[ExI] Psychology of markets explanations

[dan_ust at yahoo.com]

--- On Thu, 6/4/09, Stathis Papaioannou <stathisp at gmail.com> wrote:
> 2009/6/4 Dan <dan_ust at yahoo.com>:
> 
>> So where would, for you, psychology enter into the
>> discussion of, say, the current financial crisis in a way
>> that would actually add something to the explanation?
>> Simply saying that had people changed their preferences is
>> not enough in my view.  (Recall, too, the problem with an
>> inflationary boom is not so much preferences as such as
>> conditions that created contradictory expectations about
>> preferences -- specifically that one can increase both
>> consumption and savings at the same time.  (Artificially
>> low interest rates or an increased money supply, initially,
>> sets up the expectation that the supply of loanable is
>> higher than it really is.  This simultaneously creates a
>> disincentive to save (or lowers the incentive to save) and
>> an incentive to spend and borrow.**))
> 
> Is it the belief that one can increase consumption and
> savings at the
> same time or is it interest rates? Lower interest rates
> effectively
> lower the cost the money, so more people borrow money, all
> else being
> equal. But that doesn't give the full picture. There are
> many, many
> other factors at play, not only irrational belief about
> spending and
> saving but the bankers' belief that house prices will
> continue rising
> or that complex derivatives can insure against catastrophic
> losses;
> and these are all psychological factors, even if they can't
> as easily
> be quantified or manipulated as interest rates.

The way inflation generally enters contemporary economies is via central banks lowering interest rates -- the interest rates they directly control -- which is known as "credit expansion."*  (The actual rate some pays is usually higher.  In the US, for instance, the Fed sets the prime lending rate).  It can also come about via direct creation of monies -- as when central banks just increase the "base money" supply, viz., create new accounts -- or when reserve requirements are lowered.

You probably know much of this, but it's perhaps best to look at the role of the interest rate.  Yes, it sets the cost of borrowing money.  If the interest rate is set by market interactions -- by suppliers and demanders of loanable funds -- then the rate will tend to equilibrate savings and loans under full reserve banking.  (Fractional reserve banks can inflate, but even they will approach a sort of equilibration.)  If the interest rate is artificially lowered, under full reserve banking, then this will have the same effect as artificially lowering prices: there will be a shortage of loanable funds as the demand will not be equilibrated with supply.  (The opposite happens if the rate is artificially increased.  Of course, the same happens if entrepreneurs make mistakes -- setting the rate too high or too low -- but they have an incentive to get it right -- specificaly to make profits and to avoid losses -- whereas central bankers don't experience
 the
 same incentive (if Bernanke gets it wrong, it's not his money in play) or, if they do, not as quickly (since Bernanke is very far removed from the actual goings on, there's a huge time lag between his crew's setting rates and what actually happens; add to this, the Fed and other central banks are generally reactive not proactive).)

Given time lags in a large money economy -- like the US's or the world's -- artificially lowering interest rates under a fractional reserve system creates new money.  The new money enters the system via the loanable funds markets -- typically benefiting the biggest debtors first.  (In any modern economy, the biggest debtors tend to be the state and large financial institutions.)  The loans they take are then spent -- or, in the case of fractional reserve banks, re-loaned out (the banks get a loan from the Fed (this money simply didn't exist before) and since they only need to keep a fraction in reserves, so this creates more new money.  Were the process instantaneous, there would be an immediate rise in prices across the board -- as the value of the money unit instantly dropped.*

This is not the case, however, as new money (whether as new credit or not) takes time and is path dependent.  Those who first get new monies (e.g., new loans) can early on buy up resources for their projects.  This drives up the prices in the markets they first enter.  (Supply and demand in action.)  Even if some entrepreneurs anticipate this -- e.g., if I guess that Big Bank just got a billion in new funds and generally invests that in, say, bird feeders, I might, before Big Bank even makes an investment, invest in factors used to make bird feeders.  But unless we assume perfect entrepreneuers -- i.e., people able to perfectly forecast all of this*** -- some of this new money is going to flow into a market before people can adjust.  Some real factors will change hands and the later price adjustments will only come afterward.  Beforehand, this means, just about everyone was acting as if there was no new money.

This process continues to ripple through the economy.  The actual path is takes is not predictable beforehand -- save for generalities like the first people who get the new money or new credit will have an advantage and later players will not (because they will be in an environment where some prices have already adjusted, more or less, upward).  As it proceeds, though, the effect is as if the earlier holder of the new money had real savings.  This is how savings and loanable funds or investments get disequilibrated.  (Or, to be more precise, since no real world market is ever in equilibrium, they become more equilibrated than normal.)

Does this make sense?

Also, this is not an irrational belief model.  It's people acting on the local information they have -- particular prices, particular interest rates, and other data -- without anticipating inflation.  Now, of course, people do try to anticipate inflation in real markets -- hence things like inflation premia on loans or COLA in labor contracts -- but such anticipation is never perfect and path dependencies don't allow a robust prediction of relative price changes.  (Relative changes are critical here.  Again, if all price rose in lockstep or instantly, then little would change (but see ** below) -- as a 10% return on investments would remain 10% and a person's salary would rise in step with the prices of good and services she buys.  This would be, IIRC, just like Hume's angel -- the one who, in an effort to aid humanity, doubles everyone's cash supply.)  But as soon as people do start to anticipate inflation more, their real behavior will change too:
 they, in general, will become more present-centered as they will expect savings to not be worth as much (e.g., if I save $1000 today, it might only be worth, say, $900 next year, so why not spend it now?  This is why in really inflation, people start buying up anything at all in hopes of getting something for money they expect to fall ever more in value) and more reckless in their investing.  And this is, in fact, what we do empirically see, no?

Regards,

Dan

*  Inflation used to take place by actually printing up more money or, when metallic monies were prevalent, by meddling with the specie content of coins and enforcing their trading at par.  (All of this requires some form of enforcement -- usually through legal tender laws or other ways of privileging inflated monies.  Else, if people can switch to other monies, they will; there will be a flight to quality as ever more people won't except inflated monies and switch to sounder ones.  This goes against the usual interpretation of Gresham's Law -- where bad money drives out good.  However, Gresham's Law only applies when bad (lower value) money is forced upon people at par with good money.  If no one is forced to accept bad money, they generally won't -- especially once they know it's of lower value.)

** Of course, there might still be "shoe leather" and "menu" costs, so it wouldn't be totally costless.  Shoe leather costs are costs associated with carrying more money to deal with higher prices.  It's based on the notion, people would have to make more trips to the bank or MAC machine to get more money.  (Of course, with electronic fund transfers, this seems quaint, but even these are not costless.)  Menu costs are the costs of changing prices of goods to match the new higher prices.  (Obviously, this too is quaint, though there are still costs associated with changing the web site to reflect changed prices.  Or renegotiating contracts to make sure they reflect ditto.  Unlike shoe leather costs, these costs would also appear for that extremely rare if not extinction bird deflation.)

***  All real world entrepreneurs are imperfect, though some are better than others.  Real world government workers, too, are no better, so they can't improve on entrepreneurial imperfection; they can only add their imperfections to the mix, making things, on average, worse.  (Yes, they might get lucky, but this is no different than a gamble -- and a bad one at that since regulators and such have the same flaws but lack the incentives to correct these.  A regulator who gets it wrong is, in general, not playing with her or his money or resources.  The same regulator, too, tends to lack the information to even get it right were the incentives irrelevant here.)