Consumers Are Optimistic Again. Here’s the Reason Why.

On Oct. 26, number crunchers were presented with two seemingly conflicting economics statistics. The Commerce Department reported that the economy grew at a mediocre 2 percent annual rate in the third quarter. But the University of Michigan/Thomson Reuters Consumer Sentiment Index came in at the highest level in five years, with consumers judging “their current financial situation more favorably in October than any time in the past five years.”

How can gloomy macroeconomists and buoyant consumers coexist?

The answer lies in understanding the dynamics of success and failure—and how the two phenomena can spread like a virus. Failure begets failure and pessimism: that was the story of 2008 through 2010. But there has been a sharp decrease in financial failure in the U.S. in the past two years. The rising tide of success has allowed America’s economic ship to churn ahead through the debt-ceiling debacle, the European crisis, and fears of a fiscal cliff.

Financial failure is a major trauma, especially in a country with a weak safety net. Lose your job, and you can quickly find yourself without any income, health insurance, or a home. “Failure could have a chilling effect on people’s confidence about the economy, because people tend to overestimate the severity and likelihood of things,” says Joshua Aronson, professor of psychology at New York University. When your friend gets laid off, you begin to act as if it might happen to you.

Starting in 2008, failure ripped through the highly indebted U.S. economy the way influenza tore through Europe in the wake of World War I. Foreclosed homes were dumped onto the market by lenders at fire-sale prices, thus pushing down the value of all homes on the block. Mass layoffs led scared workers to hoard cash and save instead of spending. Thanks to the stimulus, the Federal Reserve, natural regeneration, changing habits—pick your reason—financial failure has come off the boil and has been replaced by financial success. Bank failures, which peaked at 157 in 2010, fell to 92 in 2011; through the first 42 weeks of 2011, only 46 banks have gone down. The volume of publicly announced layoffs fell from 1.45 million in 2009 to 606,000 in 2011, according to outplacement firm Challenger, Gray & Christmas. Through the first nine months of 2012, mass cullings are off another 19 percent. The private sector has added 4.73 million payroll positions since February 2010.

The improving job market is allowing more Americans to successfully keep up with their financial obligations. The delinquency rate on credit cards, which peaked at 6.6 percent in early 2009, has fallen for 12 straight quarters and now stands at just 3.1 percent—the lowest level in at least two decades, according to credit-card comparison website Cardhub.com. In September, the number of homes on the receiving end of a foreclosure filing—180,427—was half the rate of September 2009, and the lowest monthly total since July 2007.

And 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, or buy a new car, or buy a slightly bigger home. Retail sales are up 5.6 percent through the first nine months of 2012.

But there’s 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.

Not to worry, though. Despite the outbreak of financial success and confidence, we’re still several years away from a Minsky Moment.