Business Cycles and the Role of Confidence: Evidence for Europe*
| DOI | http://doi.org/10.1111/j.1468-0084.2007.00472.x |
| Author | Karl Taylor,Robert McNabb |
| Published date | 01 April 2007 |
| Date | 01 April 2007 |
185
©Blackwell Publishing Ltd and the Department of Economics, University of Oxford, 2007. Published by Blackwell Publishing Ltd,
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OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 69, 2 (2007) 0305-9049
doi: 10.1111/j.1468-0084.2007.00472.x
Business Cycles and the Role of Confidence:
Evidence for Europe*
Karl Taylor† and Robert McNabb‡
†Department of Economics, University of Sheffield, Sheffield, UK
(e-mail: k.b.taylor@sheffield.ac.uk)
‡Cardiff Business School, Cardiff University, Cardiff, UK
(e-mail: mcnabb@cardiff.ac.uk)
Abstract
This paper examines whether indicators of consumer and business confidence can pre-
dict movements in GDP over the business cycle for four European economies. The
empirical methodology used to investigate the properties of the data comprises cross-
correlation statistics, implementing an approach developed by den Haan [Journal
of Monetary Economics (2000), Vol. 46, pp. 3–30]. The predictive power of confi-
dence indicators is also examined, investigating whether they can predict discrete
events, namely economic downturns, and whether they can quantitatively forecast
point estimates of economic activity. The results indicate that both consumer and
business confidence indicators are procyclical and generally play a significant role in
predicting downturns.
I. Introduction
The view that measures of consumer confidence can predict fluctuations in the level of
economic activity independently of other leading indicators is a popular one, though
how much additional information is contained in these measures compared with other
leading indicators is a matter of dispute (see, e.g. Carroll, Fuhrer and Wilcox, 1994;
*We are grateful to the editor JonathanTemple and two anonymous referees. We would also like to thank
Sarah Brown, Mustafa Caglayan, Lynne Evans, Sourafel Girma, Zisimos Koustas, Kevin Lee, David Peel,
Stephen Pudney, Stephen Wheatley Price and participants of the 6th (2002) International Conference on
Macroeconomic Analysis and International Finance, Crete, and participants at the ESRC Money, Macro and
Finance 2002 conference ‘Understanding the Evolving Macroeconomy’ at the University of Warwick for
helpful comments and suggestions.
JEL Classification numbers: D84, E32, E37.
186 Bulletin
Matsusaka and Sbordone, 1995; Eppright, Arguea and Huth, 1998; Bram and Lud-
vigson, 1998). The possibility that indicators of business confidence also anticipate
business cycle activity has been subject to less empirical scrutiny. In the present
study, we use measures of both consumer and business confidence to examine their
ability to predict business cycle activity over and above existing leading indicators
for four European economies. The data we employ in the study provide consistent
measures of business and consumer confidence for the four countries and, to our
knowledge, have not previously been used to investigate the role of business and
consumer expectations in predicting business cycle fluctuations.
In the following section we provide a summary of the current literature, and in
section III the data used in the study are described. The cross-sectional properties
of the data are investigated based on an approach developed by den Haan (2000),
described in section IV. This methodology is advantageous in that the data do not
require detrending and so can be implemented regardless of whether variables are
stationary or non-stationary. The remainder of the paper then focuses on the main
objectives of the paper, namely, investigating whether confidence measures have a
role in forecasting. Specifically, we consider whether confidence indicators can pre-
dict economic downturns, i.e. discrete turning points in the business cycle. Finally,
confidence indicators are employed in vector autoregression (VAR) analysis to assess
out-of-sample quantitative point forecasts of GDP growth, in particular, to address
whether forecasting errors are significantly reduced by the inclusion of confidence
indicators.
The empirical analysis reveals that, across countries, both consumer and business
confidence indicators generally have good predictive power in identifying discrete
turning points in the business cycle. By way of example, in the UK a 1 percentage
point increase in business confidence reduces the probability of an economic down-
turn by around 4 percentage points, while a 1 percentage point increase in consumer
confidence has a similar impact of reducing the probability of an economic downturn
by around 3 percentage points.1It is also worth noting that there is also a role for
confidence indicators in reducing the forecasting error associated with quantitative
point estimates. A reduction in forecasting error of around 5%, by the inclusion of
confidence indicators, is statistically significant for the UK and the Netherlands.
II. Confidence indicators and economic activity
A theoretical rationalization for a causal link between consumer and business con-
fidence on the one hand and fluctuations in the level of economic activity on the
other can be found in a range of dynamic general equilibrium models that incorpo-
rate, inter alia, the subjective views of economic agents. These models give rise to
multiple equilibria that are not determined by standard economic fundamentals and
1These figures are for illustration. Discrete turning points in the business cycle are estimated via a probit
model. This is a nonlinear model in which the effects are evaluated at the mean values of the other variables
employed in the model.
©Blackwell Publishing Ltd and the Department of Economics, University of Oxford 2007
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