Information Cascades
What bugs me about the Milton Friedman economist crowd is their reliance on the “efficient markets” theory which rests on the quaint notion that Homo Economicus is a totally rational being with all the information he needs to make decisions. Robert Schiller of Yale points out this morning, that it doesn’t work out that way in the real world because people often participate in “herd behavior” like a housing bubble.
Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.
When everyone you know is buying a house, you override your own instinct that prices are too high and join the herd. The information held by any one individual is usually incomplete and so you look to the judgements of others to make your choice.
This theory poses a major challenge to the “efficient markets” view of the world, which assumes that investors are like independent-minded voters, relying only on their own information to make decisions. The efficient-markets view holds that the market is wiser than any individual: in aggregate, the market will come to the correct decision. But the theory is flawed because it does not recognize that people must rely on the judgments of others.
The other part of the problem is that even policy makers like the President or the Fed Chairman may be using old data to make decisions. Charles Biderman of Trim Tabs Investment Research makes a strong case that most government data is woefully out of date. In fact, he presents some pretty strong data to back up my contention that we are already in a recession.
FOR the first time since the fourth quarter of 2003, TrimTabs estimates, consumers will have less money to spend this quarter on a year-over-year basis. The firm expects this figure to fall 0.6 percent from the same period in 2007.
While that may not seem like a meaningful decline, it becomes more significant when compared with the increases the index showed during the real estate boom.
Back when homes were everybody’s favorite A.T.M., mortgage equity extraction propelled the TrimTabs consumer indicator. Beginning in late 2004, quarterly comparisons with year-earlier periods shot up; they peaked at a growth rate of 17 percent in the first quarter of 2006. During that period, consumers had $1.69 trillion to spend; equity extraction accounted for $191 billion then, TrimTabs said, its peak amount.
As I said yesterday, the home equity ATM has closed. The average consumer was not living better because of rising wages, but because of rising borrowing. That game is finished. Whether an economy 70% dependant on robust consumer spending can be reoriented towards savings, investment and production will be the task of the next administration.
I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you.
Eric Hundin
We are in recession already!
and Biderman is a nutbag! He was criticizing the average investor last summer for pulling out of mutual funds, saying, “Fear and ignorance seem to be gripping retail investors these days,” said Charles Biderman, chief executive of Santa Rosa, Calif.-based TrimTabs on Thursday, pointing to ongoing concerns about subprime lending and slumping housing markets.
“There’s no credit risk; no bank is going to lose money on this subprime fear,” he added. “Income-tax collections are strong, and you don’t have a housing collapse when wage income and job growth are surging.”
Uh huh. He may have come over to enlightenment since then, but he’s a shill nonetheless. here’s the link to the original story:
http://www.marketwatch.com/news/story/second-biggest-outflow-year-points-fund-market/story.aspx?guid=%7B88D64DA2%2DCA6E%2D4F39%2D81AA%2D440FD495ED90%7D
all supply and demand, no?
if someone wants if, someone will sell it.
the marketplace in all i’s infinite complexity
money is just the medium to facilitate this exchange
The market’s biggest weaknesses are drug-like effects. Short term boom, long term devastation.
If humans were entirely rational immortal beings, then libertarian market principles would be the best way to go.
What the people around you are doing is part of “all the information”. I think calling it “herd behavior” is a little unfair – it’s not that I see everyone I know buying a house in an expensive market and feel compelled to follow. But when a lot of people I consider intelligent are buying a house, I may figure that it’s a good idea for me, too.
I may make a bad decision based on misperceptions of what’s in my best interests, but I’m still acting rationally.
My partner, T, wants her own house in the worst way. We, she and I, have researched the question every which way, as they say. All the facts we have uncovered point to one clear Kiyosaki point. A mortgaged home is a liability. We would have to pay twice its price in interest to finally own it. These facts sit in a folder on her computer ready to peruse at any time. Yet, she wants her own home in the worst way and just when I think she’s let it go, she turns to me and says, “I found just the one and they’re holding an Open House.”
Rhbee,
Why do you think paying twice the price in interest over a 30 year period is odd? Doesn’t Kiyosaki encourage you to own rental properties?
Jon,
I don’t know about “herd mentality,” being proof we need to regulate the market.
Quite the opposite, “Democracy” as you imagine it IS DANGEROUS precisely because of “herd mentality,” and the market rewards constantly non-herd thinking. Federal government as you are well aware puts all the eggs in one herd basket. That’s why foreign forms of economy all have sucked our wind and will continue to do so, as long as we don’t accept “more government” as a solution to anything.
I think you are probably right now “rushing to judgement,” a sure sign of herd mentality by assuming we have economic crisis right now we cannot imagine or manage.
I continue to find it very odd, on the one subject where I am concerned enough to violate the market (and have a war) ensuring the free flow of oil, you have faith in the market, BUT in all the little stuff like real estate values, unemployment at 7-8%, inflation at 3-4%, you want to rush in with market controls. You don’t find it odd?
Here’s the real thing: Global economy is what the US is involved in. Which country is WINNING? Meaning which country does everyone else wish they could live in? You shouldn’t judge that in a vacuum, otherwise you end up sounding JUST LIKE the folks saying Japan was buying up the US or saying Communism was a worthy goal.
There is a real chance frankly, that ALL THE “PROBLEMS” faced by our system right now have been caused by government.
Whether they win or not, Obama is proof we don’t have a race problem here. Hillary is proof we don’t have a sex problem here. The deficit is proof, taxing the rich to win votes (democracy) doesn’t seem to work in the interests of the poor. Things look pretty good to me, they don’t to you? Where would you rather live?
Morgan-The government supposedly had a responsibility to supervise the bond rating agencies who gave AAA rating to worthless securities. The government supposedly had a responsibility to supervise Mortgage brokers who conned people into teaser mortgages and falsified their income statements.
It’s our responsibility to try to improve on the existing system of market capitalism we have lived with since 1980. I’m simply trying to suggest that there is a role for regulation, because you can’t deny that there are greedheads out there that will constantly try to game the system.
Morgan – you seem to assume any criticism of the current situation implies there is something better out there.
IMO there is no where better to live, but we can certainly make this place better to live than it currently is.
And most of the current issues arise from the gov’t not doing it’s job, not in being too involved. In fact this might very well be the reason most of the recessions the US has suffered occur during Republician control of the gov’t.
Kevin, real estate bubble and resultant credit bubble were result of government sanctioned tax cuts in 1997, changing the amount of gains tax on real estate transactions. It’s not that government gets too involved or not, it’s that when they do something they don’t know what will happen on the other side of their “solution.”
Jon,
Here is a short history of the 20th century according to me, morgan warstler:
1900-1913: everything is fine, “democracy” as a word barely exists in our lexicon.
1913-1980: the 16th amendment is passed / ratified (income tax). Until this moment, when the feds wanted money for say a monument, they went state-to-state hat in hand and BEGGED. Then over 67 years, we have two world wars (WWI was justification for 16th amendment), and EVERY SINGLE DEMOCRAT PRESIDENT delivers a new FREE “right” – something “rich” people are to pay to give “poor” people.
1980-now: Deficits are discovered as the antidote to the “rob the rich” sales job called democracy. Ronald Reagan says “i didn’t come here to BALANCE the budget,” and he means it. Republican strategy for 30 years has been blindingly simple – SPEND&CUT TAXES.
Bill Clinton was the first Democrat president to deliver NO new free shit to poor people. The only snow job going on right now, is young voters about to get nothing for their efforts.
Instead of getting caught up in the short-term, blinders-on, eyes-down daydream of “YES WE CAN,” let me suggest another a deeper subject that you can make your academic name on:
Forget the politics. Forget the politicians. I think it is now defensible intellectually to cast “democracy” as AN IMPOSSIBILITY. Think of it as a losing gambit, a historical strategy used by some politicians to gain power without actually starting or running companies in a capitalist republic.
Seriously. If you think of it as game play, “democracy” was a wining strategy for Wilson, FDR, Truman, JFK, and LBJ.
Reagan was the first president (thanks to atwater and stockman) to DEFEND against the gambit with DEFICITS. This is true long range game play thinking.
Clinton was the FIRST Democrat to promise free stuff and be made a liar. You have to admit, Clinton delivered NOTHING. He gained the poor nothing.
If you want to accurately understand 8 years of BUSH2, just imagine his MAIN GOAL as HUGE, MASSIVE DEFICITS.
Did he do his job? Yep. This is what I’m saying – taxing the rich to get elected is coming to an end in the grand scope of U.S history. It is happening because as game theory goes, democracy is a winning strategy unless there are massive deficits. Deficits beat democracy every time.
Kevin, I agree completely, but when you compare this country to other countries, to make it better – your JOB is to find the parts we do NO ONE ELSE does and do it more. Copying losers is a losing strategy. Europe has nothing to teach us, except what doesnt work.
So what do we do that makes us different? Free markets. You want to outpace other countries even more? Accent free markets. There is no other choice.
Funny you should list JFK, Morgan, as the fellow who bought the Presidency for Jack said as you do that democracy was spent.
In any event it is a kind of faith, is it not? Margaret Mead called it “the touching belief” of the Americans. However much it may be a whim already dispelled, nonetheless it’s a whim of steel and plutonium, and blood and sacrifice.
And the alternatives have proved utterly horrific.
Morgan, we do own quite a few cash flowing rentals, thank you very much. That’s my point. Even with that knowledge and experience under our financial belt, my partner still wants a home of her own. It isn’t part of a “herd mentality” activity. The rentals may represent that. She comes from a generation of Americans that saw home ownership as one of the goals of their adult life. Her acceptance of this overrides her knowledge of the financial relationship required.
As I think about this past decade or so of house buying I do see that the process of buying was made different as the herd began to see ownership as investment. The cascade of information that Jon refers to was really more likely what Vance Packard called the hidden persuaders. The point is that the market as you seem to want it is consuming the beautiful America that you so obviously, as does Kevin, love. Or to quote another philosophy, “So Say We All.”
Rhbee,
Dude, you are proof you are wrong. If you can figure all the above out and have stood against the herd, that’s game, set, and match – for me.
You certainly aren’t allowed to claim to be adept and say the system is unfair for all the idiots. You want me to be enslaved because your life partner is a sucker (no offense)? Seriously? Her failings are the REASON for your life philosophy of tell, “Morgan what to do?”
I’m reminded of a poker saying, “if you sit down at the table and can’t figure out who the sucker is, it is you.”
Performing all week, same time, same channel!
Morgan, it sounds like you’ve hit one to many tennis balls. But I’ll bounce it back to you anyway. We have rental, I said, and it may well be that we do because we joined a heard. Luckily for us, we’re faster that your average lemming and got out before the cliff. That doesn’t mean the cliff isn’t still there nor that most of the marketeers have gone home. They are still sitting somewhere on their big butts waiting to think up the next big bubble.
The major point I would contribute to this discussion is that the use of the idea of ‘herd’ mentality can be somewhat deceptive, because it tends to reinforce the idea that the norm (either really or ideally) is somehow individualistic; precisely the position that all of these rational choice theorists are espousing.
What needs to be recognised is that actually our knowledge gathering and decision making procedures are primarily collective. This sounds a bit strange, but the fundamental point is simply that virtually all of human knowledge is based upon deferring to other peoples experience and the conclusions they have drawn from it. Try having a conversation about any major intellectual topic (including economics, and related financial decisions) with someone and think how many of the claims you make you can personally verify.
More than this, it is not just that the positions we hold or the decisions we take are taken wholesale from someone else, but rather that the limits or acceptable positions/decisions that can be held/taken are determined by the social networks within which we are situated. These limits are what we might call the ‘consensus’ within which we operate, and the mechanisms which generate such consensus are what really needs to be understood if you’re going to get a grip of ‘herd behaviour’ and the like in speculative bubble situations.
Pete Wolf- That is a spot on analysis. We are having a month long conversation here about the relative ways that classic Friedman economics may not apply in an age of cheap (Internet enabled) collaboration. The fundamentalists still feel the government needs to stay out of every market decision. I tend to believe that the government can send signals to the market through tax or regulatory actions that improve the overall social welfare.
I’ve put up a new example here:
http://jtaplin.wordpress.com/2008/03/03/listening-to-mr-market/
I must admit to not being an expert on economics, I’m a philosopher by trade (if one can consider it thus), but I do dabble, and I entirely agree that the Friedmanite economics of the past few decades needs to be thoroughly debunked and replaced with something less ideologically rigid (not that this is its only problem by any means).
I bring up this idea of flexibility/rigidity very deliberately, because I think that mainstream economics encourages decisions on economic policy to be made with one hand tied behind your back.
If you think interest rate control, money supply control, tax cuts, and (most infuriatingly) deregulation are the only tools one can wield to manage the economy, then you’re ignoring a whole range of other innovative ways in which the economy can be shaped in more specific and subtle ways. As an additional point, this also tends to obscure the fact that economies are not homogeneous – if all you have are global solutions you tend to forget that there are such things as local problems.
The main problem we have is that we have an entirely too unscientific view of market mechanisms. Many people have talked loosely about the somewhat religious quality of free market fundamentalism, but I think there is quite a specific claim to be made here.
We suffer from a false dichotomy: either you support Capitalism (with a big C), meaning full blown free market liberalism, or you deny the self-organising power of market system and believe in some kind of centrally planned economy (a la Soviet Communism). Of course, the Soviet system failed, and as such we all must be big C Capitalists. The reactionary free market Capitalism that comes out of this opposition, in valorising the market as something which always produces the best results paints anything more interventionist than itself as being some form of planned economy (i.e., against or not accepting of the advantages of self-regulating market mechanisms).
This is like in the case of someone who has fractured their leg, claiming that the only two options are leaving the bone to mend itself, or rebuilding the leg from scratch with whatever know-how you have. Obviously, the second option (which leaves you with a crude prosthetic with all the functionality of soviet planned economy) is unpalatable. Thus we are told to leave the leg be, its mystical self-regulating healing ability must be left to its own devices.
Obviously, in this analogous case we want to say that the edifices of modern medicine can supplement the natural self-regulating processes of the body, maybe with a surgery or two, a cast, a splint or some appropriate medications. In the case of the leg we can study the specifics of the legs structure, and the self-regulating processes it exhibits, and we can learn how to shape these with appropriate intervention, without necessarily trying to replace or redesign them in potentially disastrous ways.
It is perfectly possible to understand market mechanisms in just the same way we understand the functioning of the human body, and its perfectly possible to develop techniques for shaping and aiding the market’s own self-regulating processes. By claiming that any intervention is in principle a disruption of these mechanisms all one does is hold back the development of better understanding of and techniques for managing our economies. This is to be needlessly inflexible.
To push the analogy perhaps dangerously far, this makes the above mentioned ‘cut taxes and deregulate’ policy akin to the practice of bloodletting in early-modern medicine – a cure-all of dubious value which those who practice it are loathe to abandon, no matter its ineffectiveness.
It is those that would use the herd mentality for its own devious ends that I think we need to keep in mind. Jon in his example poses a new gas tax that would have an economic effect but also a political one. The herd is made up of childish minds that whine and whimper when their 4 bys can’t make that desert run they see as their inalienable right. Politics seems to be all about prodding the herd in whichever direction you need it to go while at the same time making it seem that it is all the movement is the individual’s idea. That’s really what’s so funny about the oxymoronic “Free Market”. “TANSTAAFL”
Make that “making it seem that all the movement”
Finally we are getting somewhere! See Pete, I am a capitalist BECAUSE I’m a philosopher.
Certainly there is no herd mentality, because there is no herd. There is no collective intelligence. There is no knowledge given away for free. There is no true altruism. ALL of these constructs are false narratives told by folks with ulterior motives.
Be clear, I’m all for Linux, I’m all for wikipedia, in the same way, I’m all for private lands controlled by a private person, but turned over for and in his own interests, to others to molest and exploit freely under his rule. At some point a symbiotic relationship is formed between owners and exploiters, no one actually votes on it – all opinions are not equal.
If the government ran wikipedia or Linux, it would never get off the ground.
Here’s a conundrum for your “it is all a herd” paradigm: EDUCATION. Philosophically, I’d urge you to read Ishmael and My Ishmael,a s well as Rousseau’s Emile as primers.
Economically, the cost of education should fall dramatically every year. What it costs to transfer the same amount of knowledge from one mind to the next mind should go down. It doesn’t.
IN FACT, we have the most uneconomical approach to education possible, we SEEK a LOWER teacher:student ratio as if that is a good thing, when is fact it sucks.
A lower teach:student ratio means each new teacher is stupider than the last one. If I said we have to teach these 1000 students Econ 101, and we have $1000 to do it, we have a million dollar project on our hands.
The obvious answer is to let the smartest Econ son of a bitch going hire underlings and guarantee the students will learn. He takes in $1M and then pays the students some fraction of the $1000, the faster they learn the subject matter, and gives them a piece of the action for helping each other student learn.
The dumbest way is to say we need a teacher student ration of 10:1, so each teacher can only make $10K – and we have to have 10 students who get the smartest guy we can find to take that deal, and 10 students get the 100th smartest guy we can find to take that deal.
In those 100 teachers we will find American Academia and they have a god damn union. Yes there are some bright dedicated teachers who are “altruistically” sacrificing to make the world better, and also we’ll find almost all couldn’t go succeed in the world in the very subject they teach about.
I used to have to go sit in the office of my local newspaper editor to read the AP wire as it came in to get enough data to feed my habit… now it is at my finger tips wherever I go, the fact that EDU hasn’t grown that quickly ONLY POINTS to one thing: government controls in any regard ruin the advantages of “collective” “herd” or “shared” benefits.
I’m speaking in broad strokes here, but my point holds nicely. We need to radically rethink and re-examine what motivates people, it isn’t always $$$… BUT, that study’s province is ECONOMICS, because econ isn’t about $, it is about incentives and dis-incentives.
“But Obama sounded like a cross between a social activist and a flannel-shirted software C.E.O. — as a nonhierarchical, collaborative leader who can inspire autonomous individuals to cooperate for the sake of common concerns.”
http://www.nytimes.com/2008/03/04/opinion/04brooks.html?ref=opinion
Ta-da! Quoting myself:
“Be clear, I’m all for Linux, I’m all for wikipedia, in the same way, I’m all for private lands controlled by a private person, but turned over for and in his own interests, to others to molest and exploit freely under his rule. At some point a symbiotic relationship is formed between owners and exploiters, no one actually votes on it – all opinions are not equal.”
Obama OWNS the movement. Others can suggest shit more freely, but it is his to decide.
Deal with it. Capitalist republic at it’s finest.
Swami Morgan, your bit about the husband hiring out his wife for someone else to rape reminds me of something my grandfather, a member of San Francisco’s Olympic Club, told me in the 1960s.
“We’re a club of vice presidents. We all work for the presidents and chairmen up at the Bohemian Club. And they work for the owners at the Pacific-Union Club. Each club is smaller and more exclusive, the farther one gets up Nob Hill. If you work very hard you can earn your way into the Bohemian, but you can never earn your way into the Pacific-Union. You must be born there.”
At the time I reckoned my grandfather had disclosed something important and portentous! Ah, to be callow again!
Anyway, I’m working on a succinct reply to your education example, as I arrive at your destination by a radically dissimilar route.
My grandfather picked me up on Sundays and took me to get donuts for the family. He often told me something quite the opposite, eventually, one of his examples was about was about JFK…. Junior.
He said America was great because it was near impossible to pass on wealth, hell look at Camelot, in just two generations, the kid was so dumb he flew upside down and killed two ladies. That’s been my experience… The “principal” soon dwindles, as the inheritor trys more and more ludicrous schemes to recover it.
Yeah, true. Nobody wants to have to pay their dues anymore. Maybe it’s the Yuppie thing: “I want it all, and I want it now.” I went to school with a bunch of children of the original Jet Set, and a shocking chunk of my classmates killed themselves in shiny toys they never bothered to master.
Maybe we’d be better off in England, where it supposedly takes four generations for the heirs to rival Paris & Nikki.
The only thing I’ve gleaned from my grandfather’s lesson in Gnothi Seauton is that it is well to remember that the Bohemians also are hirelings.
Incidentally, the estimable President of Jon’s university is an ex officio member, by reciprocal privileges, of the Olympic Club.
Morgan-Went to boarding school with some dim bulbs named Morgan, Frick and Auchincloss. “Shirtsleeves to shirtsleeves in three generations.”
And I aks you, Jon, did not a whole mess of ‘em end up killing themselves in fast machines?
Hughvic- They certainly indulged in some dangerous behavior.