, so that the identified shock does not have an immediate impact on any of the variables in the econometric model. Our reasoning is twofold: first, news about the economy is quickly internalized in stock and credit markets. The business-sentiment shock that is identified in this method is thus orthogonal to shocks to stock and credit markets. Second, the business-sentiment shock only affects the other variables in the system with a delay. Thus we are identifying shocks to the slow moving (or long-run component) of business-sentiment and not the short-run component. Our identification is that the long-run component of business-sentiment is not contaminated by news. Our index is presented in figure 1. We then perform historical decompositions utilizing this model, to identify the impact of these structural shocks on all of the macroeconomic and financial variables. This method allows us to compare the actual with the counterfactual path of the economy without the impact of business-sentiment shocks; see figure 2.


Figure 1.  Identified business sentiment shock

Source: Kabiri et al., ‘Role of sentiment’. Notes: The solid line represents the identified (orthogonalised) business-sentiment shock obtained from ordering The Wall Street Journal (WSJ) sentiment series last in a ten-variable vector error correction model. The shaded regions represent NBER recessions.


Figure 2.   Historical decomposition for May 1923 to November 1923

Source: Kabiri et al., ‘Role of sentiment’.
Notes: Industrial production, the stock market, bank loans, and prices are normalized to equal 100 for the first date of each subperiod.


The disaggregation of sentiment shows a particular importance of sentiment in the period before the Great Depression (or in other words, in the lead-up to economic collapse). During the Great Depression, however, the identification exercise makes it hard to separate negative sentiment from the negative real economic performance. There may then be a spiral in economic news generates more negative sentiment, which then leads to worse economic performance and so on, but the causal mechanism in that process cannot be clearly identified, as it can for the pre-1929 era.


There are examples of positive sentiment affecting outcomes. In the summer of 1926, the industrial production index rises, but a counterfactual case without economic sentiment shows a decline. The press was filled with ‘feel good’ items, partly because of the celebration of a round anniversary. An ecstatic article on the way foreign countries perceived the 150th anniversary of the Declaration of Independence, for instance, commented on ‘the amazing progress that has been made by the United States’ and details of the ‘incredible total’ of American wealth.


As for negative impacts, one of the largest was in July 1923 and was driven by news of government instability in Europe. A characteristic article reported the comments on the return of a prominent Senator from Europe, explaining how ‘most, like myself, have failed to realize how exhausted by war are many of the nations of Europe, both as to governmental finance and private endeavour’. The case is not that the European misery was hurting America directly, but that it was dragging down business-sentiment. The same pattern is repeated in the lead-up to the Great Depression.


The historical lesson has contemporary implications. The changes in the current global outlook may be transmitting such sentiment shocks due to the range of potential economic and political outcomes that are now being imagined.



To contact the authors:




Kabiri, A., James, H., Landon-Lane, J., Tuckett, D., and Nyman, R., ‘The role of sentiment in the US economy: 1920 to 1934’, Economic History Review (forthcoming).