Why do people keep referring to the last several years as normal? Over and over again I hear supposed experts on CNBC and other news channels saying things like “normally,” “how things usually are,” or “under normal circumstances” when referring to the economic conditions present over the past several years. I hear the talking heads asking when banks will return to “normal lending practices.”
There is nothing normal about a recession; likewise, a boom phase is equally abnormal. During the boom phase no one asked when the banks would return to normal lending practices.
This is an example of what psychologists refer to as “regression fallacy.” Regression fallacy theory states that individuals are more likely to interpret exceptional events/performance/scores as being average and expect the results to continue. Statisticians refer to this a Regression Toward the Mean.
To illustrate this point consider the following scenario. If XYZ company’s stock shows 80% earnings growth for two years in a row while its closest competitors only show 15% earnings growth over the same period of time then investors are likely to expect XYZ’s earnings growth for next year to be around 80%.
It is important that we are aware of our tendency to make this mistake. If the goal for the economy is to return to “normal” then we must recognize that the last several years have been an exceptional boom, not normal or average.