Just How Important Is Consumer Confidence in Global Financial Markets?

In 2008, Warren Buffet described confidence as being the oxygen to an economy. Buffett explained how confidence is key to the economy when explaining, “I don’t think I’ve ever seen people as fearful economically as they are right now.” Essentially confidence is a major factor within the economy, as if people are not confident in a financial system, they will not use it. We only need to look at the current situation in Cyprus to see how a lack of confidence can damage an economic system.

Essentially Cyprus is now in a situation whereby it either accepts the proposed bank levy on savings or leaves the Euro. Neither of these options are good for Cyprus as a nation, or its people, however due to the situation the nation has got itself into, it has no choice. However, as mentioned, the crisis in Cyprus is one of confidence. Firstly the nation’s banking system has been damaged. This is due to consumer losing trust in the system, which was inevitable once the government initially contemplated the possibility of taking away part of the country’s bank deposits. Restoring this trust and confidence will be a long and difficult process, however is the only way the economy can return to a fit state. Secondly, and perhaps more importantly, consumers trust in the Cypriot government and European Union has been damaged, which again is difficult to restore.

So having considered the loss of confidence within the Cypriot economy currently, we should consider why this is actually a bad thing. Essentially if consumers are not confident in their economy, they will not use it. This has been demonstrated by the reported queues at cash machines this week in Cyprus, with limits imposed on withdrawals. It will be interesting to see what happens once Cypriot banks unfreeze accounts, however an obvious prediction would be that the majority of people take their money out of their accounts. This would be a reasonably normal concept to see when consumers lose faith in the state of an economy, however with the added potential for a tax on savings, in this case it is even more likely. So why is this bad then? Well firstly if everyone wants to withdraw their funds, the bank will simply not have the cash to pay this out. This is because a bank works by taking cash from people in the short term and lending this out in the long term in the ‘maturity transformation’ sense, keeping only a small amount of cash to cover the day to day needs of people. Whilst in the short terms banks simply do not have the cash to pay people out, the bigger picture is that banks will have less money, meaning they have less ability to generate funds and therefore the economy will begin to stagnate and growth will be minimal.

The original question posed at the start of this blog was to examine just how important confidence is within an economy. Confidence is essential for an economy to run smoothly, a point highlighted by Warren Buffet. If people trust an economy and are confident within it, then they are likely to be happy to invest their money, allowing banks to use this to lend out, essentially increasing their profits but also increasing the money flow within an economy along with economic growth. However, when looking at the example of Cyprus, we can see just how catastrophic it can be if confidence is removed from an economy. Therefore in my opinion and probably in the general opinion of most people, confidence is one of the key factors to maintain within an economy in order to ensure economic stability.