[ExI] Psychology of markets explanations

Stathis Papaioannou stathisp at gmail.com
Fri Jun 5 11:48:45 UTC 2009

2009/6/5  <dan_ust at yahoo.com>:

> 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).)

Then why does every country have a central bank? If they just muck
things up you would think that over time a country that tries out an
economic system without a central bank would prosper, and its
neighbours would either take note and copy it or else fall further and
further behind. The US did not have a central bank in the 19th
century, and experienced multiple boom/bust cycles, more than in the
20th century.

> 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?

Yes, it makes sense, except when it doesn't work that way. Japan in
the 1990's lowered interest rates to near zero, printed money, and
went for big time government deficit spending. This might have been
expected to caused inflation, maybe even hyperinflation, and a
collapse in the value of the yen. Instead, Japan had continuing
deflation and the yen remained strong. But perhaps the recession would
have been even worse in the absence of these policies, and perhaps a
tighter monetary policy might have prevented the Japanese asset price
bubble from inflating to the extent that it did.

> 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?

In general it is what we see, but it also depends on the population.
The aforementioned Japanese seem constitutionally less inclined to
borrow money for consumer spending than Americans are, no matter how
cheap and easy it is to get a loan.

Stathis Papaioannou

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