[ExI] Psychology of markets explanations

[dan_ust at yahoo.com]

--- On Wed, 6/10/09, Stathis Papaioannou <stathisp at gmail.com> wrote:
> 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.

I don't think that quite responds to Glasner's view.  First, he's talking about how the monopoly arose and applies not so much to banking as to legal tender and minting.  Historically, most states have had some kind of control over this.

Also, I don't think his explanation need mean whenever we see a state it must needs have a monopoly over money.  It would mainly apply to states that were threatened or felt their existence would be threatened by leaving money alone.  States that aren't under and don't perceive such threats, probably won't feel any pressure to monopolize or, in more advanced economies, set up a central bank.  (Note: a monopoly on money is not necessarily a monopoly on banking.  This is no different than a state having a monopoly on the roads, but hiring out construction, repair, and even management to private firms.)

This might explain why some third world countries adopt things like currency boards (instead of central banks; note, though, a currency board is still monopolistic control) or just allow another country's currency to work.  Many of these nations are client states of America or another country.

In the recent EU case, it's arguable that it's too early to tell, but the various EU members are not in security competition with each other (and many are US client regimes anyhow) and using the Euro is not exactly likely to threaten them with a rival internal currency.  Remember, Glasner is not arguing states just love to have a monopoly on money period, but that this enhances their security over leaving money in the hands of private mints and private suppliers.  (The basic idea is that a state of old -- say, an ancient state -- that leaves the mint outside of its control risks having whoever runs the private mint entering the political-military arena against the state.  Basically, one can imagine a despot might be deposed because his enemies can raise funds to pay mercenaries to fight his army.  So said despot decides the mint must be under his control.)  The Euro certainly doesn't leave such in the hands of private mints and suppliers.

Finally, on this particular issue, I wouldn't make an argument that because something is widespread or ubiquitous that it's better than the alternatives.  Could be, but history is not over and one must ask why it's been selected over the alternatives.  Certainly, too, something might win out over alternatives in a way that you or I might not like -- as when a bad alternative catches on and stays caught on because it's linked to better marketing.  (And don't think marketing only takes place when private individuals and firms operate in a free market.)

[snip]
>>> 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 know that's the economic justification for these policies.  I think the justification is wrong and the policies don't work.  (In some cases, too, it might be that these are policies in search of justifications -- as when well-connected political groups get some "fiscal stimulus" that really is just a wealth transfer, but it's rationalized as helping the whole of society.)

> 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?

I think a better analogy would be a doctor of previous times treating a medical condition with a treatment that's worse than the disease.  The patient might recover, but that's in spite of the treatment.  Certainly, this analogy fits the current crisis -- and most if not all previous crises -- since the doctors -- the people at the Fed and other central bankers, the federal government, and government advising economists -- all failed to see a crisis brewing up until it actually hit the markets AND seem to have had a lot with creating the conditions for the crisis in the first place.  From my view, an even more precise analogy would be a team doctors who take a healthy person, inject him with all sorts of drugs that cause him to go into cardiac arrest, and then try things like transfusing blood from his leg to his chest or increasing his blood pressure in hopes this will resolve the problem.  And their playbook appears to change as the successive (but
 not successful) treatments fail.
 
> > 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.

Put that way, not exactly but close.  I think the problem is with many psychology of markets explanations is they're relying on people to react to some sort of market changing in broadly the same fashion -- especially when that's at odds with what they take to be economic intuitions.  Such economic intuitions are often wrong NOT because they're based on sound theory BUT because they're based on simplified models, such as the homo economicus* view or the Efficient Market Hypothesis (EMH), or unsound theory.  (That EMH is wrong, of course, is NOT an argument for government intervention.  Government intervention won't make the market any more efficient; it'll merely introduce new factors into the problem, perverting incentives and distorting information.  Usually, too, such interventions are done to benefit elites -- even if the marketing campaign for them tells us, with a straight face, that they're for the common good.)

If you're just going to say, e.g., that if people's psychology changes, so will markets, I agree, but this is a trivial point.  For instance, if people's demands for leisure, savings, goods, services, and money change, this can impact how any particular inflation affects the economy.  This doesn't, however, mean that inflation will have no impact and it's hard to see how everyone's psychology would likely change in a way that neutralizes a bad monetary policy.  (Also, a lot of the psychology of markets explanations when applied to crises seem to presume people are acting incorrectly to the factors in a crisis -- such as overestimating how far stocks might fall.  However, sticking with these cases, the researchers often have the benefit of hindsight and other information unavailable to the average investor.  Given imperfect information and uncertainty about the future (will the asset go down 10% or 20%? will it hit bottom and start to rise next year or
 ten years from now?), bounded rationality, and the various incentives, a lot of seemingly incorrect behavior looks sensible.)

Regards,

Dan

*  This is not to say some simplifications might not be helpful in understanding or teaching economics.  Still, one must be careful to be clear about the limitations, especially when simplifications become falsifications.  In the case of homo economicus, just looking at wealth and pretending people aspire to some sort of efficient accumulation of such flies right in the face of how real world people act: they don't just chase after ever bigger piles of wealth.  An economic theory that only looked at wealth would be lopsided and mostly inapplicable to the real world.  See also Kirzner's _The Economic Point of View: An Essay in the History of Economic Thought_.  The whole book is online at:

http://www.econlib.org/library/NPDBooks/Kirzner/krzPV.html