How following the crowd can doom us all

JDN 2457110 EDT 21:30

Humans are nothing if not social animals. We like to follow the crowd, do what everyone else is doing—and many of us will continue to do so even if our own behavior doesn’t make sense to us. There is a very famous experiment in cognitive science that demonstrates this vividly.

People are given a very simple task to perform several times: We show you line X and lines A, B, and C. Now tell us which of A, B or C is the same length as X. Couldn’t be easier, right? But there’s a trick: seven other people are in the same room performing the same experiment, and they all say that B is the same length as X, even though you can clearly see that A is the correct answer. Do you stick with what you know, or say what everyone else is saying? Typically, you say what everyone else is saying. Over 18 trials, 75% of people followed the crowd at least once, and some people followed the crowd every single time. Some people even began to doubt their own perception, wondering if B really was the right answer—there are four lights, anyone?

Given that our behavior can be distorted by others in such simple and obvious tasks, it should be no surprise that it can be distorted even more in complex and ambiguous tasks—like those involved in finance. If everyone is buying up Beanie Babies or Tweeter stock, maybe you should too, right? Can all those people be wrong?

In fact, matters are even worse with the stock market, because it is in a sense rational to buy into a bubble if you know that other people will as well. As long as you aren’t the last to buy in, you can make a lot of money that way. In speculation, you try to predict the way that other people will cause prices to move and base your decisions around that—but then everyone else is doing the same thing. By Keynes called it a “beauty contest”; apparently in his day it was common to have contests for picking the most beautiful photo—but how is beauty assessed? By how many people pick it! So you actually don’t want to choose the one you think is most beautiful, you want to choose the one you think most people will think is the most beautiful—or the one you think most people will think most people will think….

Our herd behavior probably made a lot more sense when we evolved it millennia ago; when most of your threats are external and human beings don’t have that much influence over our environment, the majority opinion is quite likely to be right, and can often given you an answer much faster than you could figure it out on your own. (If everyone else thinks a lion is hiding in the bushes, there’s probably a lion hiding in the bushes—and if there is, the last thing you want is to be the only one who didn’t run.) The problem arises when this tendency to follow the ground feeds back on itself, and our behavior becomes driven not by the external reality but by an attempt to predict each other’s predictions of each other’s predictions. Yet this is exactly how financial markets are structured.

With this in mind, the surprise is not why markets are unstable—the surprise is why markets are ever stable. I think the main reason markets ever manage price stability is actually something most economists think of as a failure of markets: Price rigidity and so-called “menu costs“. If it’s costly to change your price, you won’t be constantly trying to adjust it to the mood of the hour—or the minute, or the microsecondbut instead trying to tie it to the fundamental value of what you’re selling so that the price will continue to be close for a long time ahead. You may get shortages in times of high demand and gluts in times of low demand, but as long as those two things roughly balance out you’ll leave the price where it is. But if you can instantly and costlessly change the price however you want, you can raise it when people seem particularly interested in buying and lower it when they don’t, and then people can start trying to buy when your price is low and sell when it is high. If people were completely rational and had perfect information, this arbitrage would stabilize prices—but since they’re not, arbitrage attempts can over- or under-compensate, and thus result in cyclical or even chaotic changes in prices.

Our herd behavior then makes this worse, as more people buying leads to, well, more people buying, and more people selling leads to more people selling. If there were no other causes of behavior, the result would be prices that explode outward exponentially; but even with other forces trying to counteract them, prices can move suddenly and unpredictably.

If most traders are irrational or under-informed while a handful are rational and well-informed, the latter can exploit the former for enormous amounts of money; this fact is often used to argue that irrational or under-informed traders will simply drop out, but it should only take you a few moments of thought to see why that isn’t necessarily true. The incentives isn’t just to be well-informed but also to keep others from being well-informed. If everyone were rational and had perfect information, stock trading would be the most boring job in the world, because the prices would never change except perhaps to grow with the growth rate of the overall economy. Wall Street therefore has every incentive in the world not to let that happen. And now perhaps you can see why they are so opposed to regulations that would require them to improve transparency or slow down market changes. Without the ability to deceive people about the real value of assets or trigger irrational bouts of mass buying or selling, Wall Street would make little or no money at all. Not only are markets inherently unstable by themselves, in addition we have extremely powerful individuals and institutions who are driven to ensure that this instability is never corrected.

This is why as our markets have become ever more streamlined and interconnected, instead of becoming more efficient as expected, they have actually become more unstable. They were never stable—and the gold standard made that instability worse—but despite monetary policy that has provided us with very stable inflation in the prices of real goods, the prices of assets such as stocks and real estate have continued to fluctuate wildly. Real estate isn’t as bad as stocks, again because of price rigidity—houses rarely have their values re-assessed multiple times per year, let alone multiple times per second. But real estate markets are still unstable, because of so many people trying to speculate on them. We think of real estate as a good way to make money fast—and if you’re lucky, it can be. But in a rational and efficient market, real estate would be almost as boring as stock trading; your profits would be driven entirely by population growth (increasing the demand for land without changing the supply) and the value added in construction of buildings. In fact, the population growth effect should be sapped by a land tax, and then you should only make a profit if you actually build things. Simply owning land shouldn’t be a way of making money—and the reason for this should be obvious: You’re not actually doing anything. I don’t like patent rents very much, but at least inventing new technologies is actually beneficial for society. Owning land contributes absolutely nothing, and yet it has been one of the primary means of amassing wealth for centuries and continues to be today.

But (so-called) investors and the banks and hedge funds they control have little reason to change their ways, as long as the system is set up so that they can keep profiting from the instability that they foster. Particularly when we let them keep the profits when things go well, but immediately rush to bail them out when things go badly, they have basically no incentive at all not to take maximum risk and seek maximum instability. We need a fundamentally different outlook on the proper role and structure of finance in our economy.

Fortunately one is emerging, summarized in a slogan among economically-savvy liberals: Banking should be boring. (Elizabeth Warren has said this, as have Joseph Stiglitz and Paul Krugman.) And indeed it should, for all banks are supposed to be doing is lending money from people who have it and don’t need it to people who need it but don’t have it. They aren’t supposed to be making large profits of their own, because they aren’t the ones actually adding value to the economy. Indeed it was never quite clear to me why banks should be privatized in the first place, though I guess it makes more sense than, oh, say, prisons.

Unfortunately, the majority opinion right now, at least among those who make policy, seems to be that banks don’t need to be restructured or even placed on a tighter leash; no, they need to be set free so they can work their magic again. Even otherwise reasonable, intelligent people quickly become unshakeable ideologues when it comes to the idea of raising taxes or tightening regulations. And as much as I’d like to think that it’s just a small but powerful minority of people who thinks this way, I know full well that a large proportion of Americans believe in these views and intentionally elect politicians who will act upon them.

All the more reason to break from the crowd, don’t you think?

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