The real elephant in the room is falling house prices. We can fix this by lowering mortgage interest rates.
Modes of Behavioral Finance
- Feedback Models
- Observations
- academic research has until recently hardly addressed the feedback model.
- The same feedback may also produce a negative bubble, downward price movements propelling
- there is a tendency for stock prices to continue in the same direction over intervals of six months to a year, but to reverse themselves over longer intervals. (Thaler, De Bondt, 1985)
- Representation Heuristic – Tversky and Kahneman
- judgments tend to be made using a representativeness heuristic, whereby people try to predict by seeking the closest match to past patterns, without attention to the observed probability of matching the pattern.
- people may tend to match stock price patterns into salient categories such as dramatic and persistent price trends, thus leading to feedback dynamics, even if these categories may be rarely seen in fundamental underlying factors
- Biased Self-Attribution – Daryl Bem (1965, underlying phenomenon); Daniel, Hirschleifer and Subramanyam (1999, promoting feedback)
- attribute events that confirm the validity of their actions to their own high ability, and attribute events that disconfirm their actions to bad luck or sabotage.
- Smart Money vs. Ordinary Investors
- Observations
- It must somehow be the case that a smaller element of “smart money” or the “marginal trader” is able to offset the foolishness of many investors and make the markets efficient.
- The efficient markets theory, as it is commonly expressed, asserts that when irrational optimists buy a stock, smart money sells, when irrational pessimists sell a stock, smart money buys, thereby eliminating the effect of the irrational traders on market price.
- But, finance theory does not necessarily imply that smart money succeeds in fully offsetting the impact of ordinary investors.
- Problems
- in one model with both feedback traders and smart money, the smart money tended to amplify, rather than diminish, the effect of feedback traders, by buying in ahead of the feedback traders in anticipation of the price increases they will cause (De Long, Shleifer, Summers and Waldman, 1990b)
- Style — The smart money are rational utility maximizers. Barberis and Shleifer presented a numerical implementation of their model and found that smart money did not fully offset the effects of the feedback traders. Style classes go through periods of boom and bust amplified by the feedback.
- Observations
FROM EFFICIENT MARKET THEORY TO BEHAVIORAL FINANCE
—Robert Shiller on Behavioral Finance
The recession finally reached Silicon Valley
—Stephen Levy, reporting a 7% unemployment rate and 4,000 fewer jobs, year over year, at the Center for the Continuing Study of the California Economy said last week.
I am just wondering — as I say, it can’t be proven — I’m just wondering if a lot of this was by design to create economic panic.
—Rush, the economic powerhouse, Limbaugh
- U.S. retail store traffic: down 24% last weekend from a year earlier
- Retail sales: down 5.3%, Dec. 19 through Dec. 21
Because we have magneto trouble, we need not assume that we shall soon be back in a rumbling waggon and that motoring is over.
It is not true that what the business men pay out as costs of production necessarily comes back to them as the sale-proceeds of what they produce. It is the characteristic of a boom that their sale-proceeds exceed their costs; and it is the characteristic of a slump that their costs exceed their sale-proceeds. Moreover, it is a delusion to suppose that they can necessarily restore equilibrium by reducing their total costs, whether it be by restricting their output or cutting rates of remuneration; for the reduction of their outgoings may, by reducing the purchasing power of the earners who are also their customers, diminish their sale-proceeds by a nearly equal amount.
…If, then, I am right, the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for capital investment.
—Keynes, The Great Slump
What’s been striking me lately is how many people who talk and write about macroeconomics just don’t get Keynes’s essential point — the fact that economies can suffer from insufficient aggregate demand because people want to acquire liquid assets rather than real goods.
Bookings for non-defense capital goods excluding aircraft, a measure of future business investment, increased 4.7 percent, the most since September 2006, after a 6.6 percent slump in October.
Housing is still in a freefall
—Nariman Behravesh, chief economist at IHS Global Insight
For those who are impatient with modeling and prefer to strike out on their own into the richness that an uninhibited use of metaphor seems to open up, the advice is to stop and think. Are you sure that you really have such deep insights that you are better off turning your back on the cumulative discourse among generally intelligent people that is modern economics? But of course you are.
And for those, like me, who basically try to understand the world through the metaphors provided by models, the advice is not to let importan ideas slip by just because they haven’t been formulated your way. Look for the folk wisdom on clouds — ideas that come from people who do not write formal models but may have rich insights. There may be some very interesting things out there. Strangely, though, I can’t think of any.
- Models
- Metaphors
- Economic Analysis and the preference for tractable problems
Development, Geography, and Economic TheoryBy Paul R. Krugman
If you print money like there is no tomorrow, the S&P will go up
]
Stilltitled 