Between Euphoria and Fear: Has Traditional Microeconomics Ignored the Mood Swings That Drive Financial Crises?

By Stein, Janice Gross | Literary Review of Canada, November 2009 | Go to article overview

Between Euphoria and Fear: Has Traditional Microeconomics Ignored the Mood Swings That Drive Financial Crises?


Stein, Janice Gross, Literary Review of Canada


IN THE WAKE OF LAST YEAR'S FINANCIAL CRISIS, Alan Greenspan, former chair of the United States Federal Reserve, expressed astonishment at the irrational behaviour of institutional leaders. "Those of us who looked to the self-interest of lending institutions to protect shareholders' equity--myself especially--are in a state of shocked disbelief." A strong believer in the rationality of decision making, Greenspan was shocked by the myopic behaviour of bankers who exposed their institutions to large risk for short-term gain.

He is not alone in his confusion. Looking back, we cannot seem to make up our minds about what went wrong. For some, such as Greenspan, it is individual decision making that was "irrational." For others, such as Joseph Heath in his September essay for this publication, it is individually rational, self-interested decisions that resulted in collectively poor outcomes. These two diagnoses are quite different. In fact, they contradict one another.

Those who blame irrational investors point to the behaviour of many who, after the stock market began to drop in 2008, seemed to make a bad situation worse by selling their shares and mutual funds. As a group, they would have lost much less money had they simply held onto whatever funds they owned. This kind of "irrational" reaction is quite common. An analysis of investor behaviour in all U.S. equity funds from 1991 through 2004 by Geoffrey Friesen and Travis Sapp, for example, found that fund holders consistently bought high and sold low except during long secular bull markets.

That people frequently do not behave like rational investors is not trivial. Financial decision making should be a relatively easy example of rational choice. It is reasonable to expect consumers to balance carefully the likely costs and benefits in the decisions they make on large issues that matter to them, such as saving for retirement and mortgages. On these kinds of issues, measurement is not difficult, and we can estimate the probabilities with reasonable confidence. If the rational choice models that economists so love are a poor predictor here, then they are unlikely to be good predictors anywhere.

Many economists disagree. Even if individuals do not behave rationally in the financial marketplace, they argue, collectively we still get optimal outcomes. How can this work?

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Experts in this camp would say that although some consumers are irrational--seduced by clever advertising, overly optimistic in their expectations or short-sighted in their time horizons--their random "noise" is cancelled out either by the large numbers who do make rational choices or by those whose choices err in the opposite direction. As long as the numbers are large enough, we can safely ignore those people who buy subprime mortgages in the expectation that housing prices will continue to rise indefinitely.

Recent evidence has made such optimism impossible to defend. For the argument to work, the errors must be random. Evidence from psychology tells us these errors are not random but systematic. We know, for example, that people generally get far more upset about losses they suffer than they get pleasure from comparable gains that they make. Investors who sold out of the equities markets during the fall of 2008, in the middle of the market crash, and then sat on the sidelines, were likely to celebrate the fact that they had avoided later losses that season, ignoring the gains they likely missed when markets rallied this past spring and summer. Here, individual irrationality is far more than random noise that is washed out in an efficient marketplace. On the contrary, these decisions create large "irrational" swings in financial markets.

Well and good, Joseph Heath argued in these pages two months ago, but there is a fundamental asymmetry between rationality and irrationality, even when irrationality is systematic, patterned and predictable. …

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