Causes of Bubbles

This is something that I have been covering with my Behavioural Economics students.

Behvaioural economists pay special attention to the causes of financial bubbles. Many explanations are offered, but key among them are herding, relative positioning and overconfidence. These psychological factors are sometimes referred to ‘Animal Spirits’ (from economist John Maynard Keynes) or ‘Irrational Exuberance’ (Alan Greenspan former US Fed Chairman) not only create bubbles but also greater volatility in the booms and busts.

1. Following the herd: Decision making in a world of uncertainty

Wall St - herdingPeople tend to follow the herd, especially information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets.

2. The role of relative positioning in investor behaviour.

Another cause of financial bubbles is relative positioning, which is a concern people have regrading their own economic and social status relative to other people. Any deterioration is a person’s relative positioning should reduce a person’s well-being. Many people will invest more as share prices increase for fear that otherwise their economic status will fall relative to those who are currently investing and making a lot of money, at least on paper (shares that they own). This fuels further increases in share values, but not on the basis of changes in the fundamental values of the assets. Relative positioning is similar to herding, but people aren’t following the leader. Instead they’re trying to protect their relative economic and social status by keeping up with others in their reference group who are already investing.

3. Overconfidence and underconfidence

Overconfidence is a belief, fed by emotions, that you can predict movements better than you actually can. When you’re overconfident, you’re not as smart as you think you are. Overconfidence tends to lead to great investment in financial assets that you would otherwise. Some economists argue that people invest in assets that they wouldn’t invest in if they considered more objective criteria and weren’t ruled by emotions.

Underconfidence is also emotionally driven. It’s a belief that you have a less capacity to understand and predict asset prices than you actually have. It tends to lead in panic-driven selling of financial assets, causing many people to dump assets they should keep, based on objective criteria.

Confidence is affected by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.

4. Institutional failure

Credit Rating AgenciesAfter the recent Global Financial Crisis (started in 2007) economists have emphasised the role of institutions in affecting decision making. Investment decisions that can be bad for society but good for the individual can be a product of the institutional environment. If decision makers face little or no downside risk when making very risky decisions, they’ll take those risks. The recent GFC showed that eventhough corporate decision makers and brokers often bear little or no cost for potentially bad financial decisions or for providing poor financial advice, they still earn significant salaries/bonuses. Why not engage in these behaviours if you come out with a lot of cash. Some people will refrain from behaving this way for moral reasons. But history has shown that plenty of people will make decisions that harm society if those decisions benefit them personally.

This is a classic moral hazard problem where the individual or institution doesn’t bear the costs of the decision. Nothing irrational is happening here, but such behaviour can fuel bubbles and busts and can cause bankruptcies and liquidity crises. Also, if regulations are not well designed, rational decision makers can provide misleading information to clients. Credit rating agencies (Moody’s, Standard & Poor’s, Fitch) were giving AAA ratings (very safe) to financial assets when they were more like BB (junk status). The quality of regulation and its enforcement play an important role in influencing investment behaviour therefore it is imperative that there is more accurate information about investments.

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