Wednesday, April 9, 2008

The Economics of Herding and Irrational Exuberance

Readers Question: Is there an economic term for the phenomenon of ignoring (or turning a blind eye to) future risk, assuming that the current situation will prevail? I refer to the situation we currently see of both borrowers and lenders who are being caught by interest rate rises, having seemingly assumed that interest rates would stay low.

An assumption of classical economics is that consumers and firms are rational. i.e. they take care to make the best choices given the information available.

In theory, people would seek to avoid situations where they buy overvalued assets. However, in the real world, we often have seen asset bubbles and behaviour which seems to be irrational. This is often termed irrational exuberance. It is studied in behavioural economics

Examples of Booms and Busts

Throughout history there have been many examples of speculative booms where investors jumped onto rising commodity prices, ignoring the economic fundamentals. Some examples of famous booms and busts include:
  • The price of tulips 17th Century immortalized by the book "Extraordinary Popular Delusions and the Madness of Crowds, "
  • The South Sea Company 1720
  • Florida Real Estate craze of 1926
  • The Wall Street boom of the 1920s and crash of 1929.
  • Dot Com bubble 2000-2002
  • House price boom in America 2001-2007
In all these cases, people ignore potential risk and get caught up in a wave of speculative buying. Assets tend to rise by much more than there underlying value. However, there comes a point when people realise the assets are overvalued and so start selling. This can cause an asset slump. The bubble can turn to a bust. After the bubble has burst, people start asking the question - why did so many people ignore the risk and get carried away?

Why People ignore Risk
  • The Madness of Crowds - This is the idea that the majority must be right. If other people are piling into a stock, it must be a good thing. Therefore, people feel safe because the so-called experts are recommending the stock. This is sometimes known as the herding effect.
  • New Paradigm. This applied particularly to the dot-com bubble in 2000-02. People were aware share prices were worth much more than earnings suggested they should be. However, the argument was that internet stocks were different to old stocks. The internet offered a chance for speculative growth, therefore, we shouldn't use old pricing formula.
  • People like the prospect of making a lot of Money. These asset bubbles generate stories of people making a lot of money. Maybe people think they can beat the market. i.e. they know there could be a crash, but, they believe they will be able to get out at the top.
Situation at the Moment.

In the post-2001 period, there was a period of easy and cheap credit. People felt that low-cost borrowing would continue for a long time. Therefore, many took out risky mortgages. Mortgage companies sold on their debt, thinking this acted as a kind of insurance. The problem was that the risk of lending was spread throughout the financial sector. People taking out mortgages felt secure because:
  • The mortgage companies who were very keen to lend.
  • Interest rates were very low (especially in the US)
  • Mortgage companies were keen to lend because they saw house prices rising (and felt they would always keep rising)
  • They sold on their loans in the form of CDOs to other finance companies.

However, the problem was that interest rates of 1.5% didn't last. They increased as consumer spending rose. Mortgage companies in the US were motivated to sell mortgages that were inappropriate.House prices didn't keep rising.

The effect was that mortgage defaults rose and house prices fell. This led to the credit crunch and shortage of funds causing interbank lending to become more difficult and expensive.

The problem here is that people were focused on a small aspect of the overall picture. There was certainly a strong sense of belief in rising house prices. Also, the last financial crisis led the Federal Reserve to aggressively cut rates to avoid problems.

However, it is of course, always easy to be wise after the event.


1 comment:

Anonymous said...

Great summary, but do you not think that there was more to the low interest rate fixation then meets the eye?

Obviously, a lot of people just pay what they can afford when they get a mortgage, so lower rates meant a bigger price tag over time as people bid up prices.

But I think some people also thought they were *justified* in paying more because rates were lower, without considering the lifetime cost of a mortgage.

A 5% interest rate in a 3% inflation environment is different to a 10% interest rate when inflation is 8%.

Assuming they don't get bailed out, the last round of buyers will be paying of their mortgages with a real slug of their earnings for 25 years, because inflation is no longer there to do any of the heavy lifting for them...