[ExI] Psychology of markets explanations

[dan_ust at yahoo.com]

--- On Fri, 5/29/09, Stathis Papaioannou <stathisp at gmail.com> wrote:
>>> And if they had the right mindset, they wouldn't
>>> allow
>>> another bubble to form either.
>>> If population, natural resources and new
>>> technology are
>>> kept constant,
>>> psychology is the one thing left that contributes
>>> to the economic cycle.
>>
>> Psychological explanations of recession go
>> back a long way -- and always rise up again,
>> despite being refuted.  This is like the view
>> of gambler who's down to his last stack thinking
>> that if he only just thinks positive, he'll
>> win.  His false optimism will likely get him deeper
>> losses.
> 
> I wasn't referring to anything so crude as "think
> positive". In the
> most basic terms, economics reduces to physical resources
> and human psychology.

First, how does this relate to the specific example: how psychology "contributes to the economic cycle."  And how it would help to change "psychology" (or, more likely, how people think and feel) would ameliorate the current crisis or economic cycles in general.

Second, I believe economic laws superseded psychology in a certain way: as long as you have agents that act -- i.e., that have purposive behavior -- economic laws apply.  Granted, and no Austrian would argue against this, psychology might explain why these agents have the particular purposes they do -- e.g., why status symbols become important or why people feel more pain from losses than they appear to feel pleasure from gains.*  But none of this would controvene economic laws.  E.g., the Law of Supply and Demand would still apply, regardless of why people prefer a particular good or service.  (It might better to see economic or praxeological laws as akin to mathematics.  This is not to say they don't apply to the real world, but rather that they apply regardless of the particular material we're dealing with.)

> Capital, interest rates, the price of commodities etc. are
> not physical objects, but ideas that influence behaviour.

Not exactly on "capital" -- because it depends on what you mean by that term.  Generally, it's used to mean goods used to make other goods.  In that sense, capital is actual stuff -- like a machine that stamps out a piece of metal used to make a car.  This is how it's used in Austrian Business Cycle Theory (ABCT).  And this is not a minor detail.  The take home from ABCT is that an unsustainable booms are unsustainable because they arrange real capital in ways that don't actually support what consumers want.  In the current crisis, all those houses and condos being built are real.  All the stuff used to make them -- construction equipment, wood, labor -- is real.  All these things, when they are committed to a given capital structure are hard to shift to other structures and this shifting is not costless.  Capital goods themselves tend to be the hardest things to shift and workers tend to be among the easiest factors to shift.  (Of course, there's some
 variability.  Capital goods are not homogeneous, but they are not all completely specific either.  Ludwig Lachmann pointed this out in his _Capital and Its Structure_ where he talks about capital having multiple specificity.  This means that most capital goods have more than one use -- though the uses have different costs and benefits.  E.g., you can use a spanner as a hammer, but that's not the best use and a spanner is usually a pretty inefficient hammer.)

This leads to a boom creating lots of capital structure that is useless in the long run and must be adjusted.  Think of the current crisis where all that construction equipment will likely be re-absorbed, but it will earn less money, and it will be used a lot less efficiently.  Some of it will just have to be scrapped completely.

Now, you might refer back to psychology and just say "if people only wanted to pay for those homes, all would be fine."  But that's the point.  They never really wanted them -- or they never really expected them.  It's not so much that people one day changed their mind, but that the actual boom didn't reflect actual market demand for new housing but only the distortions caused by inflation.  Absent the inflation, in other words, all those unwanted homes never would've been built.

> Consider it
> as a physics problem: you want to get from situation A,
> which is a
> recession, to situation B, which is a boom. If it's
> physically
> possible with the resources available, then the problem is
> how to get
> all the parts in A moving in such a way as to bring about
> B. Getting
> the parts moving in the right way means controlling the
> behaviour of
> the humans who move the other parts, and behaviour is
> determined by
> psychology.

I think Mises's analogy of a builder would be helpful.  The problem is prices, interest rates, and other financial data should, within limits, coordinate with or anticipate other data, such as expected demands and actual supplies.  The analogy is, IIRC, of a builder needing certain amount of materials to build some homes.  He checks his "inventory" using the price system.  Unfortunately, the price system is inflated so that it appears there are more materials -- more wood, more bricks, more workers -- available.  So he starts to build, say, 100 homes of a certain kind.  The actual supply would really only support 80 homes of that kind.  (Remember, in a real world economy, there's no way to stand outside and "know" what the real data are save via the price system -- which is not perfect, but is the best available means of doing such calculations.)  After the homes are half completed, he notices that he indeed doesn't have enough materials to complete all
 of them.  In fact, he won't even be able to complete 80 of them.  At best, if he stops work on 40 of them and reconfigures the labor and materials, he might get 60 completed.  In this example, the A is the recession -- half completion on 100 homes without enough factors to complete all of them -- and one can't get to B -- full completion of 100 homes.  The boom was merely the belief that one could get to B.  That particular B is off limits and B' -- 80 completed homes -- was possible at the start, but at A (the recession) is no longer possible and any attempt to get to B or B' will only result in further losses -- as there simply are no resources to get to them.  In fact, at this point C -- 60 homes completed -- is the best possible solution and prolonging construction past this point under the assumption more than that can be completed will only result in something worse than C -- maybe the worst case being a bunch a incomplete homes and no buyers as
 winter sets in.  The complimentary real factors -- woods, bricks, nails, laborers, fuel, etc. -- simply don't exist in the right quantities to get to B or B'.

The corrective here, too, is NOT to keep shooting for B (or even for B'), but to allow the re-adjustment to take place as quickly as possible -- i.e., to stop the inflation so that the builder (and everyone else, presumably) finds out as quickly as possible what homes to complete and what to write off, what to shift over and what to stop working on, etc.

(Of course, a real world economy is much more complex than this -- and usually has much more potential and it can often take a lot longer to notice a particular project is really unworkable.  This complexity, though, should actually make one rail even more strongly against inflation -- if one desires to avoid unsustainable booms.  Why?  Because the task of figuring out just which projects are unworkable is that much harder when the price system is thrown out of whack.)

Regards,

Dan

*  Though such explanations often seem faddish and tend to misunderstand economics.  E.g., on the latter, are there really any good ways to measure this and even if there seem to be the researchers might not be isolating losses in the same way.  Think of the usual example of choosing to 100% odds of getting $10,000 over, say, 80% odds of getting $20,000 -- where the net gain would seem to favor the latter option as it, on average, will yield $16,000.  For instance, people might be more risk averse than psychologists expect them to be not because people are irrationally weighting losses more than gains, but because they value certainty over uncertaintly.  Economics is as economics really silent on this.  If a person prefers lower risk as something in itself or not, economic laws still apply and still explain how she or he will act and economize -- but it wouldn't explain why she or he will have those specific preferences.