There’s an ongoing, long term argument about the nature of financial crises. Many believe that they’re caused by the underlying fundamentals of the economy, imbalances of various kinds, leading to failure. Others argue that the only fundamental is the inevitable hopelessness of human nature in the face of uncertainty: panic.
Of course, panic itself is a bit of a vague term, although it clearly refers to some kind of failure of collective nerve in the market. For a panic based model of financial crises to have any validity we’d need to link it to some of the more pervasive failure modes of human rationality. And, as it turns out, it's our need to feel in control and our urge to tell stories that leads us into the pit of financial damnation.
Where’s My Umbrella?
Perhaps the most balanced view of market crises is that taken by Itay Goldstein in Fundamentals or Panic: Lessons from the Empirical Literature on Financial Crises. As he points out it’s a bit too easy to simply argue that crises derive from one or the other:
“While evidence provides link between fundamentals and crises, it does not go against the panic hypothesis. As theory shows, fundamentals may trigger panic, and so panic acts to amplify the effect of fundamentals on the economy. Hence, the fundamental-based approach and panic-based approach are not inconsistent with each other.”
This, of course, is consistent with other evidence we’ve seen: often economic theory does explain economic events, right up to the point when it doesn’t. It’s the academic equivalent of the man who’ll lend you an umbrella in a dry spell but takes it away when it rains. Or a bank loan officer.
So it does seem to be the case that many financial crises are triggered by some kind of fundamental economic issue, but this isn’t exactly the same as saying that human nature is irrelevant. For panic to ensue in any given situation we need to understand how people co-ordinate their actions. In economic jargon it’s assumed that they exhibit complementarities: they mutually reinforce each others behaviour and cause some kind of contagion effect.
But the question is, how might this occur?
A couple of recent papers suggest possible mechanisms. In Public Information and Coordination: Evidence from a Credit Registry Expansion Andrew Hertzberg, Jose Maria Liberti and Daniel Paravisini show that the introduction of public disclosure of lending policies is enough to cause an increased rate of default in firms close to financial distress. In essence, lenders coordinate their behaviour not in response to each other but in response to an external event. This, the so-called public-information multiplier, implies that public information may have a larger effect than the same information held privately.
The key point about this is that it forms a natural experiment that shows that investors are more likely to withdraw their cash if they think that others are going to. This is the kind of behaviour that causes and exacerbates bank runs and other financial crises.
A second paper, Payoff complementarities and financial fragility: Evidence from mutual fund outflows by Qi Chen, Itay Goldstein and Wei Jiang shows a similar effect of complementarities in US mutual funds, where the expectation of investors withdrawing monies from a fund, usually in response to poor past performance, leads to other investors withdrawing funds. The effect is exacerbated in funds which are illiquid, which is as you’d expect because the value of illiquid funds will be more damaged by withdrawals than those of liquid funds. Meanwhile the effect is seen less in funds with large or institutional investors, presumably because they’re relatively sanguine about complementarities because they control large swathes of the assets and recognize that the impact of other investors withdrawing funds is relatively limited.
In essence what’s being demonstrated here is a self-fulfilling prophesy: the more likely investors are to think there’s going to be a problem the more likely it is that they will cause one. Worse, perhaps, it suggests that open ended mutual funds are particularly vulnerable to this kind of problem because they’re committed to paying back investors on demand.
While none of this is conclusive it certainly suggests that panic, or at least a co-ordination of beliefs that amounts to panic, has some kind of role to play in financial crises over and above any issue of fundamentals. So the next question is how does this relate to the mixed up psychology that tends to typifies human interactions with money.
Anat Bracha and Elke Weber try to answer this in A Psychological Perspective on Panic:
“We argue that the human need for predictability and control is central to a psychological account of panics. Confidence in a system such as a financial market results when investors believe they understand how things work, which leads to a sense of predictability This sense of predictability gives investors a feeling of control, which then legitimizes further opportunity seeking (reaping benefits while avoiding catastrophic losses) that is often riskier than it is perceived to be”
So, in essence we are psychologically inclined to ignore the fundamental uncertainty inherent in the universe because we have to believe that we understand the world around us, that we can predict the future and control our lives. Unfortunately this isn’t true and when it all goes wrong:
“Events that destroy this sense of predictability and perceived control trigger panics, the feeling that crucial control has been lost and that the future is unpredictable, and hence, dangerous. Resulting behavior, including a retreat to safe and familiar options, aims to minimize exposure to such danger until a new model of how things work has been established”.
Bracha and Weber pinpoint the illusion of control as the critical factor in financial panics and suggest that this is implemented through the creation of mental models explaining the world. We know these models as “stories” or “narratives”, and they’re typically affected by confirmation bias such that we generally fail to test for breaches of the model. The net effect of this is to cause overconfidence most of the time and a disproportionate negative reaction when things go wrong: we’re simply not prepared for when the models fail.
Whereas most economic modelling of the way humans update information assumes Baysian reasoning and a smooth, moderated updating of beliefs what an illusion of control based narrative model gives us is a set of manic depressive swings from elation to despair, and back again. Our view of the world is dichotomous, it’s either all bad or all good and when our beliefs about our levels of control are breached we swing from high to low.
All this is especially likely to happen after long periods in which our narrative models have received constant positive feedback and will often initially lead to denial of changed circumstances. As we saw in The Zeitgeist Investor this is a typical cycle for stockmarkets – long periods of stability interrupted by shorter episodes of rapid change. Nothing could be better for causing an overreaction, either upwards in joy or downwards in despair.
Nothing New In The Market
Of course we kind of knew all this already, but getting our hands on some actual evidence is always a plus. When we lose control through some epoch shaking financial event we co-ordinate ourselves through our anticipation of what others will do. Our concept of theory of mind allows us to predict what other people will do in any given situation and, thus, our very humanity triggers the panic that dominates markets.
But while fundamentals may be the trigger ultimately it’s human nature that causes the panic. Which means that just when we’re feeling most in control is when we should be most fearful. Nothing new here, time to pass right along.