Thursday, January 21, 2010

The twisted economics of finance

I was reading this article the other day in the New Yorker about the aftermath of the financial meltdown last year. Since it's actually only available for subscribers, a quick summary might be: lots of "Chicago-school" economists have radically changed their thinking about the economy since the crash, and those who haven't are crazy. These economists were the dominant intellectual force behind the successful laissez-faire, pro-market, anti-regulation economic policy crusades of the 80s onward.

In the article, author John Cassidy talks about "rational expectations" theories of economics, which, simply put, hypothesize that people have a "true" model of the economy in their little heads and factor in all the variables of this model (whatever the hell it may actually be) when they make economic decisions. One of the economists in the story, Eugene Fama, claims that in the stockmarket, people's behavior, both in the run-up to and aftermath of the financial crisis, was largely rational. This claim is insane for a few reasons, but it reminded me specifically of an argument my father and I had with my mother some ten years ago about stocks (my mother, by the way, is a real life economist, but not a crazy one).

As far as I can tell, the principal reason people buy stocks is that they expect other people to find that stock more desirable in the future and pay a higher price for it. Those people, in turn, pay a higher price for it for precisely the same reason. Now it's possible that I don't understand stock ownership that well, but to my knowledge owning a stock in company x gives you a stake in that company in only a vague and narrow sense. Since it doesn't give you much real power in the actual operation of the company, the stock has little to no intrinsic value. [I suppose this isn't true if you own a large percentage of the shares, right? How does that actually work? How much power do individual shareholders have? Another note: I suppose the other major exception is any anticipation that some other shareholder/individual/company will buy out the company in question, in which case your stake in the company does have concrete value. How much a factor is this really though?]

I know that some stocks also pay out modest dividends, but my intuition is that people "invest" in the stock market hoping to make a long term profit on their shares. For whatever reason they expect the "value" of the stock to increase. Generally that reason is rationalized as "the financial success of the company," but that rule only makes sense if everyone simultaneously accepts it. There's nothing wrong with a system like this one based on public trust (the whole system with money seems to work well in similar fashion). However, it has little to do with people having any knowledge about the economy as a whole when they buy a stock, and it also leaves the system particularly prone to irrational speculation and frightening crashes, precisely because people's behavior is motivated largely by their perceptions of and assumptions about other people's behavior, rather than objective facts or models.

People are always making judgments with other people's biases in mind, and so in theory any part of the economy could become the object of speculation. This is also why "rational expectations" theory is so absurd. But it still seems that the purely financial sectors of the economy are more prone to expectation-biased behavior, since the money isn't invested with any productive intent, but purely with the intent of making more money. A strong argument for a financial transaction tax?

As a side note, judging from recent testimony before Congress, CEOs of the big financial companies have no intention of taking responsibility for the financial crisis, nor of supporting real financial reform. They persist in their denial of a complex social and psychological economy. What they also don't realize is that although the politics of the moment seem to be on their side, the politics of the next crisis certainly won't be. I don't think Americans will have the stomach for another round of bailouts, and our spite could result in a much worse crisis next time around if the whole financial system is allowed to collapse. Let's hope it doesn't come to that anytime soon.

1 comment:

  1. Sam: From your economist mother. Nice write-up. Our argument illustrated the dilemma. I was right that ONE consideration of stock market investors is (or used to be) that the company whose stocks they bought would make profits -- issuing dividends. But you and Dad were right in reading the psychology at the time -- that lots of people were investing because they knew other people were investing and the price would keep rising. Of course this problem was far worse for the housing market, which is less liquid (more sticky) than for the stock market --whose decline has reflected not contributed to the economic crisis. One point, not in their defense but just to clarify the idea of the rational expectations school. Their argument is best understood via this example: if the government tries to "grow" the economy by increasing deficit spending, everyone will anticipate and adjust to the impending inflation, undermining the intended stimulative effect. This is of course the polar opposite of Keynes' demand management. . . .