Guest Post: Rationality and Fragility in Financial Markets

Rajiv Sethi

In a recent paper on financial innovation and fragility, Gennaioli, Shleifer and Vishny argue that investors (and often also financial intermediaries) are hobbled by certain systematic cognitive biases that cause them to neglect unlikely events when assessing asset values. They argue that such “local thinking” results in the creation and excessive issuance of engineered securities that are widely believed to be close substitutes for more traditional safe assets, but turn out to be much riskier than initially anticipated. This psychological regularity, they believe, accounts for a number of historical episodes of financial instability:

Many recent episodes of financial innovation share a common narrative. It begins with a strong demand from investors for a particular, often safe, pattern of cash flows. Some traditional securities available in the market offer this pattern, but investors demand more (so prices are high). In response to demand, financial intermediaries create new securities offering the sought after pattern of cash flows, usually by carving them out of existing projects or other securities that are more risky. By virtue of diversification, tranching, insurance, and other forms of financial engineering, the new securities are believed by the investors, and often by the intermediaries themselves, to be good substitutes for the traditional ones, and are consequently issued and bought in great volumes. At some point, news reveals that new securities are vulnerable to some unattended risks, and in particular are not good substitutes for the traditional securities. Both investors and intermediaries are surprised by the news, and investors sell these “false substitutes,” moving back to the traditional securities with the cash flows they seek. As investors fly for safety, financial institutions are stuck holding the supply of the new securities (or worse yet, having to dump them as well in a fire sale because they are leveraged). The prices of traditional securities rise while those of the new ones fall sharply.

The authors claim that this sequence of events describes not only the recent experience with collateralized debt obligations and money market funds, but also earlier episodes of financial innovation, including prepayment tranching of collateralized mortgage obligations in the 1980s.

In order to explore precisely the implications of local thinking in the context of financial innovation, the authors construct a model based on a number of stark, simplifying assumptions. There are two assets: a traditional safe security and a risky asset that has three possible terminal payoffs. The worst case outcome for the risky asset is also the least likely to occur (this is a crucial assumption). Investors are homogeneous and highly risk averse. Financial innovation takes the form of separating the cash flows from the risky asset into two components: a “safe” security that earns the the worst case payoff regardless of the actual outcome, and a risky residual claim. Under rational expectations this innovation is welfare improving, and the quantity of the substitute issued is precisely such that all such claims would be covered even if the worst case loss were to materialize. That is, the substitute security really is safe.

Under local thinking, the least likely event (which is also the worst case outcome) is simply neglected, and beliefs about the other two outcomes are correspondingly inflated. The intermediate outcome is now (mistakenly) perceived to be the worst, and a greater quantity of the substitute security is issued than could be honored if the actual worst case outcome were to be realized. Now suppose that some bad news arrives, conditional on which the objective probabilities of the three outcomes are altered in such a manner as to make the intermediate outcome the least likely. Local thinking then causes investors to become excessively pessimistic: the worst case outcome not only becomes suddenly salient, but the less disastrous intermediate outcome is neglected and the decline in the price of the asset previously thought to be safe is greater than it would be under rational expectations.

The development of a theoretical framework within which common elements of various historical episodes can be examined is clearly a worthwhile exercise. But what troubles me about this paper (and much of the behavioral finance literature) is that the rational expectations hypothesis of identical, accurate forecasts is replaced by an equally implausible hypothesis of identical, inaccurate forecasts. The underlying assumption is that financial market participants operating under competitive conditions will reliably express cognitive biases identified in controlled laboratory environments. And the implication is that financial instability could be avoided if only we were less cognitively constrained, or constrained in different ways — endowed with a propensity to overestimate rather than discount the likelihood of unlikely events for example.

This narrowly psychological approach to financial fragility neglects two of the most analytically interesting aspects of market dynamics: belief heterogeneity and evolutionary selection. Even behavioral propensities that are psychologically rare in the general population can become widespread in financial markets if they result in the adoption of successful strategies. As a result, asset prices disproportionately reflect the beliefs of investors who have been most successful in the recent past. There is no reason why these beliefs should consistently conform to those in the general population.

I have argued previously for the further development of this ecological perspective on financial instability, and similar themes have been explored elsewhere; see especially Macroeconomic Resilience and David Murphy. As I said in an earlier post, a bit too much is being asked of behavioral economics at this time, more than it has the capacity to deliver.

Print Friendly, PDF & Email

15 comments

  1. craazyman

    Oh Lord. When it comes to analysis of intrinsic cognitive bias, PT Barnum put it simply, using only six words:

    “A sucker is born every minute.”

    That’s really all one needs to know . . .

    In the meantime, if folks can get university jobs writing this sort of stuff, well, they are lucky indeed. ha hahaha haha.

    1. Glen

      Amen to that. And never forget it’s kissing cousin:

      Greed is good.

      Most of our economic implosion can be traced to a mad race to the bottom looking for suckers and easy money:

      Outsource to China even though labor costs only 5% of product cost and outsourcing means you eventually lose control of the technology and the market?

      Done.

      Spend less on R&D than the CEO’s salary and bonuses?

      Done.

      Sell worthless but AAA rated CDOs/CDSs to chumps and bet against them?

      Done.

      Make taxpayer bail you out when you explode the world’s economy?

      Done.

  2. Tom Crowl

    Good piece…

    And good point!

    CERTAINTY in the social sciences regarding complex/chaotic systems IS NOT a mark of WISDOM.

    While he lacked the ‘proper’ credentials, a quote from this well regarded social scientist may be in order:

    In theory there is no difference between theory and practice. In practice there is.
    Yogi Berra

  3. DownSouth

    I don’t find this to be a terribly enlightening post. In the end, doesn’t it boil down to the pot calling the kettle black?

    What Sethi offers us is a defense of classical economics. Behavioral economics mounts an attack on homo economicus, the rational self-maximizer that stands at the core of classical economic theory.

    But instead of admitting the obvious, which is that homo economicus has about as much basis in factual reality as the big bearded man sitting on his throne in heaven, Sethi instead hones in on the deficiencies of behavioral economics. So what Sethi ends up giving us is error vs. error, wrong vs. wrong. I agree with Sethi that behavioral economics has its deficiencies. What I disagree with is that pointing out these deficiencies constitutes a defense of orthodox economic theory.

    Perhaps Sethi’s highly reductionist and simplistic worldview is best illustrated in the following paragraph:

    This narrowly psychological approach to financial fragility neglects two of the most analytically interesting aspects of market dynamics: belief heterogeneity and evolutionary selection. Even behavioral propensities that are psychologically rare in the general population can become widespread in financial markets if they result in the adoption of successful strategies. As a result, asset prices disproportionately reflect the beliefs of investors who have been most successful in the recent past. There is no reason why these beliefs should consistently conform to those in the general population.

    Sethi is undeniably a child of the age of the individual. But the reality is that “evolutionary selection” is far more complex than Sethi’s classical economic ideology holds, which focuses strictly on the individual. Sethi asserts that “asset prices disproportionately reflect the beliefs of investors who have been most successful in the recent past.” The emphasis here is solely on individual (i.e. individual investor) fitness as opposed to group fitness.

    That the selfish and predatory behaviors of Goldman Sachs (to take the most notorious example) have been successful for certain individuals who work for Goldman is undeniably true. And it is also true that most in the world of finance have emulated these behaviors. But what are the implications for long-term group survival, for the eventual success of the broader society, of these behaviors? And what good does it do to be the most successful individual within a group, only to later have the entire group perish?

    It has repeatedly been demonstrated that classical economic theory has no answers to these questions. And Sethi certainly provides no new insights here, but instead falls back on the dogmas of classical economic theory, which are based more on a quasi-religious faith than any this-world reality.

    1. Mickey Marzick in Akron, Ohio

      Down,

      You mean to say that Lloyd Blankfind isn’t doing God’s work after all, just John Calvin’s and to HELL with the rest of US “looters”? Say it ain’t so…

      Cuidado!

  4. Ronald

    “Many recent episodes of financial innovation share a common narrative. It begins with a strong demand from investors for a particular, often safe, pattern of cash flows.”

    Exactly who are these investors? Political and financial elite using various parts of the financial plumbing system to create easy money? The creation of financial engineering products are sold as necessary for economic growth but in reality they are intended for the purpose of skimming off the top. The creation of credit to pump up GDP has fostered an economic illusion and that illusion is showing real signs of disappearing.

    1. Tom Crowl

      You’re absolutely right!!!!

      We’ve had a multi-decade covert ‘welfare system’ for a class of people who claim to be all about ‘individualism’ and the ‘magic’ of the unregulated market.

      I’m much in agreement with (and participating in) an ecological/biological approach to economics and social questions in general…

      Decision Technologies: Currencies and the Social Contract
      http://culturalengineer.blogspot.com/2010/07/decision-technologies-currencies-and.html

  5. Mickey Marzick in Akron, Ohio

    “…the implication is that financial instability could be avoided if only we were less cognitively constrained, or constrained in different ways — endowed with a propensity to overestimate rather than discount the likelihood of unlikely events for example.”

    But wasn’t VAR and the development of securitization intended to reduce just such a propensity – to discount the likelihood of a default/failure. But once the initial roll out had proved successful and was followed by several successive reiterations there was no reason to – rational expectations [group think] – to think otherwise. Besides did anyone even understand the process at this point?The “herd” stampeded and naysayers were either trampled or left behind in the dust. But along the way fortunes were made and squirreled away before the herd ran off the cliff. Then as the carcasses rotted the “few” left to scavenge made even more…

    Key to this, however, was the role of the guardians – both private and public – in the process. Aren’t they discharged with the responsibility to look for the “unlikely event” that could lead to systemic financial instabillity? But when the “guardians” themselves have been swept up in the stampede behavioral economics is woefully inadequate or too late to the party to see the black swan because its focus is only on some of the players and not necessarily the most important ones which brings us back to ECONNED. Namely, how narrowly construed theories elegant in their simplicity confined to academic journals captured both investors and guardians alike in the real world over the course of the past four or five decades.

    But now the “group think” – not ECONNED – has us believing that the theories underlying this experiment and the subsequent policies implemented to achieve them FAILED. NO, they actually SUCCEEDED. Free-market capitalism is neither in theory nor in practice intended to lift everyone’s boat. The very SUCCESS of this variant of capitalism brought us financial instability. Not its FAILURE. The business cycle – boom and bust – is historically the period of free-market capitalism, isn’t it? Prosperity followed by financial collapse [PANIC]… 1792, 1819, 1837, 1857, 1873, 1907, 1929? The only difference now is that the regulatory regime ensures that the winners remain winners and their losses become the taxpayers’ problem, strongly suggesting that markets are neither free nor “capitalistic”. Prior to this regime, many a capitalist went to the wall…

    The cognitive inabilty [dissonance? myopia?] to see this is perhaps the real constraint to be explained by this propensity not to look for the likely event, however unlikely it may seem. Behavorial economics devoid of historical context, in contrast to Yves’ much broader ecological context, will remain woefully inadequate as a result.

  6. dr

    “certain systematic cognitive biases that cause them to neglect unlikely events when assessing asset values”

    lol…

    It’s called a public bailout-all fat tail risks are assumed by the sovereign.

  7. Hugh

    “Hobbled by certain systematic cognitive biases” that make them discount risk, this used to be called “blinded by greed”. As for “innovations”, insert scams and for “fragility” insert bubbles and the post reads much more easily.

    My take on what is being said here is because you have different kinds of bubbles you can’t predict the scams that are being used as buy ins to them because they too will vary.

    Personally, I think this completely misses the point. Bubbles are dead easy to spot. They can be seen years in advance of their peaks, let alone of their bursting. A bubble has to be huge to have an effect on markets. So really all you need to do is watch out for things with a potential to go big and where the math makes no sense or the assumptions are impossible. You can nip some bubbles in the bud, simply because conceptually there is no way for them to work. Others you can catch in their early phases, long before they become dangerous. I have never seen a bubble creep up on markets and explode on them unawares.

    1. jdmckay

      “Hobbled by certain systematic cognitive biases” that make them discount risk, this used to be called “blinded by greed”. As for “innovations”, insert scams and for “fragility” insert bubbles and the post reads much more easily.

      Hugh dude…

      These professionals went into their lab and worked hard on this paper. When you summarize this detailed analysis as “blinded by greed”, IMO you cross dangerous line from professional analyst >> truth… a domain necessarily avoided at all costs as it contaminates and corrodes the functioning of free markets.

      Additionally, I think you are missing 3rd prong of author’s and/or study’s insightful discovery… this hitherto, unrevealed phenomena they call (drumroll):

      local think

      Yup, just like fisherman have boats, cowboys wear boots, so it is that bankers… free from shackles of regulation and prudence, steal all the money they can get their grubbies on and don’t seem to know any better. His brilliant good fund/bad fund model demonstrates these Pavlovian Poodles are really one trick ponies.

      I shouldn’t have to spell it out for you, but I think the authors are trying to tell us that, as a responsible society, if we had intervened locally when these wayward youth were merely punks attending Young Republican/Federalist Soc. Meetings at Harvard Law school, we could have pointed out their myopia so that, before they bought up all the media, all the politicians, corrupted the accounting process, stole elections, took all the judges on junkets for “education”… eg. before they became biggest criminal organization in the history of humanity… we could have saved their sorry asses.

      The authors are trying to tell us that we have failed these poor bastards… you & me, we just didn’t care enough.

  8. scharfy

    In theory there is no difference between theory and practice. In practice there is. – yogi berra

  9. Ray Phenicie

    I find it amazing that the powers that be in the world of American finance, ignored so many warning signs posted all around the world wide web that the financial system was about to self destruct long before it actually did go over the edge. Gabriel Kolko is a pretty smart guy. Smarter than Hank Paulson, Ben Bernanke or Barak Obama.
    What the posts below show is that more often than not, the upper echelon in this country are on a pathological, suicide mission and don’t give a ______ about anyone else as long as they have the opportunity to make a few bucks and finance the wife’s mink coat. Strange that a few hundred people can hurt millions of others and destroy a system.
    Signs of dementia exist everywhere I look.

    Why a Global Economic Deluge Looms
    http://www.counterpunch.org/kolko06152006.html

    July 26, 2006
    Bankers Fear World Economic Meltdown
    http://www.counterpunch.org/kolko07262006.html

Comments are closed.