The Confidence Paradox: Can Confidence Account for Business Cycles?

In matters of investment expectations, investors rely both on a forecast and on an estimate of the reliability of this forecast, which prompts the feeling of confidence. Although confidence “is one of the major determinants” of investment decisions in John Maynard Keynes’s theory, the fluctuations of which account for the “essential character of the Trade Cycle,” it has been relatively little studied in economics. The purpose of this article is to draw on the headway of modern psychology, entrepreneurship, and neuroscience in order to propose an explanation of business cycles based on the cycles of confidence. Economists call this explanation a “paradox” since the very conditions of the economic boom may set the stage for a downturn. Conversely, the fact that confidence is low may gradually induce an improvement of entrepreneurs’ decisions and thus of the economic context. The basic mechanism pertains to a possible discrepancy between the two dimensions of investment: demand (short-term effects) and supply (long-term effects). Confidence seems to have a major impact on cognitive effort, on the number of data sought, the way they are analyzed, on creativity and alertness, on the type of reasoning, and the causal ascription of events.