Greed and Fear

A post by Will Wilkinson reminded me of something:

The New York-based blogger for The Economist’s Free Exchange replies to my lament by arguing that economists do have a theory of the psychology of coordinated expectation. They do, sort of. But they don’t have the kind of theory that I have in mind. Harvard’s Gregory Mankiw admits as much when he blogs:

Yale’s Bob Shiller argues that confidence is the key to getting the economy back on track.

I think a lot of economists would agree with that. The question is what would make people more confident. Bob thinks that confidence would rise if the government borrowed more and spent more. Other economists think that confidence would rise if the government committed itself to, say, lower taxes on capital income. The sad truth is that we economists don’t know very much about what drives the animal spirits of economic participants. Until we figure it out, it is best to be suspicious of any policy whose benefits are supposed to work through the amorphous channel of “confidence.” [emphasis added]

In what macro textbook can one find references to empirical psychological work on confidence? On individual-level variability in confidence, on the conditions under which the confidence of various personality types is affected by economic variables, on the relationship between changes in condfidence and changes in economic behavior, on the social “infectiousness” of changes in confidence, etc.

I have a lot of respect for Shiller, but Mankiw is right. Shiller doesn’t have any real evidential basis for claims about what policies will induce confidence. And neither does anyone else.

The reason economics doesn't have an explanation for confidence is because Fear is an emotional, irrational motivation.

Economic jargon and financial lingo obscure that all investment decisions are the result of a tug-o-war between two primal human motivations – greed and fear. Reason is in there too, but only as a referee. Fortunately, this competition between avarice and apprehension usually results in outcomes that approximate rational decisions. When these relatively rational outcomes are pooled together in the financial markets they come ever nearer to strictly rational results as investors who are too fearful sell to buyers whose greed tells them to buy. But every so often one of these motivations wins out and the market becomes seriously distorted. So, when they talk about confidence or moral hazard recognize that what they are really talking about is Fear or lack of it.

Incidentally, a dearth of Fear, not Greed, was the proximate cause of the current financial crisis. People overestimated the diversification provided by mortgage securitization and accuracy of computerized risk models. Add to this the moral hazard created by the Long Term Capital Management bailout in 1997 and you have people who aren't afraid enough. People thinking they had nothing to fear overreacted and have become too fearful. We need to remove that fear through government guarantees and spending.

As Will mentioned above, the Economist blog tries to explain as best as they can. I've decided to translate:

So what is the cause of the micro fear? There was a sudden exogenous change to individual expectations.

Why are people afraid? Something came out of nowhere and scared the shit out of them.

First wealth fell (because of the housing crash and falling share values). This meant that saving stocks fell, generating cutbacks on consumption to bring saving back to the desired level.

Home prices and the stock market fell. That was scary and they decided to save.

Also many people calibrated wage and asset risk based on Great Moderation variables (that is, low levels of wage and asset volatility). Asset market declines and increased job insecurity forced many people to recalibrate their perceived asset and wage risk (both permanent and transitory).

People didn't think they had anything to fear, so they partied like it was 1999. Then, holy shit!

When people perceive more risk they desire an even larger stock of wealth. When they experience uncertainty they cannot even assign a probability distribution to expected shocks and they hoard even more resources—a few weeks ago we cited a paper that showed that growing up in a risky environment alters investment behaviour (you crave less variable assets).

People freaked out. Realizing that the world was still a dangerous place, they started stocking up on cans, buying ammo, and heading for the hills.

How does this all aggregate? Well, a structural change means everyone experiences a shock to their perception of risk and initially there is uncertainty, so we would expect a fall in aggregate demand and deleveraging. Aggregate demand will plummet when there is so much uncertainty, but will recover to a lower level under the new, riskier regime. By how much exactly will consumption fall? Unfortunately, the data does not yet exist to calibrate the new riskier regime (we are still in the uncertain phase).

What happens when everybody runs for the hills? Well, there's a traffic jam. Eventually though, some people will realize that everybody is heading for the hills and it may be better to go back home rather than waiting in traffic. Others will return too and they'll all buy alarm systems for their houses. That's obviously better than living in a hut in the mountains. But we have no idea when this will happen. Everybody is still heading for the hills.

Economists hope that if the government provides some guarantee, then at least some uncertainty will be resolved and we will feel more inclined to save and lend.

Economists hope that the government can tell people it's safe to go back home.