A Psychology Lesson From the Markets

Hi! I found Shiller old article. It is very interesting for those who love Behavioural Finance. He addressed psychology to play role in market equilibrium. The full article is indeed available in http://www.nytimes.com/2007/08/26/business/yourmoney/26view.html?scp=28&sq=economic+view+and+shiller&st=nyt

Happy reading…


A Psychology Lesson From the Markets

Robert Shiller (Published in New York Times: August 26, 2007)

IT is no surprise that the Federal Reserve’s discount rate cut has not entirely reassured investors. The Fed can stop a run on the banks, but it cannot control the speculative cycle — a cycle built on psychology and misperceptions that has been sweeping much of the world for the last 10 or 12 years.

I have worked with Karl E. Case, a professor of economics at Wellesley College, with help from the Yale School of Management, in conducting questionnaire surveys of recent home buyers. In Los Angeles and San Francisco in 2005, when actual home prices were rising more than 20 percent a year, we found that respondents anticipated big increases far into the future. At that time, the median expected annual climb for the succeeding 10 years was 9 percent.

This expectation would mean that a house valued at an already high level of $650,000 in 2005 would be worth more than $1.5 million in 2015. For most people in 2005, it would also mean that they should buy a house soon, or forever be excluded from owning one — and that it would be better to stretch and buy the most expensive house they could afford, to capture the huge profits of homeownership.

Now, of course, prices have been falling, and our survey over the last few months shows that in Los Angeles and San Francisco, the median 10-year expected price increase among recent home buyers has come down to 5 percent a year — a number that is likely to decline further if prices continue to drop. As price expectations fall, homeowners lose the incentive to pay off a mortgage on a home they are realizing is beyond their means. They decide to default. We thus have the beginnings of a mortgage crisis.

The problem is fundamental, tied to the imbalance caused by irrationally high home prices and declining optimism that the prices will go higher. Cutting interest rates will not change this basic situation.

The problem is fundamental because the speculative cycle afflicts much of the world. Housing booms have not occurred everywhere, but they have been commonplace since the late 1990s in North America, Europe, Asia and Australia.

We have also seen similar worldwide boom cycles in the stock market over the last 10 or 12 years. Many countries shared in the huge market booms that peaked in 2000, and just about every major stock market around the world has boomed since 2003.

Classical economics cannot explain this cycle, because underlying these booms is popular reaction to the price increases themselves. Rising prices encourage investors to expect more price increases, and their optimism feeds back into even more increases, again and again in a vicious circle. As the boom continues, there is less fear of borrowing heavily, or of lending heavily. In this situation, lower lending standards seem perfectly appropriate — and even a fair way to permit everyone to prosper.

Booms cannot go on forever. Downward price feedback sets in. That is when balance sheets become impaired and widening credit problems start to show up.

The puzzle is why this speculative cycle has occurred recently in so much of the world. What do all these countries share that drives them to speculative booms?

One might think that investor optimism is generated by rapid world economic growth that is using up scarce resources and driving up asset prices. Since 2004, the International Monetary Fund’s real per capita growth figures for gross domestic product worldwide have been fairly high: around 4 percent a year.

It is noteworthy that from 1995 to 2003, when these booms took root, that growth figure averaged only 2.4 percent a year. A good part of the extra growth since 2004 has probably been the increased spending caused by the speculative booms themselves.

The greatest recent economic successes have apparently been in China and India. Because these are the most populous countries, together accounting for 37 percent of the world’s population, their success has become an international symbol of spectacular growth.

But it is easy to overstate their importance. China’s and India’s economies are actually a tiny fraction of world G.D.P.— together only 7 percent. The popular impressions of suddenly rapid growth are thus mostly a perceptual error, like the optical illusions documented by psychologists.

The growth of capitalism around the world has caused trust in the social safety net to decline, even in the United States, where 401(k)’s are replacing traditional pensions.

People worry that they must increase their wealth to fend for themselves. One might think that this lack of trust would promote much precautionary saving, but world savings rates are not high over all. It has generally fit in better with popular perceptions of the booms to be smart investors, not great savers.

As we all try to adjust to a rapidly growing and increasingly capitalist world, we have been trying to discover who we are and how we fit into it. This has meant an enormous change in values.

Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem.

That is why it is so hard to turn around investor attitudes once a downward psychology sets in. The Fed and other central banks do not have lithium or Prozac in their bag of remedies, and so cannot control it.

Robert J. Shiller is professor of economics and finance at Yale, author of “Irrational Exuberance” and co-founder and chief economist of MacroMarkets LLC.

Published by:

Rayenda Brahmana

About research: google scholar: https://scholar.google.com/citations?hl=id&user=jlvpW3QAAAAJ&view_op=list_works&sortby=pubdate https://publons.com/researcher/1457129/rayenda-brahmana/ Others: twitter: @raye_brahm instagram: kolom.riset email: kolom.riset(at)gmail.com raye_brahm(at)yahoo.com

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