[ExI] Psychology of markets explanations

Stathis Papaioannou stathisp at gmail.com
Wed Jun 10 12:36:23 UTC 2009

2009/6/10  <dan_ust at yahoo.com>:

>> Then why does every country have a central bank?
> I don't have a rock solid explanation, but recall my mention David Glasner's essay "An Evolutionary Theory of the State Monopoly Over Money"?*  In that essay, Glasner posits that states tend to interfere in and gain monopolies over money to deny financial resources being used to alter or overthrow their rule.  This need not have been a conscious policy.  States that arose that were didn't try to control money might find themselves, on average, losing to those that did -- as a short run inflation could pay to keep a regime in power until a crisis or war was over.  This appears to backed by the historical record.  The pattern of inflations prior to the widespread use of paper monies and even well after and until the 20th century was usually inflationary boom during war followed by a recession
> after.

Then you have to explain why many governments have voluntarily given
up control of their central bank. Of course there are accusations that
the central bankers are employed by government and subject to
political influence, but why would the government even pretend that
they are independent? It's not as if the voters care, as they care
about an independent judiciary.

> Money supply has increased in Japan, but prices have, on the whole, fallen.***  Why is that?  The falling prices can't be the result of the increased money supply -- because increasing the supply of money while holding all else constant would result in higher prices (i.e., there would be more money (after increasing the supply) than the things traded for money, so one would expect prices to rise).  In this case, it could be either some increase on the supply side of goods and services offsetting the growth in money supply.  (This doesn't really neutralize inflation.  It merely masks it.  An analogy might prove helpful.  If I take from your supply of canned beans, then your supply of such will fall.  Eventually, you'll notice the pile getting smaller and wonder what's happening.  However, imagine I steal a few cans a day, but BillK adds in twice as many cans as I steal.  Let's say you don't see him adding in those extra cans, but you do notice me taking
>  some cans each day.  You might, wrongfully, conclude, my taking the cans is making your total supply of canned beans.)
> Or it could be the demand to hold money has grown.  In this case, the demand for goods and service actually must fall: people prefer to spend less even though more money's being adding into the money supply.  And this probably does play a role in the Japanese economy and in any economy when an inflationary boom finally crashes: though inflation might continue, people desire to hold more cash, so prices don't rise (or don't rise as much).
> Or it could be a combination of the two.
>> But perhaps the recession would
>> have been even worse in the absence of these policies,
> How so?  They've had now year upon year of declines.  There has been some debate about V, U, and L style recessions.  A V is a fast decline followed by a fast recovery.  This seems to be what happened with the 1921 recession.  In that example, the Harding Administration did almost nothing save for shave the government.  (Of course, one could argue that this was a postwar recession and that it was purely a quick readjustment to peacetime.  Even so, there was an inflationary boom during the war.)
>> and perhaps a
>> tighter monetary policy might have prevented the Japanese
>> asset price
>> bubble from inflating to the extent that it did.
> In which case, what?  A "tighter monetary policy" would've been what?  If not deflationary, at least disinflationary or less inflationary.  With less money being pumped in, all else being the same, I think there would've been either a smaller bubble (and maybe a weaker and shorter recession, though I believe the strength and duration of recessions depends also on how monetary and other government authorities react to them and not just on the raw amount of inflation).

That's what central banks and governments try to do: adjust fiscal and
monetary policy to smooth out the economic cycles. I understand that
those opposed to any sort of monetary or fiscal manipulation think
this is ultimately a self-defeating exercise, and you will ultimately
just make the problem worse than it otherwise would have been. But in
form isn't this argument like the argument that medical treatment can
only ultimately make you worse, since nature knows best?

>>> 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.
> Yes, it would vary, though the point is the incentives are set in one direction.  Cultural norms and such might incline people not to take advantage of this, but why have perverse incentives in the first place?  It's almost as if we passed a law in our countries that allowed anyone to shot people wearing striped shirts without fear of retribution.  Sure, few people would, given cultural norms, go out looking to shoot people wearing striped shirts, by a few would and why set up that kind of rule in the first place?
>> 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.
> Perhaps, but then this fits in with a rise in the demand for money.  And, in fact, Americans often do that too during recessions: they often slow down their spending and hold larger cash balances.  This is, in my mind, a reasonable reaction to a financial downturn.  You don't know if you'll have a job, so you spend less.  You might even cut back on investments because the market looks shakey and you're not sure if XYZ stock or your mutual fund will ever recover.  (People and firms might overshoot, cutting back too much, but there's no iron law of economics that says they always overshoot or that a monetary authority or government official -- all of whom have incentives to downplay downturns (no pun intended) -- will do any better.  In fact, my guess is they'll do worse.  Witness, e.g., the current crisis and their reaction to it, including President Obama's reaction to recent economic data -- the data showing that the stimulus is not working.)

Which returns to the original question of whether psychology
influences markets. If I understand your position so far, it is that
peoples' psychology, eg. the tendency to save more in a recession, can
be broadly generalised for the purposes of economic modelling, and it
is not possible to effect a change in psychology in order to effect a
change in markets.

Stathis Papaioannou

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