Animal Spirits: lessons to be learned out of the crisis.

Dear readers

Back in June we already wrote about the importance of psychology on issues such as inflation (The Unemployment – Inflation Theme). When inflation is discussed it is only a small step towards asset inflation and asset bubbles more specifically. One of the fuel components of the Great Credit Crisis was obviously the housing bubble. Before that people had only just shrugged off another crisis, that is the dotcom bubble.

Unfortunately in this debate on too many occasions one forgets to mention the responsibility of central banks and certainly that of former US Federal Reserve Chairman, Alan Greenspan who fuelled both bubbles with aggressive monetary policy like the way he handled the LTCM Crisis, Y2K and 9/11 events.

According to the Chairman it was not up to central banks to detect the build up of asset bubbles. The only thing a central bank should do in case of an asset bubble burst was to provide enough liquidity to the banking system in order that it would not collapse. Later on this was named the Greenspan doctrine and is closely related to issues such as lender-of-last-resort and moral hazard.

It is not our intention in this newsletter to overload Mr. Greenspan with all the sins of Israel, but do think that central banks should spend more time in studying asset price developments and should search for bubbles which could potentially wreck a (global) economy.

By trying to fix this problem we will have to look at how central banks and (investment) banks have been operating over the last 3-4 decades. Certainly since the Greenspan era there was this blind believe in the “Invisible Hand” and the Efficient Market Theory. There was this dogmatic conviction that the market was always right and would solve any problem. Putting this into doubt brings us on a collision course with one of the greatest economic thinkers of the 20th century Milton Friedman and his Chicago School.

We do not want to throw the free market principle over board. We are still strongly convinced that this has been the best socio-economic model in creating wealth. We all know by now what the credentials were of a state planned economy. So we will not touch this part of the discussion.

More importantly is to go to the core of the assumptions which are being made by the Efficient Market Theory and monetarists such as Milton Friedman. All of these theories start from the hypothesis that all market participants act rationally. Even Mr. Friedman knew that everybody has its individual preferences, but the concept of Homo Economicus, was so tempting as abstraction and strategic simplification, is the only way we can impose some intellectual order on the complexity of economic life.

This reasoning was the corner stone to theories such as the idea Mr. Friedman always taught us that employees and employers remain rational when negotiating on wages or deciding on investments and taking inflation into account this in an undiluted way.

But if this is true, bubbles could not exist. The Efficient Market Theory is also claiming that all information is priced into the market at any time and today’s price is the best indicator for the price of tomorrow. Furthermore the market always finds a balance between buyers and sellers at the right price. This equilibrium can only be disturbed due to a shock in the supply and demand chain, like for example the oil shock we have known in the 1970s. The thought of a previous price increase would lead to another is simply impossible to these classical economists.

However, how can one explain that from one day to another prices collapse? We all have seen the charts of stocks or real estate that fell of a cliff. Conventional economists have no explanation to this either. Even one of its greatest supporters, Alan Greenspan himself, admitted in 2008 he was spooked by this thought.

Behavioral economists may have the answer to this. They have done extensive research around the concept of “the illusion of money”. During a bubble build up it became obvious that investors are selectively ignoring obvious data and their behavior distorts price developments which inflates the price of the underlying asset. Dr. Robert Shiller, one of the great researchers on behavioral finance, applied this to the housing market and described it as follows: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.” (1)

First of all this comes close to experiences that most of us must have had in the past when trading or investing, in for example stocks. We can call it the state of denial where an investment is going against you, and one refuses to cut your losses. The self fulfilling prophecy in believing that a position will come back to its initial level and hopefully goes back above it. Information is selectively read and analysed and other data pointing to a justification of the correction is ignored.

This to us is already a first sign of the presence of irrational participants in financial markets.

Another lesson that we should have learned already long before the outbreak of the Great Credit Crisis is that markets are more driven by mutual trust than pure rational decision taking. One can detect this easily in the functioning of emerging markets where spreads are much wider compared to developed markets. The spread is the reflexion of available liquidity which can simply be brought back to trust as well. It is because not a lot of people are confident putting their savings at work in let’s say a country like Kazakhstan (just to name one) that it is difficult to find an equilibrium between a buyer and a seller.

This is only an emotional perception, which can easily trigger anxiety and can quickly turn into outright panic. This is what ultimately causes a collapse of prices, what we have seen on many occasions in the past. How many of us didn’t own stocks during the dotcom bubble which decimated overnight? All of us are driven by this illusion of money. It is the failure of this money illusion to account for inflation that will lead to emotion driven investment decisions with painful outcomes at the end of the process.

This is also what happened in the real estate market. Lenders had huge trust in economic data that over the past 70-80 years real estate prices never dropped on average on a national scale. They did not take into account that for example a rise in interest rates would have devastating effects on the repayment capacities of a large number of borrowers. This would lead to foreclosures and would negatively affect the value of houses. Unfortunately when the Federal Reserve started rising rates rapidly from 2003 onwards real estate prices did come under pressure.

Finally it does not take a neurologist or Sigmund Freud to know that there is a huge difference between starting from scratch and making EUR 2 million or having EUR 10 million and losing EUR 8 million but ending up with the same EUR 2 million. For our Homo Economicus, who behaves rationally, it would not make any difference. Unfortunately socio economic pressures around us indicate it makes a massive difference!

Neuroscientists have identified the source of this problem and it is located in the cortex of the brain. People who experienced a car accident with severe head injuries or even patients suffering from autism apparently do not have problems with a balancing exercise of gains versus losses. In both cases a malfunctioning of the ventromedial prefrontal cortex (VMPFC) is to blame. This does not mean that we should put the whole investment world on drugs which would switch out our VMPFC functioning in order to avoid bubbles in the future.

A more useful tool would be the model developed by a group of researchers at MIT which is known by the name “the Adaptive Market Hypothesis” (AMH). The framework they worked out is based upon the evolutionary theory and tries to predict increased volatility among investors. Basically it comes down to measuring the correlation between price changes that took place on a certain trading day and the influence of this on the price change the day after. (2)

This goes against the Efficient Market Theory that argues that price changes are randomly generated in time. However during the build up of a bubble they will identify high correlation, indicating that investors are showing herding behaviour and vice versa. The approach does not throw away the Efficient Market Theory as they recognize that markets can be in an efficient or rational mode but at times it can turn inefficient or irrational. After a bubble has burst the market can return into a more rational condition where investors’ view on the direction of the market is not influenced by each other. But during a bubble build up investors decisions will be highly correlated. We recognize this from street talk such as the TINA-hype (there-is-no-alternative) during the dotcom area and the subprime cycle.

If this AMH model proves to be reliable, it could be used as a tool by central banks to determine their monetary policy. This does not imply that a central bank should immediately start hiking rates when it detects a bubble but as a regulator it can start adjusting certain anomalies in the industry via legislation or rhetoric.

The AMH has also another advantage. It would help explaining why certain trading strategies are successful in certain specific markets. This would increase the performance of funds.

Now we are dealing with the aftermath of the Great Credit Crisis a debate should be started to revise the Efficient Market Theory and the unlimited trust in strength of “the invisible hand” of financial markets. Not only behavioural scientists have the answer to do this. Academics should also go back to their libraries and read the likes of Hyman Minsky. He already warned during the 1990s that financial markets are by definition unstable.

Unfortunately also in the academic world there was herding behaviour. Those who dared to argue that for example Eugene Fama’s theory was build on lose sand got marginalised and treated as a paria. How long took it before the likes of Paul Krugman and Nouriel Roubini were taken seriously? Also among the brightest minds of the world Animal Spirits are king.

(1)Robert Shiller “The Subprime solution: How Today’s Global Financial Crisis Happened and What to Do about It” Princeton University Press, 2009

(2) See also Gary Stix “The Science of Bubbles & Busts”, Scientific American, 2009