Sunday, May 17, 2009

Markets aren't Rational-Actor driven...

For those of us who weren't shocked about the housing bubble Robert Shiller was one of the key economists we were reading.  His new book is on my to buy list... but for now...

Story Time for the Economy

Speculative booms are driven by psychological feedback. Rising stock prices generate stories of smart investors getting rich. People become envious of others’ successes, and begin to wonder if rising prices don’t portend further increases. A temptation arises to get into the market, even among people who are fundamentally doubtful that the boom will continue. So rising prices feed back into more rising prices, and the cycle repeats again and again – for a while.

During a boom, people considering getting into asset markets weigh the fear of regret if they don’t against the pain of possible loss if they do. There is no authoritative answer about what the “right” decision is, and no consensus among experts about the proper level of exposure to these markets. Should it be 30 per cent in stocks and 70 per cent in housing? Or the reverse? Who knows? So the ultimate human decision must be based on the relative salience of these discordant emotional factors. In a boom environment, the emotional factors are biased toward getting into the market.

But one must ask what would sustain such a movement now. There seems to be no dramatic fundamental news since March other than the price increases themselves. The human tendency to react to price increases is always there waiting to generate booms and bubbles. The feedback is only an amplification mechanism for other factors that predispose people to want to get into the markets. The whole world can’t recover all of the enthusiasm of a few years ago from feedback alone, for there is a giant coordination problem: we are not all attentive to price increases at the same time, so we make decisions to buy at very different times. As a result, things happen slowly, and, meanwhile, more bad news may be revealed.

The only way world confidence can return dramatically is if our thinking coordinates around some inspiring story beyond that of the price increases themselves.

In my 2009 book with George Akerlof, Animal Spirits, we describe the ups and downs of a macro-economy as being substantially driven by stories. Such narratives, especially those fueled by accessible human-interest stories, are the thought viruses whose contagion drives the economy. The contagion rate of stories depends on their relation to feedback, but plausible stories have to be there in the first place. The narratives have substantial persistence in that they affect our views.

The story that drove the worldwide stock-market bubble that peaked in 2000 was complex, but, put crudely, it was that bright, aggressive people were leading the way to a new era of capitalist glory in a rapidly globalising economy. Such people became new entrepreneurs and world travelers on the way to prosperity. This narrative seemed plausible to casual observers, because it was tied to millions of little human-interest stories about the obvious successes of those — friends, neighbors, and family members — who had the vision to participate enthusiastically in the new environment.

But it is hard today to re-create such a narrative, given so many stories of trouble. The stock markets’ rebound since March seems not to be built around any inspirational story, but rather the mere absence of more really bad news and the knowledge that all previous recessions have come to an end. At a time when the newspapers are filled with pictures of foreclosure sales – and even of surplus homes being demolished – it is hard to see any cause for the markets’ rebound other than this “all recessions come to an end sooner or later” story.

Indeed, the “capitalists triumphant” story is tarnished, as is our faith in international trade. So, here is the problem: there isn’t a plausible driver of a dramatic recovery.

Starting an economic recovery is like launching a new movie: nobody knows how people will react to it until people actually get to see it and talk about it among themselves. Our efforts to stimulate the economy should be focused on improving the script for those stories, making these stories believable again.

This means making capitalism work better, and making it clear that there is no threat of protectionism. But the rationale must be to get the world economy out of its current risky situation, not to propel us into yet another speculative bubble

Posted via web from jimnichols's posterous

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