Dealing with prophecies

One of the most fascinating phenomena that you can ever come across in dealing with the economic theory of expectations is the self-fulfilling prophecy. Deals are made and broken, companies flourish and crash, countries enjoy explosive growth and suffer from recession, all because of the power of expectations.

The logic behind self-fulfilling prophecies is simple: if someone makes a claim that an event will occur, it will influence the actions of their surroundings, which in the end will cause that occurrence itself. One of the most relevant examples in the world today is in the financial market. If a leading brokerage firm makes a prediction that a country’s economic performance will be outstanding for a given year, and that it would be the place to invest funds, then (regardless of the actual condition of the economy) people will be influenced by that prediction. People will start to invest their money there, based on the recommendations, causing a massive inflow of funds into said country. Due to the influx of money, economic performance will improve, which in turn will draw in more investors and more funds. By the end of the year, the quantity of funds drawn in will all but ensure an “outstanding” economic performance, as forecast by the brokerage firm at the beginning of the year. The reverse also applies, as perfectly demonstrated by the 1997 Asian economic crisis. All it took was one cry of “the Thai is falling” (yes, it’s a bad pun, and yes, I know it’s the Baht and not the Thai, but it would be less funny if I wrote the Baht is falling, and I’m writing this so I can write whatever I want, so there) to destroy not just Thailand but also many other Asian economies.

Why does this occur? Expectations. People make decisions and take action to maximize their inter-temporal utility based on what (they think) will happen in the future. If the government announces that tomorrow, gasoline prices will rise, everyone will rush to the gas pumps to fill up their tanks. If the newspaper’s front page headline is about an Enron-like scandal, within 1 hour the company’s stock prices will plummet because everyone decides to sell before it’s too late. When governments announce that they predict a jolt in inflation, people’s behavior will be influenced to actually cause that inflation to come about. This is what causes self-fulfilling prophecies. People’s actions become influenced by their expectations and predictions, or even by the predictions of others that they feel are credible, and in the end, those actions are what cause the predictions to come true.

I’ve been writing mostly about self-fulfilling prophecies in finance and economics. But, self-fulfilling prophecies do apply in other situations. A study by Diekmann, Galinsky, and Tenbrunsel (2003) shows that self-fulfilling prophecies also occur in negotiation processes. The study shows that negotiators who expect a very competitive opponent will subconsciously become less competitive themselves, causing lower negotiated outcomes for themselves, regardless of whether the opponent was actually very competitive.

I’m quite sure that this, to an extent, also applies to people in general and their outlook on life. If you had two people with the same exact qualifications, intellectual capacity, and skills, with the only difference being that one is a pessimist and the other is an optimist, I’m sure that the optimist will find that things happen in their favor more often due to the effect of their optimism alone, affecting both their own actions and those of people around them. Take another example of two completely identical people, except that now, we have a well-renowned public figure label one an “incompetent buffoon” and the other one an “impeccable genius”. Just as two identical countries would enjoy differing amounts of FDI based on labels and predictions, so would these two individuals in terms of the success they will enjoy in life. The “incompetent buffoon” is likely to never get a job offer in his life, dulling his mind due to inactivity and stagnating his work aptitude due to lack of experience, ultimately turning him into more of an incompetent buffoon than he was at the beginning. The “impeccable genius”, on the other hand, gets offers from everywhere, furthering his personal development and raising his intellectual capacity from the work experience. In the end, although he might not reach the level of “impeccable genius”, he’d be much closer than he was before.

So, until next time, may you always remain optimistic, and may all the right people say all the right things about you.