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Opinion: Consumer confidence could have its dangers

October 29, 2012

According to an article on The Daily Beast, this fall, for the first time since late 2007, the percentage of Americans who say their personal financial situation is better in the past year (38 percent) is greater than those who say they are worse off now (34 percent), according to Gallup. When consumers are more confident, they're more likely to splurge a little at the mall, which could explain why retail sales are up 5.6 percent through the first nine months of 2012.

But therein exists a danger:

In good times and bad, people tend to extrapolate existing trends endlessly into the future. According to the University of Michigan consumer-sentiment indicator, for the first time since 2008, half of Americans think their income will rise in the coming year. It also found "the most favorable outlook for the unemployment rate since 1984."

Such readings may represent the triumph of hope over experience, or an outbreak of irrational exuberance. The forces holding down annual income growth are still legion and powerful, and the labor market remains far from healthy. But cycles of excessive pessimism followed by excessive optimism are familiar to students of American financial history. As the economist Hyman Minsky laid it out in his 1992 paper, "The Financial Instability Hypothesis," success can morph into a virus of overconfidence. When things go right for several years, people start to spend and invest as if nothing can go wrong. Think of recent bubbles like NASDAQ stock prices in 2000 or the Las Vegas housing market in 2006.

Read more about consumer behavior.